The Barbarians : Embarking Towards Saving the Planet


In the first of hopefully many more economic papers to come, Léa Toulemonde examines private equity groups (PEGs) which have long been seen as predatory “barbarians” that prey on weak companies that get harshly dissected in search of profit. However, since the 2008 financial crisis, this industry has faced changes, some forced but others voluntary. Now, 30 years after the first time PEGs were designated as barbarians, Léa examines the situation of the industry and asks the question: “Can PEGs make a positive impact in the world?”


Preface

I wrote this article within the framework of an Independent Study. As an undergraduate student studying Economics & Finance, still in my unrelenting quest to learn, I was fortunate to have the partner of a premier worldwide private equity firm as a dedicated mentor and supervisor.

This work is the culmination of research as well as cold outreach for interviews. It provides a comprehensive market overview of sustainable investing, and more precisely of how private equity has evolved as part of this emerging trend. But foremost, this article is a gathering of voices of a diversified panel including actors and interlocutors working directly with investment funds.

I hence want to thank all of those people who were willing to share their expertise and cherished opinions for having helped me discern the intriguing paradox that revolves around finance—how that same mechanism tool that had in the past taken us to the verge of ruin has the potential to serve our great ambitions to solve pressing social and environmental issues.

Introduction

It was the great civilizations of the past who initially came up with the term barbarian. Greeks, Romans, and Christians used the term to designate the uncivilized, warlike, and inferior, essentially those who did not follow classical customs nor spoke traditional Greek language. It was from these primitive individuals’ language, what sounded like “bar…bar” to the more civilized Greeks, that the onomatopoeic word originated.

Ironically, it was these barbarians who essentially took over the Roman Empire. Beginning in the 5Th century, they marched over and invaded the declining empire, gradually carving it up between themselves. A couple centuries later, the former barbarians were themselves civilized; new civilizations rose from the ashes of the old. Hence evolved France, Spain, England, and Italy.

The term barbarian had since then been put to rest until a resurgence in the 20th century with Bryan Burrough and John Helyar’s publication Barbarians at the Gate: The Fall of RJR Nabisco. The 1989, six months in a row New York Times bestseller, and masterpiece of investigative journalism then designated private equity groups as the new barbarians. The book called attention to the predatory tactic that wealthy individuals and business owners used to dodge taxes and get richer : leveraged buyouts (LBOs).

“The idea behind leveraged buyouts initially was some kind of financial engineering or tax arbitrage”

Managing Director, Co-Head of Skopos II fund

Barbarians at the Gates highlighted what could then be seen as a sinister mechanism through which, most often, big private equity firms—the ones that stood in the upper running with regards to access to the debt market—would buy companies by taking on financial leverage with as high debt ratio as possible, thus increasing the risk of financial distress, and would then rationalize expenses by taking out fixed cost operating leverage, all the while taking exorbitant fees on funds. As the authors saw it, rationalizing debt then entailed rationalizing headcount, getting rid of factories, thus basically milking companies dry to the detriment of initial stakeholders. In general, what allowed the eponymous villains to engage in such sinister behaviour was their lack of a legal need to disclose contingent liabilities. Indeed, the private sector could engage in moral standard infractions and negative externalities all the while the public domain remained unaware of their actions.

This mechanism, Burrough and Helyar chose to illustrate through recounting the story of the biggest LBO of all times: the LBO of RJR Nabisco. Barbarians at the Gate hence centred around Ross Johnson, at the time CEO of the food and tobacco conglomerate who had intended to buy out the rest of the Nabisco shareholders. The book described how one greedy man’s bid precipitated a bidding war, leaving RJR Nabisco exposed to corporate raiders including nearly all of the big private equity (PE) players of the day and ultimately resulting in a spectacular defeat for Mr. Johnson by KKR & Co.

Since being introduced by Burrough and Helyar, the term barbarian  has designated something very specific: big notorious corporate raiders like Ross Johnson, KKR & Co. and other PEGs (private equity groups) who made profits by buying large numbers of undervalued companies’ shares, taking over their management and eventually selling them for huge profit.

Then the 2008 financial crisis hit and shook the entire world leaving lasting effects on PE.

“Today, the situation in which PEGs put a lot of debt on a private company is very old style”

Director at EY

What had happened leading to the crisis was that all those companies that had been bought out by PEGs had very high leverage—that is very little cushion. Then with the recession most could not generate enough cash to pay due interests, leading a lot of companies into bankruptcy. Hence, from the 2008 crash the finance world learned that although LBO is not necessarily in itself a bad idea, its initial part about putting too much debt on a company was destructive. With this realisation, banks no longer financed companies with nearly as much debt as they used to pre-2008.

“Leverage used to be a lot more aggressive”

Private Equity Associate at Goldman Sachs

Along with less aggressive leverage other elements eventually started to add on to the meaning of private equity as well, to the point that the term private equity is now much more widespread than it used to be. Today, growth equity, turn-around, venture, middle and upper market are all part of the field. 

The typical perception is that PEGs are small to medium size enterprises that use some kind of leverage to invest in companies that they keep for about 3 to 5 years during which they create as much value as possible, hence basically trying to buy low and sell high. But that is not necessarily the case. A PEG might buy an extremely large company or a start-up using no debt at all. It might hold real estate assets for as long as 25 years in which case it would rather anticipate yield returns.

