Private Equity and the ‘S’ in ESG

Social issues in private equity are not only important from a risk perspective, but can also contribute to the value of a business if managed properly, IFM Investors says.

Much of the focus in addressing environmental, social and governance (ESG) issues has been on the E and the G, with especially environmental issues receiving much attention through carbon mitigation programs.

In private equity, this is also often the case and perhaps even more so, because when it comes to governance, improving corporate governance is an integral part of the private equity value creation model.

But often there has been much less attention for the ‘S’ in ESG.

Yet social issues are important in private equity, not just from a risk perspective, such as reputational risk, but they can also increase the value of a business when managed well, Stuart Wardman-Browne, Global Head of Private Equity at IFM Investors says in an interview with [i3] Insights.

“Private equity often changes the governance of a business and so the new focus is more around environmental and now social,” Wardman-Browne says. “What we’ve been doing is really thinking about that from a selective perspective in terms of what deals we would like to do, but then also building it into the due diligence [process],” he says.

Some three years ago the fund manager’s private equity team started to consider how social aspects interacted with the value creation process.

What came out of this exercise was just how important culture and employee satisfaction with the workplace is in the ability to drive the rapid growth companies go through in their early stages.

“In our growth companies, we are looking at very fast growth, growth rates of 50 per cent per annum are not uncommon, and typically in a business like that you might be doubling the number of staff over a fairly short period of time,” Wardman-Browne says.
“The ability to execute this change has really been around the culture of the business.”

Instilling any type of change in a business requires buy-in from not just employees, but also the board and management. Wardman-Browne makes an analogy with the gradual adoption of occupational health & safety (OH&S) standards across industries.

“If you think back to when occupational health and safety was a major problem, that really only improved when an OH&S mindset was inbuilt into the culture of employees, management and even boards,” he says.

“There were serious breakthroughs and progress around how businesses ensured that their workplaces were safe environments. You need to embed it in the culture and that’s actually quite easy to do today, because younger people in the workforce really care about these things. They want to work for a business that cares about these things; they want to work for a business that has employee engagement,” he says.

Building a culture that is attractive to employees helps improve the company’s financial bottom line too, because it leads to less turnover, resulting in retention of knowledge and business continuity, while for early stage private equity companies it makes it easier to recruit new staff.

“It is easier to hire those additional product development and sales staff in what is now a relatively tight employment market, and so there are clear financial benefits,” Wardman-Browne says.

Employing New Skills

The heightened focus on company culture and employee satisfaction requires a different approach than a purely analytical one. Although IFM is adamant that the responsibility for ESG analysis, including social issues, needs to be owned by the investment team to ensure it receives the proper attention, the private equity team has enlisted the services of a talent & culture expert to help with company due diligence.

“It was about three years ago when we made some key changes and whereas in the past it was all about sector expertise, such as healthcare and technology experts, we have since added people that bring functional expertise and the person that we use the most out of that network is a talent & culture expert.

“We use them on every opportunity that we look at and in every portfolio company that we invest in. What is the culture really like? What is the talent development plan for this business moving forward? How engaged are employees and what is the employee engagement plan?

“Some of it is routine stuff, including succession planning, but we also get them involved in interviewing senior employees to understand what they see as their roles moving forward and to understand where they see the gaps,” he says.

Wardman-Browne sees the inclusion of culture into the due diligence process as a way to establish a more systematic and strategic approach to value creation. Along the way, some of his long-held beliefs and their importance in the process were challenged, he says.

For example, many private equity teams pride themselves on their ability to identify strong management. But when looking at previous investments, Wardman-Browne realised this is not quite the dominating factor that it is sometimes made out to be.

“When you look at private equity, we all think we are gurus in making a call on strong management teams, but on average we’ve probably got a 60 per cent track record of changing management teams. Maybe, that doesn’t quite justify guru status,” he says.

“Clearly, forming a view on management is very, very important, but getting an expert third party’s view really helps to inform the plan around the talent and culture process moving forward,” he says.

Putting It In Practice

Until recently, IFM Investors was invested in a medical software company, called Genie, which is based in Brisbane. IFM held this company for about five years and during this time it rapidly grew the business, expanding its staff and helping the company transition to the cloud.

Wardman-Browne attributes a lot of the success to the cultural change it was able to affect in the company.

“We quadrupled the number of product development team members during our ownership period and went from 20 to 79. We did that by investing in getting the right culture and making Genie a great place to work, making Genie really inclusive and a diverse place to work,” he says.

Key to improving a company culture is identifying what its purpose is beyond simply generating profits. Wardman-Browne calls the reason for existing a company’s ‘noble purpose’. In the case of Genie, its noble purpose was to “help medical practitioners deliver better health outcomes”.

The team then set objectives and key result parameters for every team member that traced back to this purpose. “People want to be engaged, that is really the rationale behind being clear around what the purpose of a business is. What is it looking to deliver for its customers especially, but also the other stakeholders involved in the business?

“If you can define that, if it is genuine and it is something really worth achieving, then you can attract many more employees,” he says.

The Value Add Process

But it is not all about culture and employee satisfaction. The company financials and growth opportunities need to stack up as well. Wardman-Browne says that often the lion’s share of the work goes into establishing clear priorities in the roadmap for growth.

“We look at companies that have multiple growth levers, so they’ve already proven themselves to show good revenue growth. They are usually profitable, but they may not be very profitable yet,” he says.

“Our strategy moving forward is that we will look at those growth levers and identify which ones management should prioritise. And that may mean that we will reduce profitability in the first couple of years of ownership, because we’re adding product development teams, or we’re adding sales teams, and we believe we’re adding value.

“We’re building out a management team to be able to cope with a much larger business and so that will have a short-term impact on profit. And we’re very comfortable with that as long as we can see that there is a clear pathway for fast revenue growth,” he says.

It can be quite overwhelming for companies to decide what to focus their attention on in the early phases of growth, Wardman-Browne says. Often, it ends up in a situation where nothing gets done well and opportunities are starting to slip through management’s fingers.

“Frankly, one of the challenges for young growth companies is that they’ve got multiple things that they can do, and the real risk is that you do a bit of all of them and don’t do any of them well enough to really have an impact.

“So we often find our discussions are more around how do we take that opportunity first and properly without diluting it?” Wardman-Browne says.

Leverage in the Current Environment

Historically, private equity companies relied heavily on leverage to generate rapid growth in their portfolio companies. But in the current environment of high rates, leverage can be harder to come by.

But Wardman-Browne says that IFM has always been extremely conservative in applying leverage in their transactions and certainly doesn’t rely on it for growth.

“With fast growth companies, we are very unlikely to use leverage,” he says. We are really looking for the cash flow of the business to be reinvested in growth.

“We want management teams to be focused on the challenges of growth and doubling the workforce, not on meeting debt covenants. So in the last three growth deals that we’ve done, we have had no leverage involved,” he says.

Even with larger scale investments, IFM keeps leverage at conservative levels, as these deals often are entered into with the view of holding assets for the very long term and might need to be restructured at various points during the holding period.

Gearing up these assets would defeat the purpose of holding them for the long term.

“We are seeking out lower risk opportunities and you don’t want to take a lower risk opportunity and make it high risk by overleveraging it,” he says.

This article is sponsored by IFM Investors. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content. 

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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.