Private equity has come a long way since Barbarians at the Gate, but it clearly still has an image problem. While many academic studies show that buyouts support growth and innovation, journalists and politicians often portray an industry inhabited by vultures and asset strippers, preying on undervalued companies. That characterisation is at best one-sided. As a generalisation, it is just plain wrong. On the whole, private equity is a force for good.
As I explain in my recent book, Corporate Governance and Responsible Investment in Private Equity, the incentives baked into a buyout firm's contract with its sophisticated institutional investors create a high degree of alignment. Those investors – mainly pension funds, insurance companies and sovereign wealth funds – benefit from outsize returns: Invest Europe's 2020 data showed that European buyouts delivered an annualised IRR of 15% after fees and expenses to the end of 2019, far ahead of the 5.8% achieved by the MSCI Europe. Even if some academics take issue with the precise numbers, demand has been steadily increasing among large, well-diversified investors, because they can see their own returns and they have confidence in the future of the investment model.
These arguments are well-rehearsed, but they are not themselves an answer to the charge of asset stripping and irresponsible investment. Indeed, as investors increasingly focus on the impact – positive and negative – of their own investments, they will increasingly ask: is it responsible to increase my allocation to private equity when we are seeking to do good with our capital, as well as to generate positive financial returns?
My answer to that question is yes. Private equity offers a business model and an accountability structure that allows responsible institutional investors to select fund managers whose values are aligned with their own, whose investment strategy focuses on long-term sustainable growth and sound corporate governance, and who will report regularly across a number of decision-useful sustainability metrics.
Many leading alternative asset managers now offer ‘impact’ strategies, where a given product specifically targets investments that have a positive impact on certain environmental and/or social objectives and commits to report on those positive outcomes alongside its financial performance. Crucially, these funds do not generally expect to sacrifice financial returns for their positive impact. And the fund manager can use its significant influence on strategy and corporate governance to ensure that the portfolio company's management focuses on positive impact.
When stakeholder engagement matters to the long-term success of the company, it will absolutely matter to a private equity investor
But it would be a mistake to suggest that only strategies labelled as ‘impact’ offer the opportunity to make a positive difference. The private equity business model is based on extensive due diligence and active engagement – and the level of diligence and engagement is orders of magnitude greater than that available to, or financially viable for, an investor in a public company – however much they focus on ESG. That is what makes the private markets so well placed to deliver the positive change that investors increasingly want their capital to catalyse.
Most private equity firms invest most of their capital into private companies, rather than seeking to take listed companies away from the public markets; and de-listings account for a relatively small proportion of the capital deployed for buyout deals in Europe. The overwhelming majority of deals are in the mid-market.
Before a buyout, a private equity investor spends significant amounts of time and money assessing the business and operations of the target. It will usually have access to confidential information and can quiz management on every aspect of the business – information that management may well have to stand behind with a warranty. The buyout firm is very well placed to assess the sustainability risks and opportunities faced by the company, and can make an informed decision before investment. Then, as a condition of investment, they can establish a 100-day improvement plan, set bespoke reporting metrics that are decision-useful for the private equity firm and its ultimate investors, and establish sustainability red lines so that its core values will be respected.
After the deal is done, buyout firms focus on corporate governance. Most will have representation on the portfolio company's board of directors and will have a say on all major strategic and operational decisions. They will establish accountability mechanisms and key performance indicators, facilitating effective oversight of management's focus on ESG, as well as all other aspects of the business.
Generally, the buyout firm and its investors will only make money if the business performs well during its 3-7 year investment period, and if it is then attractive to a sophisticated buyer. That means that focusing on the long-term sustainable success of the business is a critical success factor. When stakeholder engagement matters to the long-term success of the company, it will absolutely matter to a private equity investor. For them, the value of the business the day after they have acquired it is not important – they do not need to concern themselves with quarterly reports or short-term share price fluctuations. What matters to a buyout fund is the value of the business several years hence, when they are ready to sell. Sustainable long-term performance is what drives the value creation philosophy.
Of course, not all buyout firms are alike, and investors will look carefully at the track record and investment strategy of a manager before making a commitment
Although the industry still bears the tag ‘private’, the level of transparency and reporting to investors surprises many outsiders. Increasingly – largely as a result of investor demands – this reporting extends to a wide range of sustainability metrics, which investors can then use to assess how well the buyout firm is respecting the sustainability commitments that are now routine at the time of fundraising. The industry will also continue to evolve its public profile in response to changing societal expectations, embracing the current media and political scrutiny and adapting its modus operandi as a result – just as it did in 2007, when it established the Walker Guidelines in response to calls for greater transparency.
For an investor looking to increase the impact of the capital it deploys, whilst targeting strong financial returns, private equity can make a compelling case. Of course, not all buyout firms are alike, and investors will look carefully at the track record and investment strategy of a manager before making a commitment. But the scale of the influence that a buyout firm has on its portfolio investments, and the level of reporting available to the firm and its ultimate investors, will give the asset class a real advantage in attracting investors that want to make a positive difference.
Simon Witney is a Senior Consultant at UK law firm Travers Smith