The old view of private equity investors as ruthless asset strippers is due an update
It wasn’t so long ago that private equity businesses were classified by some as the “barbarians at the gate”. Rapacious capitalism at its worst, busily snapping up much-loved high street brands and cynically stripping out everything that could not be used to bump up short-term value before selling it back into the market.
Then the era of cheap debt came to a close, and suddenly the flow of buy-outs dried up. The critical stories did likewise. Recent protests against Blackstone Group over the collapse of elderly care home operator Southern Cross seemed almost nostalgic.
Things have moved on considerably. The private equity companies have begun to show some real changes on what the sector routinely describes as ESG (that’s environmental, social and governance) issues. And they have risen robustly to defend the sector’s business model against charges that it is inherently bad for society.
In the wake of the financial crisis, the focus has been on responsible investment, and the potential for ESG issues to become a significant factor in realising the value of investments.
At the launch of the UN Principles for Responsible Investment (PRI) in 2009 at a private equity industry conference in London, a survey showed that 71% of the attendees agreed that ESG factors could affect the sale price of a company at exit. This reflected a considerable change in attitude over a short period.
The British Private Equity and Venture Capital Association (BVCA), which conducted the survey, identifies a number of drivers for responsible investment among its members. These include risk management, business opportunities and growing investor demand, with more than 330 asset managers signing up to the PRI.
There are many who say that, at least on the risk management side of the equation, this is not such a new agenda for private equity.
Ludo Bammens, director of corporate affairs for KKR, says: “Environmental assessment has always been a part of the due diligence process. But in recent years it has become important to carry this out in an increasingly thoughtful and professional way.”
How much can ESG issues influence whether a private equity firm chooses to invest in a company? It all depends on how material those issues are to whether or not the value of the company can be increased. Brammens says it can play a key part. Over the course of a year KKR will examine “a thousand potential investment opportunities”, of which only 2% will actually go forward. The company’s ESG diligence team reviews all the investment proposals as part of a filtering process.
Simon Havers, chief executive of Baird Capital Europe, says there is a simple two-part test that Baird will apply to a prospective investment. “First, is the company’s reputation irremediably shot? Second, is it in our capability to solve it? We would avoid prospects that have the wrong answer to either of those two.”
The test allows for the fact that a smart private equity investor can use the process of fixing an ESG problem as part of the process of value creation.
Baird demonstrated this when it bought Paddock Holdings from its founder in 2006. Baird was interested in the company because it saw that it was “operationally undermanaged”. This included a pretty poor health and safety record. Paddock had form both on non-reportable accidents (relatively minor) of which it had significant numbers, and reportable accidents (major).
During Baird’s ownership, substantial changes were made, including putting in a more effective operations director. Non-reportable accidents were cut by two-thirds. No reportable accidents took place during the course of Baird’s ownership.
When Paddock Holdings was sold by Baird in 2010, it had shown a 2.7-fold return on investment. That would certainly have been lower had it been a company still showing poor compliance on health and safety. Indeed, given that the buyer was Swedish multinational Assa Abloy – a company that values its own corporate reputation – it might not have been sold at all.
On the buses
Doughty Hanson focused particularly on environmental improvements when it took over Spanish bus and transport company Avanza in 2007. It carried out a review that identified a range of impacts related to fuel efficiency and climate change, as well as water conservation, land impacts, and health and safety issues.
Working with the management board, it developed a plan covering investment in a new, modern fleet of vehicles with much more efficient engines, better fuel management overall and reductions in waste generation and water use.
These cases demonstrate how things have moved on from a due diligence process of screening potential investments for deal-breaking problems, towards recognising how ESG issues can be a driver of value in the portfolio businesses of private equity companies.
Havers says this has become more significant in recent years. “There is a raised level of awareness that attending to sustainability issues is good for the profits of the portfolio company,” he says.
Tom Rotherham, associate director private equity for Hermes Fund Managers, agrees. He says: “General partners should be willing to consider whether there is a value-creation angle in this, not just risk management. If that happens, then the private equity community can take ownership of the ESG agenda rather than having it thrust upon them. If not, some investors will conclude that general partners need regular oversight.” General partners are the investment professionals who manage a private equity firm, as opposed to investment partners who don’t have an executive role.
But Rotherham has a few words of caution to add about how far the private equity owners should take things. He says there is a risk that general partners draw the wrong conclusion and think they need to do all the ESG work themselves. Rather, it should be the portfolio company management where ESG is managed. “General partners just need to make sure it’s being done effectively,” says Rotherham. In other words, board effectiveness is really the key area of focus.
Simon Havers agrees, and says the main responsibility for the private equity company is to make sure the governance is right. He argues that private equity companies need to have systems in place to make sure that ESG gets attention at the board level of portfolio companies. If you have this, then “action will cascade down”.
Others have taken more of an activist approach. 3i, for instance, has mapped out the full investment process and developed a clear approach to what it expects. 3i communications director Patrick Dunne says: “The degree of influence we have with portfolio companies obviously varies depending on the percentage stake we own, but we have an energetic approach to engagement and sharing best practice.”
Sharing best practice among the wider portfolio of owned companies is also the approach practised by KKR, which has its “green portfolio”. With these companies, it works to select key practices for improvement, establish targets and develop action plans.
But all this activity around ESG issues would still, arguably, be only window dressing if those early criticisms that the private equity business model is somehow inherently unsustainable were shown to be valid. If it is really the case that the mission of private equity is the enrichment of the few by loading businesses with unsustainable debt, that is a serious problem.
This version of what private equity is all about is dismissed by many practitioners as a caricature.
Ludo Bammens says KKR’s ownership model actually has a number of real pluses from the point of view of sustainability.