In fact, if private equity had in the past only represented a niche area of investments, one that was dominated by wealthy individuals, today, this alternative form of investment has become much more prominent amongst all types of investors which choose to invest across increasingly diversified vintage years and sectors. McKinsey’s 2019 private markets annual review report indicates a 170%increase in private market assets under management in the past decade as well as that the number of PE firms has more than doubled over that same period.

All in all, private equity still essentially holds the same meaning as it did thirty years back when Burrough and Helyar used the term barbarians to refer to PEGs—it is still about investing in, monitoring, enhancing and harvesting a company’s who’s share or equity isn’t listed on a public exchange—but, with a lot less leverage and a lot more meanings.

Moreover, the regulations rolled over post-2008 as well as the realizations triggered by the crisis seem to have changed PEGs for the better. From an industry that initially rewarded secrecy, individualism and pure profit, private equity is gradually skewing towards more transparency, collaboration, and mutual advancement.

“This unfortunate bad rap that PE has developed publicly has to do with the big PEGs that have acted in ways they should not have. But in fact, while it certainly can still do better, today PE is undeserving of a lot of criticism as PEGs have increasingly been acting, not just as dictators of terms but also as value added partners to the companies they invest in—allowing them to grow in ways they could not have achieved on their own. Add to that the fact that PE is one of the largest suppliers of jobs globally and you start to realise that this asset is absolutely essential to the economy”

Senior Associate at Sterling Investment Partners

Given this new perspective that PE investments might as well result in a win-win for all stakeholders involved, generating returns for general partners (GPs), limited partners (LPs) but also for target companies as well as their employees, is the term barbarian still relevant to designate today’s PEGs?

Some have even questioned whether this barbarian designation was appropriate to begin with or rather an overdramatic comparison on the part of Burrough and Helyar. It in fact stands to reason that, since Mr. Johnson essentially ran an inefficient business, using corporate expenses to support his lavish personal interests, then KKR & Co. was right in seizing the opportunity to run RJR Nabisco more efficiently. Thus, in this case, buying the company with excessive leverage and cutting expenses wasn’t any more barbarian than it was strategic, both for RJR Nabisco and KKR & Co.

Either way, 30 years after the resurgence of the term barbarians to designate PEGs, the term seems entitled to be reassessed. That is especially in light of the recent shift in investing trends towards responsible investing.

Responsible Investing: A Real Tendency Bound to Emerge

There is a current niche in finance in increasing focus on responsible investing. More and more, corporations and institutional investors have been taking wide-spectrum approaches to incorporate social values into their portfolio; approaches which seem to vary depending on the extent to which they want to promote a social cause.

ESG Integration

The most common style of responsible investing is environmental, social and governance (ESG) integration.  Pressure from increasingly cognitive and sensitive consumers and investors, the transfer of wealth from baby boomers to millennials paired with the increase in regulatory drivers post-2008 as well as deepened understanding of the risks associated with noncompliance to social and environmental objectives, has led to a sharp increase in incorporation of ESG criteria into investment decisions in the past decade. In 2018, $11.6 trillion of all professionally managed assets in the U.S. were under ESG integration investment approaches. More simply put, 25% of investment decisions were enhanced by consideration of environmental, social and governance factors.

Social Responsible Investing

Though the whole genesis of ESG integration, and the catalyst for responsible investing, really was the social responsible investing approach. Having taken hold as early as in the mid-1900s when investors avoided “sin” stocks (companies that dealt in alcohol, gambling, and tobacco), this technique still involves actively including or excluding certain companies or sectors in a portfolio based on the investor’s set of values-based criteria. Though this level of commitment  linked with using SRI strategics’, one notch above that of ESG integration, means that this approach has been more prone to deter investors—that is, due to potential risks of reducing returns by shrinking the investing universe or over-allocating to certain sectors.

Impact Investing

Also under the responsible investing umbrella, alongside the already established ESG and SRI methods, is the more up to date impact investing approach. The term was coined in 2007 to designate pure impact investing—that is, the specific and supposedly risky strategy that aims squarely at solving the problems of the world and generating positive measurable impact through working hand in hand with target companies to implement sustainable solutions projects.

In a 2019 report the Global Impact Investing Network (GIIN) estimated that over 1,340 organizations managed USD 502 billion in impact investing worldwide. This is nothing compared to say, the New York Stock exchange market’s capitalisation alone which was at over USD 30 trillion in 2018.  Much more capital will be needed for impact investing to meet global needs—potentially more than $1 trillion annually until 2050 according to some sources. Though, this USD 502 billion value still indicates a sharp increase in capital allocated to impact investing. And, more generally speaking, considering the multiplication of action statements by financial actors, there is still reason to be optimistic regarding the potential for responsible investing to achieve real scale.

The Multiplication of Sustainable Action Statements

A lot of big industrial and financial conglomerates have already launched ESG and impact investing strategies. La Société Générale’s UNEP-FI Positive Impact Finance Initiative as well as L’Oréal’s successive Beauty for All and L’Oréal for the Future initiatives for example feature amongst the action statements released recently, each promoting their vision of responsible investing and promoting their contribution to financing sustainability.

