Impact Voices | May 11, 2023

More private equity firms embrace impact as a path to outperformance

Tensie Whelan

Get a weekly pulse on news and trends in impact investing with our free newsletter.

*I agree to receive marketing emails from ImpactAlpha, its affiliates, and accept our terms of use and privacy policy.
By signing up you agree to receive marketing emails from ImpactAlpha Inc. and accept our Terms of Service and Privacy Policy.
Guest Author

Tensie Whelan

Across the globe, some 10,000 private equity firms enjoy ownership rights in 40,000 portfolio companies, which in turn manage 20 million employees.  PE funds are majority owners of hospitals, newspapers, schools, real estate, industrial manufacturers, consumer brands and retail, among other sectors that have significant environmental and social impacts.

At that scale, private equity has a significant influence on corporate behavior. PE firm policies and approaches can create value for all stakeholders – or extract value to the detriment of other stakeholders. Unfortunately, it’s often been the latter.

Academic researchers have shown, for example, that private equity-owned nursing homes increase prices, lay off nurses, and increase mortality rates. PE-owned private colleges increase student debt and reduce the likelihood of graduation. And PE-owned local newspapers eliminate journalists and local coverage, which correlates with lower voter turn-out in local elections. 

Extractive approaches prioritize generating significant returns by laying off workers, reducing research and development, loading up the portfolio company with debt (with the General Partners keeping most of the capital), ignoring externalities that create negative societal impacts, and avoiding investment that would help the company pivot to a more sustainable future. These short-term fixes come at the expense of long-term stakeholder value, a positive financial path for the portfolio company and societal benefits.

Private firms are not subject to the same level of transparency as public companies, which effectively means that most private firms are far behind in terms of improving their management through embedding sustainability in their business strategies. 

Fortunately, some PE firms are beginning to explore how sustainability can drive better performance in their portfolio companies, through increased diversity, employee ownership stakes or climate change commitments that reduce energy costs, for example.  And investors in the PE firms (Limited Partners) are issuing due diligence questionnaires that ask PE firms to report on their approach to material environmental, social and governance (ESG) issues.

Responsible PE

To support this trend, NYU Stern Center for Sustainable Business has developed a responsible investing framework that lays out the criteria that investors, civil society, regulators and others can explore to assess the PE firm’s performance. The framework includes human capital management, financial engineering, strategy and innovation and societal impact, among other categories, for PE firms and their portfolio companies.  

A report authored by myself and my colleague Chander Balakumar provides case studies and insights into what constitutes best-in-class in responsible versus extractive private equity. Here are some highlights from the report, The Road to Responsible Private Equity

Responsible private equity investing involves more than providing a few ESG reporting metrics. Some of the elements required include: 

  1. Good governance. Diverse and ESG credentialed board members and investment managers
  2. Sustainability integration. An investment policy and execution that integrates sustainability risks and opportunities
  3. Financial transparency. Fund management that avoids manipulation of financial reporting (e.g. misuse of subscription lines of credit, public market equivalence  valuations, and fund fees) or over-leveraging of portfolio companies
  4. Sustainable Life-Cycle. A life-cycle approach that values the long term and invests in sustainability to improve market valuation and ensure a responsible exit (e.g. the buyer will continue the sustainability focus).
  5. Operational excellence. Supporting portfolio company uptake of sustainability by  assisting with materiality and stakeholder analyses and the development of an embedded sustainability strategy, together with key performance indicators (KPIs), compensation metrics and capital allocation mechanisms that support sustainability transformation.
  6. Accountability for performance. Creating robust material ESG KPIs along with ROSI (Return on Sustainability Investment™) KPIs that track the financial returns associated with sustainability investments.  Mapping the ESG indicators to global reporting standards such as International Sustainability Standards Board (ISSB), Global Reporting Initiative (GRI), and the Task Force on Climate-Related Financial Disclosures (TCFD) with third-party auditing where appropriate.  (Reporting and disclosure metrics are process- and output-based and do not drive improved performance, which is why strategy-linked KPIs are needed)

Limited Partners who want to support a more responsible approach will find a variety of PE firms investing in better sustainability performance that also yields better financial performance.  The report provides extensive examples and research into best-in-class examples for GPs, portfolio companies, and LPs to learn from. 

Here are some highlights: 

Human capital management  

  • KKR is helping portfolio companies invest in Employee Stock Ownership Plans (ESOPs) that enable employees of all levels to benefit from improved company performance, which tends to drive better productivity and innovation.  
  • Closed Loop Partners, a firm that aims to accelerate the transition to a circular economy, is best-in-class with its ESG credentials – 80% of its partners have relevant experience in the field of recycling and sustainability.  
  • Palladium Equity Partners prides itself in being a “majority of minority employees.” 72% of its workforce identifies as minority and 64% as female. Palladium accomplished its high levels of diversity by developing a pipeline with partners such as the Association of Asian American Investment Managers, Sponsors for Educational Opportunity, and the “I Have a Dream” Foundation. 

Strategy and innovation 

  • Towerbrook, a Benefit-corporation itself, is helping its portfolio companies gain B-corp status, which creates a framework to harmonize profitability goals with societal benefit.  
  • InvestIndustrial aims to “build better companies with purpose” and has required its portfolio companies to identify material ESG issues, design sustainability strategies, and attend sustainability training offered by NYU Stern as well as annual sustainability summits.  
  • Bamboo Capital’s investment strategy targets companies that improve the lives of underserved populations in developing countries and tracks their performance through a UN Sustainable Development Goals lens, including outcomes such as jobs supported, strengthened value chains, positive effects on customers and reduced negative effects on the climate.

Societal Impact

While a PE firm does have modest societal impact in its own operations, its biggest impact comes through its portfolio companies. Best-in-class PE firms are bringing operational excellence on sustainability to their portfolio firms, driving better societal impact AND better financial performance.  

  • When it invested in Convoy, a digital freight marketplace, Generation Investment Management began with identifying material sustainability issues in the transportation sector. Convoy, a centralized decision-making platform, matches shippers and carriers, enabling greater efficiencies in routes, earnings and displaced emissions. Having identified greenhouse gas emissions as a material issue, Generation maximized the efficiency in routes by reducing trucks with empty loads to secure higher earnings and lower emissions. 

In sum, private equity (and the sector’s investors) have a unique opportunity through the infusion of capital, expertise, and governance to help companies transition to a more sustainable model that drives economic, social, and environmental performance.  We hope this guide will provide helpful tools and insights for the journey.

Tensie Whelan is Professor and Founding Director, NYU Stern Center for Sustainable Business.