“First, it is a model for active ownership. We can drive a topic effectively,” he says. “Second, it is actually more long term. We hold companies on average for seven years, which gives you time to really do something. Third, we have a large portfolio of companies and that gives us the opportunity to build a community of best practice. So what’s learned – for instance – within Alliance Boots can be shared with the rest.”
His message is echoed by Richard Ellis, director of CSR for pharmacy giant Alliance Boots, viewing the relationship through the other end of the telescope. “It is easier to do some of these things with private equity than with a plc,” he says. This means the company can look to the longer term and doesn’t need to be worried about shareholder dividends.
One former chief executive of a top plc who subsequently moved into private equity says the equation is not a simple one. “You definitely have more freedom to act under private equity ownership,” he says. For instance, companies can take a shorter term hit in order to create value in ways that plc cannot. And as the private equity company is looking to sell the business at a profit, if it’s sitting on serious risk, then it won’t be able to do this. “Environmental risk is now a big deal,” the former plc head says.
But for all the action by some of the big names, this former chief executive believes we are still near the beginning on the journey. He argues that sustainability is not high up the agenda for the vast majority of the private equity industry. “They will focus on anything they see as genuinely driving financial value but if, at the point of floating back onto the market they find people don’t much value the social and environmental aspects, then they won’t, either.” It will take society showing that it values the right things, before private equity companies will respond.
How much difference did the financial crisis make? He says there has been something of a mindset change. “Private equity companies now need to deliver real business improvement, not just apparent improvement. Flipping quickly is not happening.”
Building better companies
Tom Rotherham notes the same phenomenon, highlighting that at the point when the flow of debt dried up, private equity companies started holding on to portfolio companies longer. They increased the number of operational people they hired and, Rotherham believes, the focus returned to building better companies.
He suggests that there is “an inverse relationship between the cost of debt and the amount of effort general partners make on operational improvements in their portfolio companies. When debt returns, it is not clear why focus won’t once again drift away from operational improvements.”
His conclusion is a sobering one. “Did we learn the lessons of the crisis? When it comes to permanent change in how companies operate, the answer has to be no.”
Simon Havers believes that at least one relevant point has been picked up. “The lessons have been learned that when the storms hit you need to have made lots of friends before.” And private equity companies are starting to talk about stakeholders in ways they hadn’t previously.
So, what are the trends for the future? More integration.
There will certainly be more instances of private equity companies putting their bets on some of the technologies of the future, clean tech companies and renewable energy. This will come about through smart “market spotting” rather than a values-based conviction for “doing the right thing”.
But Ludo Bammens says it has to be applied to all sectors. “Sustainability has to be mainstreamed through your portfolio. It isn’t just about making specific investments, for instance, in clean tech,” he says.
With this in mind, he sees part of KKR’s next challenge as being to get the issues out from the sole ownership of compliance teams. KKR’s aim is to integrate ESG thinking into the sector investment teams so it is “fully a part of their own thinking and not something that is purely the realm of the diligence team”, Bammens says.
But there are big questions still on the horizon. One former senior head within a private equity company sounds a pretty big alarm bell.
He believes that from an overall corporate responsibility point of view, people are going to increasingly ask whether the societal value these businesses create is going to too few people. He expects people’s standards of living will continue to decline, because “we built our wealth on the backs of foreign resources and labour in a way which can no longer be done.”
This will mean that the questions about the huge incomes of a few will get tougher. Needless to say, that is one issue that private equity is not going to address voluntarily.
How far can companies really push the boat out on sustainability once they join the portfolio of a private equity firm? At a time when the viability of fish stocks is a serious global question, it seems that the answer is “all the way”.
On the one hand there is Carlyle Group. When it bought China Fishery Group – one of the world’s largest fishing companies, its due diligence process highlighted concerns around the viability of fish stocks in the future. As a result, it committed to a full scale review of the sustainability of the fish stocks upon which the company depended, and its current compliance with fishery quotas and other regulations.
More significantly, it looked at how the company could play its part in advancing the Marine Stewardship Council certification process for relevant fisheries in its sphere of influence.
China Fishery has now formed a corporate social responsibility committee, with external figures associated with sustainability issues as they relate to the marine environment.
Carlyle is not the only private equity firm to face up to the challenge. When Birds Eye Iglo was bought in 2006 by Permira from previous owner Unilever, it was in difficult times. It hailed from a non-strategic part of Unilever’s empire, and had been allowed to lose direction.
It had some track record on sustainability – having been involved in the initiation of the Marine Stewardship Council – but had come under fire from Greenpeace for sourcing some of its cod from the Baltic, where the legality of supplies could not be assured.
But perhaps closer to the top of Permira’s priorities was the fact that the company was under-invested, losing money and launching 70 new products a year of which only one or two would survive. Former Walkers marketing director Martin Glenn was installed to turn things around. That meant cutting costs, closing factories and throwing the poor quality brands overboard.
What was not jettisoned, however, was the company’s commitment to sustainability. An early commitment was to reduce the amount of cod in fish fingers, replacing it with more sustainable species such as pollock. This approach is now being taken a lot further.
Under the banner of Forever Food, Birds Eye has embarked on an environmental programme of considerable ambition, covering areas such as climate change, sustainable sourcing, waste, water and packaging. Glenn says the Forever Food brand takes a longstanding commitment and seeks to give reassurance to customers. It has been developed in partnership with NGOs including WWF.
Birds Eye has appointed a head of sustainability to make sure the programme stays on track.
It is likely that Birds Eye Iglo will be floated back onto the market again in the not too distant future. Improving the sustainability of the product roster is something that new shareholders will want to see. And that in itself is a sign of just how important such factors have become.