More and more, essentially industry agnostic groups are finding themselves seeking ways to skew towards positive impact compliance. For one, acquiring smaller role model companies from which they can learn is a common method. This was for example’s L’ Oréal’s intention in taking stakes in Carbios, a firm focused on finding bio-industrial solutions to reinvent the plastic lifecycle.

Goldman Sachs has also simultaneously been implementing ESG integration and impact investing strategies, respectively since 2007 and 2015, the later being when it acquired Imprint Capital, a leading institutional impact investing firm and innovator at developing investment solutions that generate measurable ESG impact. The bank’s ESG and impact assets now represent $74 billion that are being invested in such companies as Northvolt and  Beyond Meat which propose sustainable solutions to move towards a circular economy—Northvolt for example will use the capital raised to finance its battery recycling facility, which will produce the world’s greenest lithium-ion battery with minimal CO2 footprint.

All in all, there seems to be no doubt that responsible investing corresponds to the future of investing—though it is unquestionably still very early on.

The Former Barbarians: A Fundamental Part of the Emerging Responsible Investing Trend

Releases of sustainability mission statements are also multiplying on the PE side—this time exponentially. The PE giants are now all claiming to be leaders in corporate responsibility, sustainability, transparency, inclusion, and diversity. They are all putting it out there that they are integrating ESG considerations into their due diligence processes, that they are steward with their clients’ assets. Blackrock, Bain Capital, and KKR, all came up with responsible investing solutions platforms for clients as well as means to disclose information regarding their sustainability to stakeholders through annual reports.

Creating funds dedicated solely to achieving measurable social and environmental impact also seems to have become the new must amongst these PE giants. For four years now, Bain Capital has been touting about its Double Impact fund focused on health & wellness, education & workforce development, and sustainability to create long-term value and meaningful impact at scale. More recently, in 2018 and March of this year respectively, KKR and Blackrock also launched their Global Impact Funds to address the world’s social and environmental problems as identified by the UN Sustainable Development Goals (SDGs).

And there is reason to suggest that PEGs will keep becoming even more involved in responsible investing. Though that is not the case today, tomorrow, once more conglomerates start to have sustainability charters, PEGs will in turn start to respond accordingly. As PEGs continue to scale the landscape of categories in which they compete, evaluating  which businesses they think conglomerates are going to buy next, and as they discover that conglomerates prefer to acquire more sustainable businesses, they will adapt the way they source investment opportunities as well as how they operate in portfolio companies to make sure that end results fit exit strategies’ expectations.

Moreover, as PEGs continue to multiply and as competition eventually reaches a new high, it won’t just be the ones that bid higher that will win bets anymore but also those that target companies’ management and shareholders will like the most—thus most probably implying those that will be most conscious in terms of governance as well as social and environmental factors. It was in fact a high level of competition that had led to Mr. Johnson’s defeat despite the fact that he had made a higher offer for RJR Nabisco.

All in all, PEGs seem to be behaving accordingly to the trend in responsible investing that is emerging amongst financial actors. They are on the same path towards becoming environmentally and socially compliant—whether as a genuine investment thesis or pure marketing strategy. Hence is it fair to point the finger at PEGs and say that they are the barbarians?

Private Equity: An Accustomed Player in the Game of Acquisitions—not Better nor Worse

After all, PEGs in some way essentially play by the same rules as the other players in finance, including strategic buyers and investment banking divisions: it is all a big game of acquisition, consisting of investing and harvesting returns.

“And, up until now for potential target companies it has all been about “finding the right puzzle for your piece”

Head of Acquisitions for all divisions at L’Oréal

Start-ups and companies with weak management structures or facing transformative challenges have usually gone with being acquired by PEGs—that way they can use the acquisition time (usually 3 to 5 years) to strengthen in order to later be able to be integrated within a bigger company.

On the other hand, more developed companies that have achieved a certain share of markets tend to feel more ready for the big strategics. In this case, big corporations usually appeal to companies looking either to globalize or for wider industry related expertise. The target company’s founder’s ego is also often a crucial element in a brand’s decision to become acquired.

Not to mention that big strategics are for the most part not equipped or do not have the patience necessary to acquire companies that are too small or not yet robust enough. They therefore usually themselves prefer to acquire businesses after they’ve been enhanced by PEGs.

As far as investment banks are concerned, they are usually a good match for start-ups preparing to launch initial public offering (IPO) as well as for arranging debt financing for mergers and acquisitions of corporate clients by finding large-scale investors for corporate bonds.

The point in all of this is that target companies get to choose amongst a variety of players which one will get to invest.

If every player is exposed to the same market economy laws and regulation rules, if they have been implementing the same overall strategy of return on investment, and if the side effects inflicted upon other parties involved are non-restrictive as well as self-imposed, then depending on the nuance, either none of the actors providing financial services should be considered barbarians, either all of them should—that is since PEGs have essentially been behaving in the same way as any other player.

Q: So, could strategics also be considered as barbarians?

A: “Maybe”

Private Equity Associate at Goldman Sachs

It in fact stands to reason that, some of the actions of big corporations, such as aggressively merging target businesses within their own structure, depriving those companies from maintaining their own identity and organization, and thus basically letting the initially acquired business disappear, are indeed as barbarian as some PEGs.

