Being Responsible

Do people invest responsibly because they think they should, because someone else has told them to, or because they think it will result in better returns?

For the private equity industry in Europe, and perhaps elsewhere, there are arguments in favor for each, along with a swell of opinion and research showing that more LPs are demanding responsible investment criteria. Meanwhile, more GPs are abiding by them, as more institutional investors are writing such criteria into their governance manuals.

Some argue that banging the drum for responsible investing is little more than a fashion statement, aimed at bringing in more business during a lull in the market, a marketing exercise to window-dress investment opportunities. But for many of the influential private equity players, responsible investment is part of a long-term trend.

“We see this as a shift that’s been going on since World War II,” says Alan MacKay, CEO of Hermes GPE. “It’s a long-term trend towards doing things more efficiently, with minimal waste, not damaging the culture or nature in which you work.”

MacKay chairs the British Venture Capital and Private Equity (BVCA) advisory board on responsible investing, which has launched its inaugural Responsible Investment Awards this year and which the organization will present in October. MacKay believes that the issue of responsible investing has continued to grow in importance, and it is not at the point where it is impossible to ignore.

“Board members at pension funds and insurers are asking for reports from the people they give money to,” says MacKay, who notes that more PE firms are indeed providing the reports.

Mackay says that there is a renewed focus on responsible investment in 2011 because public companies are adopting stronger corporate and social responsibility standards.

Skeptics say that, in a troubled market, sale prices are less likely to reflect investment in socially responsible investing and more what a buyer can get away with, or a seller will reluctantly accept. But Mackay is convinced that the economics of ethics now play a tangible role in many company transactions.

Another objection to PE firms concentrating on environmental, social and corporate governance (ESG) issues is that they could lose agility and speed, but Mackay argues that the benefits outweigh the disadvantages.

Hermes GPE has invested in more than 200 companies, and MacKay says that he has seen dozens of cases in which involved parties have considered ESG issues, such as not using child labor in the manufacturing process.

“There are many examples where private equity has intervened and said, ‘We’re going to do this, because it can make the environment or society better,’” he says.

The BVCA awards this month specify areas where private equity firms can demonstrate their commitment to responsible investing, such as having a house policy on ESG matters; providing examples of improvement to the environment; considering social impact and governance standards; and showing a commitment to engage with other stakeholders on ESG matters.

Mackay says the responsible investment awards are built on initiatives from the United Nations, such as its Principles for Responsible Investment, introduced in 2005 and now widely adopted by many private equity firms and other investors.

Pension funds, such as the $15.5 billion Danish-based Unipension have embedded the UN principles into its tender documentation, following demands from its members for more ethical investment.

“I cannot be sure that following ethical guidelines will produce higher returns, but I want to reduce the risks we hold,” says Niels Erik Petersen, CIO of Unipension. “We do this by active engagement with companies wherever it makes sense.”

I cannot be sure that following ethical guidelines will produce higher returns, but I want to reduce the risks we hold. We do this by active engagement with companies wherever it makes sense.

Niels Erik PetersenCIOUnipension

Some investment boards refuse to pursue deals if they identify serious ESG issues, partly for fear of the consequences.

“If you’ve got any environmental or social governance factors wrong it massively increases the risks when private equity firms come to exit a business,” says Claire Wilkinson, general counsel for MVision Private Equity Advisers.

She argues that such checks have been part of the due diligence process for small investment houses for some years, while larger firms have only come to the practice more recently. Private equity firms commonly employ consultants to ensure the management team has ESG issues at heart, and will pay proper attention to the environmental and social impact of supply chains.

Weighing the risks of investment choices takes a clear head and sage advice.

Mark Harrison, director of publications at the Chartered Financial Analyst Institute, argues that in some cases, investment decisions are taken by people who have been appointed according to a political agenda.

“For some, incorporating sustainability principles can become a political act unrelated to the interests of [investors],” he says.

Harrison warns against the urge to place too high a stress on socially responsible investing or ESG factors, since the process can be expensive and time-consuming, reducing profit and meaning that investment opportunities are lost.

He also says that if ESG factors are applied to investment decisions generally, “it inevitably affects the distribution of portfolio risks,” just as investing purely in Islamic funds or in a specific industry sector would affect one’s risk profile.

“Such risks can become dangerously concentrated,” Harrison says.

For evangelists of responsible investment, this argument probably sounds like saying you should be sure to worship the devil some of the time, in case heaven doesn’t exist.

Mackay of Hermes GPE says that he can see only an upside to responsible investment and points to buyout firm Doughty Hansen, which has embraced the practice, and Kohlberg Kravis Roberts & Co., as firms that are paying attention to ESG.

But that’s not the thrust of BVCA’s awards, according to Mackay.

“It’s not about making the good guys better, it’s about making everyone be more careful of the communities where they work and making a stronger economy for everyone,” he says. “Then we’ll see whether it’s worthy of recognition.”

David Nicholson is a London-based contributor. He can be reached at dn@davidnicholson.com.