Place values and people first.
Actively employing operational practices guided by the environmental, social and governance (ESG) framework within a private equity (PE) portfolio gives the fund its best chance of outsized returns.
While at times it seems like ESG priorities can be at odds with financial outcomes, we recognize that implementation of ESG practices is actually a key driver of financial returns in a world with increasing competition among investors. By using an ESG mindset in operating businesses, the PE firm makes its portfolio companies attractive places to work in a world where the labor force is increasingly wary of working for PE. We firmly believe that winning on talent is the best way to win on investments.
Background
There’s no doubt that ESG is increasingly infiltrating the lexicon of mainstream finance from limited partners to asset managers to hedge fund traders. In an environment of increasing competition and a wider array of places to park money, shareholders and capital allocators are increasingly demanding not only financial performance but also social outcomes. By the end of 2017, there were 234 exchange-traded funds and mutual funds that purported to apply socially responsible investment practices. The number of funds claiming to use social impact frameworks in investment decisions has more than doubled since 2012. In the “Schroders Global Investor Study 2017,” 81 percent of survey respondents in the United States said sustainable investing is more important than it was five years ago.1
Yet, some remain skeptical of this “fad.” On one hand, it seems like asset managers can fit almost any investment or company into an ESG or social impact framework as every enterprise interfaces with society in some capacity and in the free markets. We lack a quantifiable, standard measurement for ESG like we have for financial returns—there’s no GAESGS (Generally Accepted ESG Scoring) despite several attempts at a data-driven approach to measure ESG. Often, investors will just tag something as “ESG-conscious” on a binary scale at investment, check the investment criteria box and then forget about it and return to what they consider to be the more important parts of their job. They’re missing the point.
Others opine that ESG practices can seem like charity work at odds with financial outcomes, which is our commitment as financial fiduciaries. The business improvements yielded by ESG practices often require upfront investment that takes time for direct returns to be realized, if ever attributable—often beyond the life of the fund or the investment. For example, changing entire office complexes to energy-efficient light bulbs will deliver cost savings in the long term, but the inflection point in these situations often comes outside of the time horizon for many investment vehicles. Additionally, offering longer term parental leave policies may have a near-term financial cost to the business, but likely creates a more engaged workforce with less turnover … but how can you definitively measure the return on investment?
Most research into returns parity between socially responsible and traditional investing has been focused on public markets, due to robustness of data and information. Some studies argue ESG-minded companies outperform, while others suggest no discernible difference or sometimes a decrease in returns. In March 2017, a study found that the Norway Sovereign Wealth funds had reduced returns by 1.9 percent points due to a commitment to excluding certain asset classes—related to tobacco, alcohol and coal—from the investment vehicle.2 As is often the case with financial research, the jury is still out for ESG’s impact on public companies. Also, research on private markets is scarcer and more difficult to substantiate.
At Alpine Investors, we’re setting out to achieve creating the best place to work, for our own employees as well as our portfolio company employees, and in terms of our goal to achieve financial results. We’ve found that the first is a key driver towards the second, and as a result, we’ve shaped our entire investment and operations strategy around placing values and people first with an operational ESG-like mindset to attract increasingly socially conscious talent. Here are some suggestions based on our experiences.
Put People First
Operate with a “PeopleFirst” playbook. PeopleFirst is a double entendre that means putting people and values first, as well as putting people first sequentially by recruiting great people prior to making an investment and ensuring that you have strong leaders on the bench before buying companies. This ensures that your portfolio companies aren’t left with no leadership or poor leadership during some of the most critical days following a majority transaction.
A majority transaction, by its very nature, is a change that can disrupt and destabilize even the best organizations, and you’re only doing yourself a disservice if you lack strong social alignment throughout. At our firm, we have an internal talent team that identifies executives and leaders with high emotional intelligence, leadership and adversity quotient that ultimately will be paired with companies undergoing a transaction to help stabilize and align the culture. Getting the right team on the bus is Step 1 in prepping a business to hit its performance targets.