Whether indeed barbarians, strategic buyers, investment banks and PEGs are constantly and synchronically, refining their return on investment strategy in order to adapt to changes in the market. 

Today, “things such as deforestation and plastic waste are coming to the public sphere of thought which is influencing how the market has been pricing responsible investments; LPs are putting pressure on PEGs to focus more on environmental sustainable goals”

VP of Sustainable Investing at Lazard Asset Management

Those financial services providers then have accordingly started to update their product offerings. ESG checklists are being implemented, some conglomerates are introducing score cards indicating each company’s metrics on sustainability as well as yearly improvement target rates, SRI methods are gradually surfacing and a few actors are creating funds dedicated to impact investing—all the while, each player makes sure that its efforts are publicized, in most cases by putting out sustainable action reports and statements. 

Now Rules are Changing, Skewing the Game to the Advantage of PE

Strategic buyers, investment banks, and PEGs behave in the same manner; each of them implements some kind of return on investment strategy which they refine accordingly as changes occur in the market, in order to attract target companies which in turn get to pick the right puzzle for their piece. Most recently, these financial actors have been incorporating similar responsible investing methods to meet increased consumer and investor demand for more compliance with environmental and social objectives. Another recent change in the market, also fundamental in understanding the current niche in increasing focus on sustainable finance, is the shift in investments from public to private equity.

“PE has been getting a lot of funds lately that have been at the expense of actively managed public equity strategies”

Senior Associate at Sterling Investment Partners

Over time, the accumulation of financial crises—the 2008 crisis, the oil crisis and then the COVID-19 crisis—have emphasized that listed companies are subject to the vagaries and volatility of the market; a business may be profitable one day and see its market capital be divided the next because it is in a market that is breaking down. A recent study included in Bain Capital’s 2020 Global Private Equity Report shows the consequence of such vagaries; over the 140 years for which public market data is available, the public markets (as represented in the study by the S&P 500 and using the modified public market equivalent (PME) metric) have generated negative returns 30% of the time—that is three times PE’s down-year rate for the 30 years since its emergence. Measures of polled net IRR further show that across developed markets—including the U.S., Europe, and Asia Pacific—buyout funds have outperformed public markets for a variety of periods.

Such findings are ultimately what led institutional investors seeking long term investments to put money into PE. In the face of prospect of diminished expected returns for most public securities,  these actors—most often pension funds, endowments, and sovereign wealth funds, with obligations far into the future—now prefer to invest in such things as energy and infrastructure, or patient capital PE funds as a way to ensure stable dividends and long-term steady growth in the value of portfolio companies. They rest on the belief that over the long term, private markets will outperform public ones.

Such belief on the part of long-term institutional investors has contributed to what JPMorgan Chase estimates to be 44% growth in pools of private capital—including private equity, private debt as well as unlisted real-estate and hedge fund assets—in the five years to the end of 2019. By looking at the quartet of Wall Street firms specialised in private investment management, The Economist further found that their assets increased by 76%, to $1.3trn. within approximately that same period of time.

On top of that, what initially contributed to this increased portfolio allocation to private capital was the gradual filling of the gap of corporate credit that had resulted from the growth in passive investing. Eventually, mid-sized companies became less comfortable in the public markets as they realized that they were not liquid enough. They became more conscious that having to disclose is a constraint for undertaking investments as temporary negative quarters and decreased share prices would then make them potential prey for takeover. And, finally, with post-2008 regulation making lending costlier for banks, who had already been reluctant to lend to midsized companies, as well as the realisation that cheaper capital can be found in private markets, initial public offering (IPOs) dropped in activity as well as profitability, public-to private deals peaked in terms of count and value, meanwhile, accordingly, the number of listed companies declined by over half 1996 peak levels.

So, over the last decade, these drivers have been disrupting the nature of western stock exchanges as they implement a shift from public to private markets—this clearly to the advantage of PEG. And, PE has been adjusting its strategy accordingly; PEGs have been multiplying to meet increasing demand for management of private investments.

Beyond Steady State Hides Massive Growth Potential for PE

Today PE seems to have reached a steady state. As capital continues to flow at an exponential rate towards private markets, scarce high-quality assets have become more competitive, thus increasing average purchase price multiples. Average PE returns have in turn been trending downward in recent decades. Hence, PE strategy must again be refined. And, while further growth will not come as a given, the near term economic outlook is very promising for PE; some analysts have predicted that PE could even grow by five times over the next decade and eventually rival public markets in scale.

It is indeed not farfetched to imagine that in order to deal with ever-increasing landscape-shifting sums of capital allocation from pension funds, endowments and sovereign wealth funds, quartet PEGs will eventually increase their market capacity by emphasizing deeper diversification across industries, geographies, and asset classes. It further stands to reason that PE could recapture and scale the competitive boost that had defined its initial success by focussing on specialisation. In this sense, small and medium sized funds would become niche specialists expert in a particular industry, geography, or asset class which would in turn attract even more capital flow into PE.

Though, to be sure, the industry is not there yet. PE currently only stands for not even 5% of Assets under Management (AuM) globally and only approximately 2% of total investable capital.

