What was once a cottage following mainly among institutional investors, the inclusion of Responsible Investment (RI) is continuing to become a standard concern within private market investments. While the public market investment managers were first to the game (think Calvert, Pax World, TIAA, etc. …), the adoption within the GP community is becoming increasingly prevalent as well.
One of the main catalysts for this improving adoption has been LP expectations (which in my mind, is a good thing). Already core practices among the mega-plan sponsors like CalPERS, leading endowments and foundations, and growing in the single-family office and sovereign wealth fund domain, are now being implemented (or in the process of) by smaller pools of long-term capital. Moreover, going back a few years, the voluntary RI standards drawn up by the U.S. Private Equity Council, and the UN’s Principles for Responsible Investment (UNPRI), have likewise ushered in a new adherence to RI.
With that in mind, I’ll briefly provide a definition of RI we can probably all agree upon, and then list some reasons more LPs are choosing to partner with GPs that incorporate RI as part of their investment process, regardless of the funds sector(s), size, or geographic focus.
Responsible Investment (RI) is a broad concept that acknowledges different approaches, such as ethical investing (i.e., anti-Sudan), socially responsible investing (i.e., tobacco-free), sustainable investing (i.e., reducing CO2 emissions), impact investing (i.e., backing of microfinance companies), and corporate governance (i.e., board diversity and anti-corruption policies).
Potentially Enhancing Returns: Yes, this may seem counterintuitive , since reducing one’s opportunity set – whether in listed or private equity – can limit potential return. However, within private markets, RI by it’s very nature of increased “hands-on” involvement from GPs, incumbent management at portfolio companies, and ad hoc operational partners, can usually serve to augment value creation, long-term company performance, and ultimately better exit values through higher multiples paid by strategic buyers or a successful flotation. Moreover, I found a recent quote from a notable LP underscoring the importance that RI factors can have on their private market interests:
“We see responsible investment as being very relevant to the private equity industry because we can really have an impact on portfolio companies, and support sustainable development and innovations.” – Finnish Central Church Fund, Finland
Enhanced Investment Analysis: While RI can provide a superior IRR at times for the reasons listed above, a related benefit as well, is it can shed light on issues that might be overlooked using traditional approaches. In essence, a dedicated RI process provides another layer of scrutiny that can help financial sponsors identify risks and opportunities that may be otherwise unseen. Moreover, funds and portfolio company management that are focused on RI, are often a good representation of a high quality organization. By seeking to consistently do the “right thing”, both GPs and LPs are rewarded with portfolio companies having highly talented and motivated management, a loyal and expanding customer base, and less of a chance of incurring unwanted headline / reputation risk.
Global Trend: While a universally accepted approach to managing RI considerations is getting closer, the common threads among GPs that incorporate it (and the LPs that continue to demand it) are quickly leading to the emergence of best practices. Simply becoming a PRI signatory is no longer sufficient, and GPs coming back to the market to fundraise without a well-defined RI process will likely have an uphill battle.
Lastly, what was once predominantly focused on mitigating risk in portfolio companies, the implementation and ongoing monitoring of RI will only become more prevalent. As LPs continue to expect more from GPs, many investors will go above and beyond by integrating RI across their entire investment cycle. As a result, it makes sense that LPs and GPs work together more often to achieve their common RI goals, which can lead to the establishment of best practices and ongoing refinement.
David M. Kraemer is the Founder and Managing Member of 10 || 2 Capital Partners, LLC