The costs of misaligned or disrupted culture in a PE transaction are real. If not managed well, the culture of a company can erode with new ownership. Employees worry about job security; there’s a divide between incumbents and new hires and strategic direction changes causing confusion. PE investors almost always experience employee turnover at the outset of a hold due to these things, and turnover is costly, often as much as six to nine months salary, as one study conducted by the Society for Human Resource Management suggested.3 Do all in your power to minimize this. For example, we use a bucket metaphor for customer retention that also applies to employee retention: Focus on plugging the hole in the bottom of the bucket first, then start filling the bucket. It’s hard to make progress with a leaky bucket. We try to make sure we’re not losing employees (or customers) out the bottom of the bucket.
Our goal is to solve the initial culture crisis by avoiding it. Employees generally have given a lot to an organization, and the worst thing is not to acknowledge that and come in with only pithy strategic goals in mind. Good leaders know how to manage these situations, and one of our guiding principles is, “first, don’t break anything.” Entering the investment with a socially aware mentality saves us a lot of operational and financial headaches and treats the employees in a way that gets them excited about the new ownership. From there, it’s crucial to ensure high employee engagement and low turnover. We measure our employee engagement quarterly at the management company level and share our employee net promote score practices across the portfolio. Make sure employees are happy, or you’ll deal with the costs of the leaky bottom of the bucket. Make the company a “best place to work” so the best employees want to work for you and don’t want to leave. Our aspiration is to have at least 50 percent of our portfolio companies be formally recognized on third-party “Best Places to Work” lists.
Another key focus is injecting diversity and inclusion into industries and companies that historically have lacked creative thinking on how to attract and retain diverse talent. Women account for only 16 percent of executive teams, and 97 percent of companies have senior leadership teams that fail to reflect the demographic composition of the U.S. labor force and population, limiting the ability of companies to relate to key populations and adapt to changing conditions.
PE firms have a broad reach and strong influence on leadership teams within their portfolios and can directly influence both: (1) the composition of business leaders across an array of businesses, and (2) the future leaders of businesses by creating a ripe executive training ground within the portfolio. Using a CEO-in-Training program can help change the composition of executive teams in your future portfolio and across the business world. Instead of recycling the executives that have already found success in business, identify and attract high potential individuals who otherwise may have struggled to receive recognition in sectors that are entrenched with unconscious bias and develop/train them into executives, growing a new crop of business leaders with a high bar on diversity and inclusion.
Lastly, while we recognize that many PE firms have achieved financial success by primarily leveraging cost-cutting measures, we’ve found that the inverse can be true. We believe that in a society in which PE is generally one of the most abhorred industries in the country, we have the opportunity to demonstrate the true value proposition of PE and its ability to add value to the economy at large. As of 2017, Alpine has grown employment by 61 percent across our portfolio during our ownership,4 which has led to similarly meaningful topline growth. We believe it’s people who drive topline growth, and so it’s crucial to get the people part of the equation right and build the right team to support sustainable growth. It’s exciting to create a flywheel effect where we increase headcount to increase success, and in turn, create even more jobs at our portfolio companies. Of course, all this is moot if you can’t attract top employees to fill the roles you’re creating—and top potential employees are increasingly intentional in selecting socially impactful roles with competitive benefits.
So What?
Taking an active role in implementing ESG-like operational policies is one of the most important things we can do as a PE firm, because it puts us in the best position to win the talent game. And, winning the talent game puts us in the best position to win the returns game. Beyond being the right thing to do, it’s the right way to win.
In looking for predictors of success, look for fresh talent in a sleepy industry. Public markets benefit from notoriety and pizzazz that attract strong talent. Private markets often struggle to entice top talent, due to limited scale, limited spotlight, limited resources or all of the above. Real value can be created with consistency by bringing top talent to businesses that are looking to grow. Talent, we’ve found, is the best leading indicator for success in an investment, and it’s nearly impossible to overweight its benefits. In private markets, investors have the luxury of longer timelines vs. public markets that must cater to quarterly earnings reports, affording private investors the chance to ensure the right people are on the bus. So, as part of your diligence in assessing where to allocate your portfolio, look for: (1) a focus on management talent, and (2) structural investment in ESG-like practices that will ensure the persistence of talent arbitrage.