Some Have Predicted that PE Could Even Take the Lead in Fulfilling Environmental Objectives

PE’s massive potential for growth over the 20’s is particularly relevant and important to grasp when discussing the current niche in increasing focus on responsible investing. That is because the industry is specifically suited for impact investing, which in turn sits at the top of the approaches to responsible investing pyramid.

“Private Equity is critical to help impact investing achieve real scale”

Senior Associate at Sterling Investment Partners

There is currently an array of entrepreneurs willing and dedicated to address society’s pressing concerns and PEGs by their nature can indeed help them achieve real scale. Private equity is designed to maximize value and manage with efficiency; it allows investors to not only support the firm financially, but also non-financially through provision of advice and management. Private equity can scrutinize over how and for whom it generates value. Not to mention, PEGs were among the initial financiers to champion impact investing.

This explains why over the last decade and initial growth phase of impact investing, most impact investing action has been in private debt and equity, including venture capital and project finance. The findings outlined in the Global Impact Platform Fund’s latest report further align with this idea; the study showed that approximately 72% of capital allocated to impact investment is raised within private markets.

In a report it published last year, the International Finance Corporations mentions  the limitations for the PEGs impact investing approach in going to scale given the fact that only a small share of the economy receives PE and venture capital (VC) funding. While this report is right in considering that in most countries, businesses tend to rely more on bank lending and retained earnings for early stage financing, promising near-term economic outlooks for the PE means that impact investing could scale within the industry over the next decade.

Further, as pension funds, endowments and sovereign wealth funds continue to allocate capital in patient capital PE funds, PEGs are refining their strategy in the real economy (that is all the non-financial elements within a society) including renewable energy infrastructure. And, as increasing competition in the PE industry directs fund managers towards becoming high-growth niche specialists, PEGs focussed solely on sustainable asset management will start to emerge—something that we are already starting to see to a certain extent.

For one, Aligned Climate Capital LLC (Aligned), an investment advisor focussed exclusively on capturing investment opportunities in climate infrastructure, deployed its wings around 2 years ago. With a management team composed of climate finance specialists differentiated in terms of technical, legal, and policy expertise and including founding CEO Peter Davidson, the former executive director of the Loan Programs Office in the US Department of Energy, Aligned sticks to its singular mission of mobilizing capital into investments that address climate change. Of course, there is still a long way to go before the majority of PEGs fully embraces the potential of impact investing, yet still, the gradual emergence of dedicated firms like Aligned in hand with PE’s massive growth potential over the next ten years suggests that responsible investing could be on the verge of a real breakthrough.

Such refined focus on SRI and impact investing on the part of a business is something that we do not yet see within investment banks and strategic conglomerates. Though, to be sure, the PEGs that do engage in such missions, might be becoming a source of inspiration for other financial services providers; while early adopters of the Operational Principles for Impact Management have essentially included PEGs, several banks are now looking to synchronize their strategy with that of PE and apply these principles to their lending portfolios. The UNEP-FI Positive Impact Finance Initiative, for one, is very big on helping banks go beyond ESG integration.

The True Intention Behind this White Knight Façade

PEGs are a fundamental part of the emerging responsible investing trend. There is evidence to suggest that they might even take the lead in fulfilling social and environmental objectives. Yet, in such money driven markets as those in Western societies we need to be cautious in our interpretation of seemingly altruistic behaviour—just because an agent does something good it does not necessarily mean they are a good person.

PEGs exist to make money. They don’t do things if the rewards are low and the risk is high”

Founder & CEO at Sustainable Platform

In a money driven market, economic agents are rational and egoistic; all carry out cost-benefit or risk v. reward analyses in order to make decisions. PEGs are no exception. Though they may be embarking towards saving the planet, to the extent that PEGs are still seeking to maximise their money returns and they are willing to go above and beyond to achieve that, these groups haven’t changed—they are still barbarian by nature. Only this time, they cannot afford the risk of not aligning with the sustainable investing trend.

In this sense, PEG’s true intention in implementing responsible investing approaches may only be to clean up their image from 2008 and please investors. This would explain why, for now, their rhetoric is overinflated and why their focus on process far exceeds delivery progress.

“ESG integration is kind of a dressed up reinvented concept of operating and managing risk”

Managing Director, Co-Head of Skopos II fund

In fact, ESG integration is in a way, embellishing taxonomy that institutional money managers use to get LPs reengaged. Investment managers and analysts had been looking at environmental, social and governance factors to avoid negative prospects far before ESG integration was even a concept. GPs have always been aware of contingent liabilities and prospects linked with environmental and social criteria—they have had plenty of strong proof points including the Deepwater Horizon oil spill, which had led to a significant loss in shareholder value. Remember WorldCom blowing up? That was further linked to governance structures. The prospective benefits of actually acting upon ESG criteria have just never been viewed as exceeding the costs—and they still to some extent aren’t which is why, with the increasing expectation put on them to implement responsible investing, PEGs have been focused more on using taxonomy to embellish their operating processes rather than on actually delivering progress.

A recent 2020 study, which had examined the 400+ PEGs that directly commit to PRI principles, found that “fewer than one in eight publicly disclose that they receive ESG reports from their portfolio companies”. Such findings further emphasize the flexibility of the ESG integration approach; a GP may choose to report only favourable case studies rather than share more encompassing or unfavourable ESG information and data. As such, it is nearly impossible to figure out how committed a PEG is to ESG integration.

