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Leverage, compensation and taxation: Doing due diligence on investment fund managers



Impact Alpha, Jan. 7 – Reforming capitalism is all the rage. Many of us in the ESG and impact investing communities are enthusiastic about calls from business and economic leaders for a ‘stakeholder economy’ that benefits more than our bottom lines. 

Ray Dalio, Marc Benioff, Jerome Powell, Peter Georgescu, Paul Collier, and John Elkington, as well as the Business Roundtable, Institute of Directors, British Academy, and the Financial Times, have recently called for an improved capitalism that serves all stakeholders. 

What does that really mean for investors? Yes, we need to work with the companies we invest in to improve environmental practices, respect human rights and maintain good governance – broadly known as environmental, social and governance, or ESG. 

However, our own investment practices and structures may be exacerbating the problems we seek to solve and creating systemic risks – for large institutional investors as well as society. 

The practices of private equity firms, in particular, have drawn increased stakeholder scrutiny. As the Center for Popular Democracy notes, private equity funds often “load companies with debt, sell the best assets for personal gain, and leave hundreds of thousands of working people behind.” All that has drawn the ire of legislators; Sen. Elizabeth Warren’s Stop Wall Street Looting Act attempts to rein in abusive practices and increase accountability. 

Despite stakeholder concerns, leverage and fund manager compensation are often not captured or prioritized by ESG and impact evaluation frameworks.

As responsible investors, we need to focus not just on the portfolio companies, but also the financial structures upon which they are based, in order to truly change capitalism.

Manager, look within

We have made great progress on developing performance indicators at the portfolio company level, yet we are lacking in frameworks to assess impacts (both positive and negative) of the way we structure our investments and run our own investment firms. If large institutional investors care about systemic risk and responding to their stakeholders, it will be critical for them to evaluate their managers just as they do their companies. 

At the Predistribution Initiative, we are starting to talk openly about these blind spots or “elephants in the room” when we explore the role of finance in addressing social and environmental challenges. Global strikes, protests, and unrest – often driven by increasing inequality – prevent progress on climate and can no longer be ignored.

Key areas for improvement include:

Increased disclosure on financial engineering

Excessive leverage, asset stripping, and monitoring fees in private equity deals may magnify returns to asset owners and/or managers, but can also put portfolio companies in precarious situations. Such mechanisms push risk down to workers if, for instance, a company’s debt burden becomes too great for it to manage. 

These workers can experience decreased pay and loss of benefits or even their jobs and pensions, as seen in initial plans for the Toys R Us bankruptcy. There are many other examples, including in healthcare and social infrastructure, where the risk of bankruptcy creates not just negative impacts for workers, but also for communities who are dependent on those resources. Even the private equity industry publication Pitchbook recently headlined an article, “Private equity should become less private to address onslaught of criticism.”

To be sure, leverage can sometimes be beneficial to investors – often pensioners and workers – while not putting companies at risk. Required reporting on responsible investment structuring would help formalize ESG risks for investors to diligence accordingly and reduce incentives for extractive behavior. 

Fund manager compensation and economic inequality

High executive compensation at private equity funds is exacerbating wealth inequality, as we have pointed out. In existing ESG frameworks, metrics exist to assess corporate executive compensation in our portfolio companies. Why shouldn’t asset owners and allocators (limited partners, or LPs) in private equity funds assess how much private equity fund executives are making? The ratios between these executives and the average worker in portfolio companies are often even greater than with corporate CEOs. 

Adding this dimension of evaluation might encourage investors to consider who is creating what value, for instance, in growth companies, and acknowledge that company employees might deserve to share in profits or equity ownership. Rewarding workers for the value they create further aligns incentives beyond executives and investment teams, to those conducting the day-to-day work. And it compensates workers (and communities, in the case of real assets) for the risk that they take, alongside the capital providers. 

Some may argue that it is capital providers who take risk in building companies and projects. However, workers often put their health and safety at risk and do backbreaking work to make these investments successful, frequently while struggling to support their families and not building any wealth of their own. Communities may risk their land and resources.

Ultimately, sharing equity and/or profits that are otherwise only captured at the fund manager level would be a meaningful way to build wealth for all stakeholders by adjusting the very systems through which wealth is created in the first place. Taxes and philanthropy are good methods to level the playing field for the disadvantaged, provide goods and services to the public, and create a social safety net. Why not also pay the workers that we back (and communities, in the case of real assets) more appropriately for the value they create and the risk they take in the first place – versus relying solely on redistribution, which can re-create cycles of dependency?

Responsible tax approaches

We are seeing greater attention to responsible tax by investors when it comes to evaluating portfolio companies. For instance, the Global Reporting Initiative (GRI) recently added metrics and guidance on responsible tax policy; the Principles for Responsible Investment (PRI) has recently advanced programming on this topic; and Rutger Bregman made this previously boring topic sexy at the recent World Economic Forum in Davos. However, a significant number of funds across asset classes are also domiciled in tax havens. We need to factor this fund-level activity into our overall ESG and impact assessments to understand the full equation and related impacts on our economy. Funds can be structured to be tax-efficient, but should not avoid paying taxes.

When it comes to tax, particularly in private equity, there is also strong interest from civil society in taxing carried interest as ordinary income versus capital gains. This is a policy matter, but we encourage investors to reflect on what they can do from a public engagement perspective to respond to stakeholder concerns. LPs could evaluate the lobbying activities of private equity fund managers in the same way they increasingly do at the portfolio company level.

Valuation methodologies and incentives

We need to re-examine the way we incentivize our investment teams, and the way we value investments. In particular, it is time to rethink a standard measure of performance, the internal rate of return (IRR). IRR’s time-value-of-money component means we are aiming to make as much money back as fast as possible, a concept that seems at odds with long-term investing and ESG integration. And if we are evaluating investment professionals on, for instance, an annual basis, and primarily on financial returns, how does that align investment team incentives with ESG, positive impacts, and stakeholder concerns? Asset owners and allocators may likewise need to apply this type of analysis to their own practices.  

Towards a new model

The Predistribution Initiative invites asset owners and allocators, asset managers, field-building organizations, civil society, labor advocates, researchers and other stakeholders to discuss and workshop solutions together. 

We hope the outcomes of such collaboration will result in stronger ESG and impact guidelines at the fund manager and fund structure levels. This analysis would include transparency on both positive and negative contributions of the investor and clearer links to systemic risk that affect investors and local communities in different, but critical, ways. 

A common statement at industry conferences is that you cannot manage what you don’t measure.  Integrating these issues into our existing ESG and impact frameworks should help build improved investment structures, which we expect to facilitate through workshops in 2020. 

This “responsible finance R&D” includes evaluating appropriate thresholds for leverage, other aspects of financial engineering, how to compensate non-investor stakeholders for the value that they create and risk that they take, alternative valuation methodologies to promote long-termism, incentive structures for investment teams for stronger ESG integration, and the potential to mainstream multi-stakeholder governance models, among other topics.

These are difficult problems without easy answers, but we must listen to stakeholders and address the very real concerns and risks that are threatening them, ourselves, and society. As we ring in a new decade, we have a chance now to reflect openly and honestly about what’s working and what’s not, in a collaborative and constructive way.

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