Global Compact International Yearbook 2015

Agenda
Financing Sustainable Development
Private equity has often been criticized for a variety of reasons,
both good and bad. There has been valid criticism of cases
where a quick exit generated better returns, or where issues
of sustainability were ignored. Private equity firms have taken
advantage of these opportunities, but I would say in their
defense that this is exactly what they have been asked to do
and incentivized to do. This industry is indeed moving away
from this unilateral, unidimensional incentive scheme that
basically has an exclusive focus on returns for its investors,
and private equity firms are starting to consider additional
factors involving CSR and sustainability, but the changes are
happening very slowly. There’s a hybrid process going on, where
the core objective is still to maximize returns on equity, as
written in the contract – this is where the monetary rewards
are, after all – but we’re seeing an express desire to bring
more sustainability considerations into limited partnership
agreements, in which the institutional investors get together
and agree with the fund managers on the broad elements of
which investments are going to be made.
This is happening in baby steps: Recall the famous cases after
several tragic high school shootings occurred in the United
States, when certain public pension schemes tried to pull out
of the funds they owned because they realized that the controlling
stakes these funds held in major gun manufacturers were
clearly not in line with their own ethical investment objectives.
Whereas these schemes would pull out of such assets
after the fact, now they would put clauses into their limited
partnership agreements with those funds to this effect, stating
that certain investment types are to be considered unethical,
irresponsible, and not in line with their investment criteria
as institutional investors.
But such progress is only incremental, in the sense that these
limited partners are merely attempting to identify some areas
that should be off-limits and then restricting the investment
activities of these funds in those areas. I have not seen any
wildly successful efforts to put anything close to a triple bottom
line or a balanced scorecard or what have you that would
add hard measures of sustainability to these agreements. At
the end of the day, this is a financial industry: People react
to the incentives they set. We should not be surprised that
their behavior is first and foremost in line with what these
incentives prescribe.
Nevertheless, the private equity industry has recognized
that while sustainability issues are not necessarily an end
in themselves, they do play an important role in mitigating
investment risk and creating more sustainable and better
businesses in the long run. Several private equity firms have
gone out of their way to integrate objective CSR criteria and
CSR reporting into their investment considerations. KKR, one
of the leading global firms, is at the forefront of this, as is
Doughty Hanson in Europe. Doughty Hanson actually piloted
some initiatives in this area in collaboration with the WWF,
issuing regular reports on the sustainability and CSR-related
impact of various investments. But these efforts at CSR in private
equity are sporadic; the companies undertaking them are
isolated players who are aware of their reputational benefits,
but they also know that this is the right thing to do and that
it’s in everyone’s best interest to mitigate investment risk of
any kind. But the industry has not yet arrived at a consistent
standard for reporting that is incentivized or that explicitly
integrates CSR considerations into the partnership contracts
that influence private equity’s investment behavior.
Isn’t this a structural problem? The financial markets reward returns
on investment, not returns on integrity. Is the whole system – with all
its incentive schemes – capable of achieving aspects of sustainability?
Gottschalg: I have no doubt that things will move in the direction
of responsible investment and sustainability eventually,
but the fundamental challenge goes back to the old saying,
“Whatever gets measured gets managed.” A few of the larger
investment managers have signed the UN’s Principles for
Responsible Investment, which is a great sign. But the middle
managers at such firms still represent a big question mark: If
I’m in their position, and not running a private equity fund,
then my incentive scheme is basically getting some revenue
from the management fee. There’s no tangible benefit to me
from considering sustainability. I get one-fifth of all the value
created in my investment – that is the measurable element,
the hard number. If I make a billion in surplus, I get 200
million to distribute to my partners. That constitutes a very
high-powered incentive scheme.
Once we try to alter this and create incentives for other concepts,
like CSR, it adds enormous complexity. Say you’re having this
discussion as an activist shareholder with Nestlé, or Nike, or
Apple – these are all complex organizations, but they have
a somewhat homogeneous business model: You can identify
the key sources of their carbon footprint, social footprint,
environmental footprint. You can work with them to identify
where their footprint is the most harmful and where the most
effective sustainability measures should happen, and come
up with an incentive scheme that would reward progress on
such measures.
Now imagine a private equity fund. A large private equity fund
may simultaneously hold a whole portfolio of companies with
a huge carbon footprint, including coal-fired power plants or
businesses active in areas where fracking is happening. Add to
this renewable energy wind parks, a computer manufacturer,
some service businesses, and a retailer. Remember, this is a
portfolio at just one fund, so they own these businesses indirectly:
Most of them are controlling stakes, but some of them
are minority stakes. These are discrete investments, the fund
has the choice to own them or not to own them.
Global Compact International Yearbook 2015 49