All of this is to say that the responsible investing method that is most widespread amongst PEGs is in fact a basic requirement; it is low hanging fruit which says a lot about the intention of these firms.

Though even methods that supposedly lock firms into generating measurable impact can be insidious—that is because most PEGs currently manage their money under the principle of diversification. There is no guarantee that a PEG that integrates impact investing as part of its business model by creating impact funds will not at the same time be managing funds in unsustainable manufacturing or real estate. Not to mention that most often, these impact funds represent only a mere proportion of a PEG’s investments.

Does Intention Matter? It Becomes Irrelevant with the Gradual Realization that, Today, Profit and Environmental Objectives are Becoming Less Contradictory and Increasingly Conjoint

So PEGs are IRR driven. Their intention in implementing responsible investing methods may or may not be genuine. Up until now, their positive impact may have even been superficial—and if that is the case, maybe we should not hold capitalism against them. After all, they need to make money and to satisfy their investors. Not to mention, they behave accordingly to any other rational and selfish economic agent.

It almost really doesn’t matter”

Senior Associate at Sterling Investment Partners

Does that matter? The premature answer is no. It does not matter what PEG’s true intentions are—or at least it will not sooner than later. That is because today, technological advancement and ardent pressure from consumers are on the verge of seeing to it that financial, environmental, and social objectives no longer be contradictory. Gradually, institutional money managers will start to realize that it is possible to jointly achieve good risk-adjusted returns and positive impact, that impact investing can make money and make a difference simultaneously. Once they become aware of that, PEGs will shift to focusing significantly more on outcome and impact investing—and in that moment in time, when the niche in sustainable investing becomes a trend, it won’t matter whether this phenomenon would have been driven by selfish intentions.

To this date, there has been enough time only for few reliable data points for the impact fund class. Studies that show the correlation between positive impact outcomes and positive equity returns are still emerging. One rare example is a 2019 survey by the GIIN which showed that impact funds seeking market-rate performance, produced returns of greater than 16% since inception—higher than what LPs would expect from an emerging market PE fund investment”. The 2017 inaugural Impact Investing Benchmark Report published by GIIN and Cambridge Associates, though less optimistic, also showed that private real assets impact investment funds can generate financial performances comparable to similar funds without a specific impact focus.

Besides studies, also, and perhaps even more instrumental in the dispelling of myths associating sustainability with trade-off in returns, are the strong proof points. One example is the remarkable returns that some PEGs exited with upon the sale of Seventh Generation, an American company that sells eco-friendly cleaning paper and personal care products, in 2016. After having managed the firm for 9 years, these stakeholders benefited from a 6 to 7 times return on an initial $100m investment.

There is also proof that investors can generate returns by acquiring bad players and turning them around. That was the case for example for Carlyle’s stake in Yashili, a large Chinese infant formula company which had suffered reputational damage from being part of China’s melamine scandal. In less than four years, Carlyle was able to implement changes in Yashili’s production line as well as recruit a new management, introduce new standards, and ultimately exit for approximately $388 million—that was 2.3 times its initial investment.

Common sense will assuredly also play an important role in dispelling myths as institutional investors realise that companies with operational constraints, including dependence on hyper carbon and sourcing energy from fossil fuels, are essentially over earning in current time. As such companies that won’t be able to earn as much profit and cash flows some thirty years from now, start to be seen as less valuable, there will be a real structural shift in capital allocation towards, in this case, renewable energy alternatives which would be more likely to improve returns and limit risk.

All in all, it seems that PEGs will in the long run remain able to fulfil their barbarian endeavours—though differently than they used to in the past. This time it will be in a way that will benefit society as a whole. This reasoning is valid for any other type of institutional money manager.

Banks too are realizing that prioritizing investments in sustainable companies ultimately entails more resilience, more profit and less risk”

Head of Impact Based Finance at Société Générale Corporate & Investment Banking

Such reasoning further gives reason to believe that the current 10% figure of PRI signatories amongst PEGs will multiply over the next decade. As PEGs become more sustainably compliant, they will be less worried about the administrative cost of reporting and of committing to ESG and transparency, and thus more ready to commit to these principles. To some extent we are already starting to see this also, and especially, with the emergence of PEGs such as Aligned, dedicated solely to sustainable investing.

As the Niche in Responsible Investing Continues to Grow, Will Institutional Investors Continue to Work with PEGs that Haven’t Been Making a Profit Conjointly with Contributing to Sustainability Efforts?

Perhaps it is also worth noting that LPs and the institutional investors who tend to put their money into PE funds, including family offices, pension funds, endowments, and high income and net worth individuals, are too warming up to the idea that responsible investing has the potential to boost returns, increase alpha, and mitigate risks. In fact, a 2018 survey by RBC Global Asset Management had already shown a rapid increase in the percentage of LPs who see ESG as a risk mitigator and alpha generator, in both cases by around 40 percentage points between 2017 and 2018, respectively reaching 58% and 18%.

Hence pressure from them will only keep building. Soon, they might even no longer accept that a PEG would not generate financial and environmental or social returns conjointly. And, with technological progress, there will come a point when so many environmental and social compliant investment alternative opportunities will be available, that more traditional less compliant PEGs will be ousted from the game.

