How Far Can ESG Drive Impact Investment in Private Equity?

Over the last few years we’ve seen a transformation within the private equity investor space.

The ruthless ‘barbarian at the gate’ and unscrupulous ‘corporate raider’ have evolved into a more thoughtful, sophisticated and socially conscious investor. In turn, this shift has heralded the ever-increasing prominence of environment, social and governance (ESG), impact, and socially responsible investing.

Like most significant behavioural and cultural shifts, this trend is driven by factors both internal and external, with chief responsibility laying at the feet of limited partners (LPs), alongside brand management concerns and an increased chance of returns.

However, for PE leaders looking to reap the rewards of social conscious investing, it’s not enough to simply look the part. If PE firms want to legitimately strike a balance between doing good and doing well, they’ll need to have social impact at the centre of how they define success and how they operate. This will require significant cultural shifts ushered in by the appropriate inclusive leadership.

The LP push and social positioning

Private equity’s move towards socially conscious investments and practices has, broadly speaking, been spurred by the requirements of limited partners. With LP’s monies sourced from pension funds, universities, governments, etc., they are often representing the interests of average citizens. As such, these LPs need to be confident that this money is being managed by people whose values align with those of their constituents.

PE firms, therefore, need to consider our current social environment. Issues including diversity and inclusion, environmental sustainability and contemporary labour practices take a more prominent position in the public consciousness, with much of this driven by the values of millennials. Adhering to these values can drive profit, and research has shown that millennials will pay more for a product when it has social or environmental sustainability as one of its benefits.

Issues including diversity and inclusion, environmental sustainability and contemporary labour practices take a more prominent position in the public consciousness, with much of this driven by the values of millennials.

This transition, coupled with the increasingly public interest in private funding means that equity investment is now a spectator sport where the audience can play a shaping role–with a rotation of its thumb or a click of its keyboard–in determining whether the leader has earned the right to continue. Organisations with diversity and inclusion practices that don’t face up to scrutiny, shaky environmental sustainability or unethical employee practices, therefore, present a far riskier investment proposition.

The resignations of Miki Agrawal of Thinx and WeWork founder Adam Neumann are just two examples of how the public now plays the role of moral arbiter. Or, take the gig economy debate and the various companies which operate within it. An initially attractive investment opportunity lost its bloom as public concerns around zero hours’ contracts and workers’ rights caused many valuations to tank.

Driving for value and driving for values

It’s clear then why impact investing has gained such a significant position in PE investment strategy, with large PE firms having set up their own separate funds focused on impact investing. Bain Capital has ‘Bain Double Impact’, which is focused on helping “mission-driven companies scale and drive meaningful change.”

On the smaller end of the market, a new breed of firm has emerged dedicated to positive change. Harlem Capital is a NYC- based minority-owned firm whose focus is to “change the face of entrepreneurship by investing in 1,000 diverse founders over the next 20 years”. This bold mission statement has already paid off for the firm, garnering public praise, media coverage and support from large cap PE firms such as KKR and TPG.

At face value this looks like an ideal scenario; businesses, PE Firms, LPs, society and the environment all benefitting from a more conscious and responsible flow of money. However, this ideal can only be truly achieved if this social conscience is an inherent, inextricable part of a PE firm’s culture, rather than a reflexive attempt to respond to an emerging zeitgeist. To fully realise the potential that impact investing holds, PE firms must not only shift where they deploy their money, but also rethink how they build an investment thesis that deeply connects to the psychology of all company constituents and the public.

This ideal can only be truly achieved if this social conscience is an inherent, inextricable part of a PE firm’s culture, rather than a reflexive attempt to respond to an emerging zeitgeist.

What’s leadership’s role in building a new PE culture?

If PE Firms are to see the full benefit of impact funds, their leadership needs to be beyond reproach, and they must promote not only a drive for value, but a drive for values. The DNA and mindset of PE cultures and their leaders must evolve to rise to the challenge of a rapidly changing landscape.

A mindset and cultural shift of this magnitude is a leadership challenge, and our model of inclusive leadership highlights the keys to making the real difference. We have found that inclusive leaders focus on:

1) Curiosity – creating the conditions for learning, creative thinking, and openness to new ideas;

2) Courage – embracing the uncomfortable, taking risks, and empowering others; all crucial for leaders who will have to work to evolve a system that has historically produced great results in its previous mode of operating; and

3) Connection – deeply understanding self and others and building bridges for meaningful engagement; a non-negotiable for investors to understand how to build a value-generating investment thesis that ignites public belief rather than ire

Our data shows that PE leaders score low on the 3Cs of the inclusive leadership model with the most marked dip found in Connection. This is not totally surprising when one considers the rigid metrics that determine success or failure within the PE space. Internal rate of return, and multiple of money will always have a high place on the agenda, but in this brave new world of impact investment and heightened public scrutiny, leadership strategy and talent management approaches need to evolve to drive all the relevant success behaviours in its leaders.

PE has the opportunity to reshape its past and its future. Once decried as a value destroyer, stripping companies of assets for profit, the stage is now set for it to balance driving value and driving values. To achieve this, PE leadership needs to deeply embed the values they aim to promote and create a leadership culture that is open to ideas and investment not solely from a financial returns perspective.

Doing good and doing well can go hand in hand.

Authored by Rosanna Trasatti, Managing Director, Global Head of Private Equity at YSC.

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