Transparency has become the new normal in a society that demands greater accountability. Look no further than companies like Equifax, Wells Fargo, Chipotle, Uber and Wynn Resorts, and it becomes easy to understand why many investors have felt the heat of unaddressed risks and increased stakeholder expectations.
While the May/June issue of Middle Market Growth focuses on impact investing, environmental, social and governance management occupies a neighboring and broader stage of the same continuum. Impact investments are made into companies, organizations and funds with the intention of generating positive social and environmental impact alongside a financial return; meanwhile, ESG management is the inclusion of environmental, social and governance considerations in traditional investments to reduce risk and increase returns.
ESG management has been used as a broad concept by the investment community to describe a range of investment factors related to environmental stewardship, social equality and ethical governance. There tends to be significant misconception, so it is worth breaking down what ESG management is and what it isn’t.
ESG management is not:
- A driver of broken deals nor lower investment returns
- A “box-checking” exercise nor reporting headache
- The same set of risks and issues for every transaction
Rather, ESG management is a set of practices:
- Aimed at creating long-term value, mitigating risk and protecting reputation
- Integrated into existing investment processes and led by investment professionals
- Expected to be a permanent part of the private equity landscape
“No longer classified as exotic concerns to be addressed outside the investment process, ESG issues have found their place in middle-market investing, and private equity firms in the lower middle market are starting to take note.”
A common misunderstanding among investors has been that ESG management is focused primarily on environmental performance and only relevant to heavy industry operations, such as paper mills and refineries. However, social and governance risks and incidents cut across all industries and are just as likely to push companies into headlines, protracted lawsuits or a regulator’s crosshairs. Amplified by unprecedented transparency through social media, companies face greater risk exposure with a larger impact than ever before.
Across industries, material ESG risks are most commonly found in the following areas of operations:
- Data privacy and security
- Labor and environmental practices in the supply chain
- Ethics and compliance
- Social and labor conditions
- Diversity and equal employment opportunity
- Worker health and safety
- Anti-bribery and -corruption
- Environmental performance
- Other areas
Malk Sustainability Partners conducted an ESG review of a company that was generating a large portion of its revenue from government customers. Previously, an employee had filed a complaint alleging that the company was acting unethically by exaggerating a partnership with a minority business enterprise arranged to be eligible for government contracts that mandated a percentage of spending with minority business enterprises. The company fired the employee, who subsequently led a legal claim against the business; the matter was settled out of court.
Impact and Value
The legal diligence team saw the settled claim and deemed the issue no longer a risk, whereas Malk saw it as evidence of a larger problem. Using a minority business enterprise to be eligible for a government contract, without that business performing actual work on the contract, is a serious violation. Furthermore, Malk found that the company did not investigate the former employee’s complaint, signifying either a careless attitude toward ethics matters or intentional disregard for unethical behavior. The issue of exaggerating the true nature of the partnership, if unresolved, could result in sanctions, fines, loss of contracts and debarment from government contract programs.
ESG Comes into Focus
Risk management, reputation preservation and value creation drive ESG management for fund managers. Investment professionals are recognizing that ESG due diligence reviews enhance visibility on operational risk and management capability and, furthermore, that such scrutiny should continue throughout the ownership period. In addition to wanting to better size up risk, GPs are looking to satisfy growing investor expectations. Most firms heading to market today can expect to receive ESG questions from pension funds, LP consultants and some endowments. Firms may even be asked to sign an ESG side letter with firm-level commitments. It’s hard to imagine a future where LP pressure is not greater than today.
No longer classified as exotic concerns to be addressed outside the investment process, ESG issues have found their place in middle-market investing, and private equity firms in the lower middle market are starting to take note. The most successful, and fruitful, ESG efforts are marked by steady adoption across the firm and consistent practices in the core of the investment process.
This article originally appeared in the May/June 2018 addition of Middle Market Growth. Find it in the MMG archive.