“Traditional investing won’t be able to stand up to sustainable investing”

Sustainable Finance professional

This observation is especially backed by the fact that over the next 30 years, $30 trillion in wealth will shift from baby boomers to significantly more conscious millennials twice as likely to invest their money into sustainable financial services providers.

Greenwashing : The Ultimate Obstacle in Sustainable Finance

As the invisible hand skews markets towards an increasingly high correlation between profitability and positive impact, and as PEGs’ IRR objectives hence become more aligned with environmental and social objectives, obstacles will arise—the most ultimate being greenwashing. Saving the world through finance will not be so easily achieved as the ideal impact investment mechanism would otherwise suggest.

Foremost, in the case where PEGs would act upon their potential to take the lead in fulfilling environmental objectives, they would still have to surmount other players’ insidiousness. In fact, as PEGs start scaling the market for positive impact targets—that is, companies offering sustainable solutions, on which PEGs would be able to inflict growth—they will have a hard time differentiating between firms making rather true or superficial impact. That is because non-industry agnostic companies, especially those stuck in non-sustainably compliant sectors such as oil & gas, will most often try to disseminate disinformation regarding their environmental and social conduct. Given that it would be a harder and encumbering process for them to change they might be more willing to accept risks associated with being unveiled—that is especially given the low probability of such scandal due to the material difficulties associated with measuring impact.

Add to that the fact that many companies do not have systems in place to collect quality data. While tangible sustainability factors such as greenhouse-gas emissions are generally well-established, it is more difficult to quantify performance for other factors such as human capital and inclusion. Hence, greenwashing will make it a challenge for PEGs to truly make a positive difference in the world once they embark on that journey. PEGs will have to focus their stringent due diligence efforts to greenwashing risks as they do today on other issues.

Not to mention that investing in the wrong companies would also mean unintentionally taking on the risks that come with those insidious players. In the case where those players would be unveiled, then the PEGs involved in such companies would then too bear the costs of scandal. These outlier cases would in turn compromise the studies seeking to show that investing in generating positive impact will generate greater profit than investing less sustainable alternatives.

“Data availability and the establishment of a standardized materiality framework will be the biggest challenge for the industry going forward. While this is a fairly daunting battle at the moment, there are a number of stakeholders in the financial, technology, and sustainability sectors focusing on building the infrastructure necessary to move this segment forward. ESG and Sustainable Investing will become increasingly prevalent as these gaps are filled and we will see exponential growth in this space. The leaders and front-runners of today will greatly benefit from investor demand in the coming months and years.”

Sustainable Finance professional

Problematic Solutions

The industry has been seeking solutions to quantifying impact.  Years of effort by standard-setting groups have made available a dozen of major reporting standards and frameworks for companies to use. Amongst the major non-financial reporting guidelines are the GRI Sustainability Reporting Standards, the OECD Guidelines for Multinational Enterprises, the ISO 26000 Guidance on social responsibility, the UN Global Compact’s Communication on Progress, as well as the IIRC International Framework.

The problem with such guidelines is that businesses have discretion to use them as they see fit. They can choose which frameworks and standards to follow, which stakeholders to address, as well as the information they want to make public. As a result, the diversity with regards to the scope and depth of company disclosures has become a defining feature of sustainability reporting as well as a source of difficulty.

Such diverse reports lead to inconsistencies in the target tracking mechanisms that PEGs who seek to generate positive impact use. In fact, a proliferation of third-party players such as Bloomberg, Sustanalitics Capital IQ, Sustainable Platform, and Morningstar as well as global systems including ISRS and GIIRS have been using company reports on sustainability to devise standardized metrics, benchmarks and rating systems investors can use to gauge results. Such tools, including the Bloomberg Industry Classification Standards (BICS), IRIS standards, B Analytics, the star rating system and GIIRS rating have been used by investors both, to scale the impact industry and to assess their own portfolio’s impacts. Based on ratings and standards, some firms may receive certifications, including the B Corp-certification, the ISRS certification, as well as the Eco Certification.

Some funds have also been creating their own tracking mechanisms. The TPG Rise Fund, for example, created the impact multiple of money (IMM) calculation to assess social returns on investment. Using the IMM helps the fund direct capital where research supports social impact, allowing it to compare investments across sectors and regions.

Though those tracking systems are only as good as input allows them to be. Hence, given that input data is often treacherous it would not be surprising that companies only generating superficial impact be rated as a top sustainability performer. Not to mention that similarly, proprietary indexes and rankings can also diverge meaning that it is not uncommon either that a company be rated as a top sustainability performer by one index and a poor performer by another.

The Increasing Expectation Put on Finance Should Not Undermine the Need for Legislation

“Unfortunately, businesses now rank higher in terms of trustworthiness than the government does”

Senior Associate at Sterling Investment Partners

Western world governments have notoriously been very poor when it comes to anything meaningful impact related. Consensus has hence gradually tended towards putting more expectation on financial institutions and the investment management industry. And, now, there is a general belief that those institutions that are steward of cash, that invest on behalf of other people, will have a more meaningful impact in the world of sustainability than any government prospect.

