A violent tragedy nearly two years ago focused the attention of private equity firms and their investors on environmental, social and corporate governance (ESG) factors.

After the shooting tragedy at Sandy Hook Elementary School in Newtown, Connecticut, in December 2012, Cerberus Capital Management was thrust into the spotlight as the owner of Bushmaster Assault Rifles, maker of the weapon used by the gunman during the shooting. Soon after the media publicized this detail, the New York-based private equity firm received a call from one of its largest limited partners, California State Teachers’ Retirement System (CalSTRS), raising questions about why the firm owned a gun maker and its social responsibility to the public. Shortly thereafter, Cerberus put the gun manufacturer up for sale. (See, "Private Equity: Investing Responsibly?")

In a statement, Cerberus said of the sale, “We believe that this decision allows us to meet our obligations to the investors whose interests we are entrusted to protect without being drawn into the national debate that is more properly pursued by those with the formal charter and public responsibility to do so.”

Since the Sandy Hook shootings, ESG issues have become increasingly important to limited partners in Europe and the U.S. In April, the Principles for Responsible Investment, or PRI, launched a new guide, called Integrating ESG in Private Equity, which outlines six principles to help private equity firms incorporate ESG factors into dealmaking practices. (See related graphic.)

The firm behind the guide, PRI Initiative, was launched by the United Nations in 2006 after former UN Secretary-General Kofi Annan brought together a group of the world’s largest institutional investors, academics and other advisers to draft a set of sustainable investment principles. At the heart of the six principles is the premise that investors have a duty to act in the best long-term interests of their beneficiaries, and that this means taking into account environmental, social and governance factors.

“The founding signatories to the principles wanted to create a global coalition to do what they already did individually—namely, engage with companies on environmental, social and governance issues—and to work together to develop best practices for incorporating ESG into fundamental analysis across asset classes,” says Fiona Reynolds, managing director of PRI.

Blue Wolf Capital

Haran Narulla is a partner at Blue Wolf Capital Partners and chair of the PRI GP Guide Working Group, which oversaw the publishing of the guide. When Blue Wolf was founded seven years ago, the founders had the strong belief that incorporating ESG factors into each facet of investment decision-making would positively contribute to a company’s performance and overall return. Additionally, the incorporation of ESG factors into Blue Wolf’s portfolio has had direct benefits. Those include financial benefits such as reduced energy costs, employee-turnover-related costs and workers compensation costs; social benefits such as fewer safety incidents, increased job satisfaction and a more productive workforce; and an overall alignment of interests through better governance infrastructure.

“Our investment strategy dovetails perfectly with ESG because we invest in messy situations where companies are facing challenges and a lot of the challenges have to do with remediating environmental challenges or social issues like labor relations. A fundamental part of what we do is help resolve those issues, so PRI really makes sense to us,” says Narulla.

New York-based Blue Wolf has been dealing with ESG factors as a part of investment thesis since its founding. For example, in November 2008, the firm purchased Healthcare Laundry Systems, which serves hospitals and clinics in Chicago. Shortly after the transaction was complete, the Obama administration changed how the government approached undocumented workers in the U.S. workforce. Blue Wolf started carefully tracking the moves of the government, took a proactive approach to the issue and voluntarily began to confirm the documentation status of all its employees. Blue Wolf worked with the union to complete the task. “The exercise resulted in a large amount of turnover at the company, but with full support of the union. We didn’t have a strike. When the federal government ultimately did come in to review the business we were given a clean bill of health. Working constructively with the labor department and the union resulted in the best possible outcome for everyone,” says Narulla.

Oak Hill Capital Partners

Oak Hill Capital Partners is another private equity firm that has confronted ESG issues head on. Founded by Texan Robert Bass, the firm has always had a culture of responsible investing. In October 2013, the firm published its first annual ESG report. Additionally, the firm is a signatory of the Principles of Responsible Investing. “A successful ESG program requires implementation and execution, not just aspirations,” says John Monsky, general counsel and chair of the ESG committee at Oak Hill Capital.

At the end of 2013, the firm added a dedicated ESG resource to its team hiring Lee Coker as ESG officer. Before working with Oak Hill Capital, Coker managed the Environmental Defense Fund’s Green Returns initiative working with leaders in the private equity sector to identify opportunities to reduce environmental impacts and build more valuable, competitive companies.

“Private equity is becoming more receptive to ESG issues. Every firm deals with these issues differently, and Oak Hill wanted to share its practices. We don’t look at our ESG initiatives as a competitive advantage, rather we want more private equity firms to see what Oak Hill is doing and begin similar practices,” says Coker. “There are some firms, like Oak Hill, that are incorporating ESG to protect and create value and others that will need a push from their LPs to get started.”

Oak Hill integrates ESG into its due diligence practice when considering an investment. By taking ESG factors into account, Coker says, Oak Hill can more accurately value potential investments and save the New York-based private equity firm money in the long run.

John Hodges, director of the financial services division of Business for Social Responsibility, agrees that private equity firms need to either step up or risk having ESG issue forced upon them. “The interest in ESG is being driven by trends. The LPs — the pensions and endowments — are facing more scrutiny themselves, which is creating more awareness of their approaches to responsible investing. So they are trying to influence the private equity firms they are invested with. Another trend is the growing evidence that companies with high-quality ESG management tend to be valued higher. Lastly, private equity firms are realizing if they don’t self-manage ESG issues as an industry, regulation may be put upon them by government. Overall, being on top of ESG issues creates better results for private equity firms on multiple fronts.”

The Private Equity Growth Capital Council is also a signatory to the PRI guide. The council held its first seminar on ESG issues in May. The seminar was well received by members, and the growth capital council now plans to hold one more in 2014 and three seminars per year starting in 2015. “Our challenge is that we have some larger firms that are very far along and smaller firms that are still trying to figure out their approach. All firms need to understand the issues involved. More LPs are asking about this, and GPs need to get out in front on it,” says Brownyn Bailey, vice president of research for growth capital council.

According to PRI, the first step to being ESG-compliant is integrating the principles within the organization. Having the appropriate organization and culture in place is key, because it enables firms to take into account the full spectrum of ESG issues in its business analysis. These practices often include a formal commitment from the top of the organization to guarantee sustained institutional dedication and resources to ESG factors; a person or team responsible for ESG considerations with the relevant expertise; employees educated on the rationale, strategy and practices for integrating ESG; linking ESG objectives to employee evaluation. The private equity firm should then set and communicate objectives for ESG integration; establish an operations group or use consultants to monitor portfolio companies and engage with LPs on the subject.

“GPs are starting to recognize that in order for ESG factors to be effectively integrated into their investment cycle, they must first be integrated into their organizational governance, structure and culture. Increasingly, GPs are committing to this at the highest level, strengthening internal resources and setting ESG objectives,” says Reynolds.

The newfound interest in ESG issues is certainly music to limited partners’ ears. With more than $45 billion of assets under management, AlpInvest Partners is an institutional investor in many name brand private equity funds. As part of its due diligence process, the global LP confirms that ESG issues are being addressed properly by general partners in the investment process. AlpInvest prefers that GPs it invests with have a structured approach to dealing with ESG issues and as a result are better able to address risks and opportunities around ESG factors.

“Taking ESG into consideration when making investments can help to deliver value in the underlying portfolio company and can thus contribute to good returns,” says Maaike van der Schoot, corporate social responsibility officer with AlpInvest. “Ignoring ESG matters could hurt firms at the end of the day, and those firms should be prepared to pay a price.”

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