Though just because economic mechanisms are moving in the right direction does not mean that there is no need for a stronger legislative framework to move faster. While it might seem today that some governments are even moving backwards in terms of generating impact, we must not forget the power of legislation. That is because for disruptive change to happen, regulation will be essential.

Transitioning from a capitalistic, profit only driven economy to sustainable capitalism, from generating negative impact to orienting businesses towards generating ecosystems, will essentially necessitate legal mandates requiring companies to not only issue sustainability reports, but also to conform those reports to a single standard–as financial disclosures must. Such enforcements and greater uniformity would help companies disclose more consistent, financially material data, thereby enabling PEGs and other investors to save time on research and analysis and to arrive at better investment decisions. Efficiency gains will also accrue for third parties providing tracking services as well as for executives who currently devote disproportionate efforts and expenses to answering repetitive requests for the same information regarding their impact that must be tabulated in diverse ways to conform different standards.

This is the direction in which the new European Taxonomy Regulation seems to be going. As of December 2021, member states of the European Union and the relevant market actors as captured by the Non-Financial Reporting Directive, will indeed have to start complying with a uniform EU-wide classification system and framework that will allow for more harmonised determination of which economic activities are sustainable. Such requirements are essential for the EU to fulfil its objective of becoming the first climate-neutral continent by 2050.

On a similar note, and within the United Nations Environment Initiative, the Positive Impact Initiative (PII) further provides principles applicable to all stakeholders involved in the effort to finance the UN’s Sustainable Development Goals (SDGs). The Positive Impact Initiative recognises the necessity for streamelineliness and getting financial and government actors on the same page when it comes to achieving disruptive societal change. Indeed, such inclusive guidelines, and setting a common language for the financial community as well as corporates, governments and civil society aim to facilitate the government’s role in stimulating the emergence and growth of new impact-based business models.

Conclusion

Thirty years after the resurgence of the term barbarian to designate PEGs—in the post 2008 era in which tendency seems to have shifted towards more transparency—the appellation still is appropriate. Underlying the mix of value creation and newfound behaviour aligning with the emerging trend in responsible investing, still hides PEGs’ initial model; it is still about investing, monitoring, enhancing, and harvesting all with the aim to maximise money returns.

To the extent that PEGs are still constantly refining their strategy to maximise monetary utility, these groups are still barbarian in nature—aren’t we all?

In a money driven market, homo economicus certainly seeks to fulfil its barbarian endeavours. The invisible hand then makes sure that such intention ends up making society as a whole better off. This time, PEGs’ strategy could even solve the world’s most pressing issues.

“In the end, it will be a win-win for everybody; you have a better society, a better the world and they make money”

Director at EY

As the allocation of capital continues to shift from public to private markets; as PEGs continue to multiply to meet increasing demand for management of private investments;  as quartet PEGs will in turn start increasing capacity by emphasizing deeper diversification; as small and mid-sized funds start to become niche specialists and the industry recaptures its competitive boost thus attracting even more capital flow; as these niche specialists start to realise that impact investing can make money and make a different simultaneously and as they hence start building their business around sustainable themes, then we will start to see a real shift away from process focussed ESG strategies towards more outcome oriented aims and sustainable capitalism.

Maybe other institutional money managers will follow in aligning money returns with positive impact. But within the around the corner era of sustainable investing PE will remain with the most potential as it is especially suited for impact investing. For one, as highly enthusiastic entrepreneurs continue to dedicate efforts towards coming up with technological solutions to address one of today’s most pressing issues that is climate change, PE will be critical to help those businesses achieve real scale as it is designed to maximise value.

Though obstacles will stand in the way of PEGs; saving the world through impact investing will require coordination and streamlining. The wide spectrum reporting standards, frameworks, and guidelines as well as the diversification of tracking mechanisms and third party rating systems, what still sounds like primitive “bar…bar” to other actors involved in the quest to solve global concerns, will eventually need to be refined. If we continue to speak a different language, if each actor continues to use different standards, and referrals, then we won’t be able to harmonize and create liquid financial markets that can efficiently differentiate between a project or business that is having a positive impact from one that doesn’t.

All stakeholders involved, PEGs, banks, companies, institutional investors, governments, municipalities, and rating agencies included, will eventually need to agree on a common consensus positive impact standard like the International Financial Reporting Standards (IFRS). From a divided playing field needs to rise a new, more united civilization.

A Postscript on the COVID-19 Pandemic: Could it Serve as an Additional Boost for Responsible Investing?

Now, more than ever, and having come even more rapidly than we would have otherwise thought, the PE industry can accelerate the transition towards sustainable capitalism.

Sources have indicated that “PEGs had been waiting for the type of market dislocation” that COVID-19 entailed. These groups are now indeed scaling the market for industries crippled by the pandemic and ready to deploy the $1.5 trillion in dry powder they have been piling up.

“We must not let that money go to waste”

CEO and Founder of BlueLikeAnOrange Sustainable Capital & former Managing Director of the World Bank

PEGs can scrutinise over for whom they generate value. This ability generates significant responsibility in such where these groups rush to acquire deals; they must be conscious of how their investments might shape “the longer-running sustainability crisis”. If the barbarians are going to save the world, they must direct this massive amount of private capital flow towards the investment needed for a more sustainable world.

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Photo credits: BCI Global

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