Private equity’s success has invited
greater scrutiny and the sector is now facing demands for disclosure of
its record on social responsibility. This mirrors the experience of
public companies a decade or more ago.
The Financial Services Authority is worried about the private equity
market. Last month it announced that it would increase scrutiny of the
largest private equity firms and the banks that lend to them, sending a
warning shot across the bows of the $232billion (£118bn) industry. The
City watchdog explained its concerns in a discussion paper: a mix of
excessive leverage, conflicts of interest and limited market access
threatens ‘overall capital market efficiency’ .*
But it is not only the FSA that is concerned about private equity’s
rise. The growth – of more than a fifth between 2004 and 2005, driven
partly by the emergence of clubs of funds with $10bn or more to spend,
is sending shivers through the CSR world too.
In the popular mind, some private equity firms are ‘locusts’, in the
words of Peer Steindrück, Germany’s finance minister, cost-cutting
through lay-offs, loading the companies they acquire with debt and
extracting huge dividends before unloading them onto the market again.
From this perspective, they are asset strippers inimical to two of
corporate social responsibility’s shibboleths – transparency and
long-termism.
Private equity typically involves equity financing of unquoted
companies, from start-ups to management buy-outs of established
companies. Historically, the industry has provided venture capital and
restored companies to health by restructuring them, but this role is
now being eclipsed by the rise of clubs of funds targeting very large
businesses. The industry is now in a similar position to public
companies a decade or so ago: it is under pressure to reveal more of
what it does, and how it does it.
‘Private equity is completely transparent and accountable to its
investors’, says a spokesman for the British Venture Capital
Association. ‘Shareholders receive detailed quarterly reports and the
industry has a long and sustained track record of consistent
outperformance.’
However, the disclosures extend only to investors. According to the
FSA, information is ‘extremely limited’ to non-investors, and this
relates not just to financial data. In contrast to quoted companies,
which are required by law to disclose details of their governance
procedures and to report, through annual business reviews, on
some environmental and social matters, the only company law reporting
requirement for a private equity firm is to deposit an annual report
and financial statement at Companies House once a year.
Seen through a CSR lens, this combination of weak disclosure,
destruction of human capital and restricted stakeholder governance
looks unpromising, according to Allen White, senior adviser to Business
for Social Responsibility**. To this dismal trio, he adds programme
vulnerability. ‘Private equity investors are best viewed as agnostic on
CSR matters. They are newcomers with neither the institutional memory
nor commitment to bring CSR activities to life,’ he says. ‘For the
general partner of a private equity fund, intangible benefits such as
reputation gains and attraction of top talent will likely fall in to
the category of “nice to have, but will not materialize within the
lifespan of the fund”. The pressure to achieve cost reductions … will
place all CSR programmes under a magnifying glass. With new management
and incentive structures aligned to mid-term performance, even a strong
CSR culture will likely not survive’.
One of the difficulties is lack of publicly available information. No
one really knows what goes on in private equity investment except the
investors themselves. But the industry has now reached a size where
people are starting to take notice – and not just because of the
activities of a few big players.
In the UK alone, private-equity backed companies now employ a fifth of
private sector workers, yet are not subject to public scrutiny. This
helps to explain why we are now seeing the private equity industry
beginning, belatedly, to polish its image. The newly-established
Private Equity Foundation, for example, will support child, education
and community charities. A dinner it held last month in London was
picketed by trade unionists. The industry is now a sitting target for
pressure groups, held back to date by lack of interest, difficulty of
obtaining information and resource constraints.
Roberto Quarta, a partner at Clayton, Dubilier & Rice, a leading
private equity firm, says: ‘The industry will have to spend more time
explaining itself – and not just to existing investors. The price of
success is that private equity will become a little less private. It
seems increasingly likely that if private equity is to sustain returns
and maintain its public ‘licence to operate’, we will be hearing …
less about the magic of debt markets.’
Ironically, what information there is in the public domain suggests
private equity firms have sophisticated risk management systems
covering environmental, social and ethical issues. 3i Group is unusual
in being one of the small number of publicly listed private equity
companies. The FTSE 100 company scrutinizes its portfolio of 1000
investments in Europe, Asia and the US for governance, environmental
and social issues. Last year it considered more than 1600 potential
investments but rejected over 1500 of these ‘for financial or
commercial reasons (including in some cases, for social, ethical or
environmental considerations.’ The company monitors cases where due
diligence has identified deal-breaking environmental, social or ethical
issues and says it will publish a summary this year. 3i also closely
monitors the CSR performance of its existing investments and publishes
its investment policy***.
But this is the exception, and it may well have to change some time
soon. Leon Black, chairman of Apollo Management, a leading private
equity firms, says: ‘It is incumbent on us to be socially responsible
and to try to co-operate with regulatory noise before the noise becomes
too loud.’ The question now is not whether, but how, the industry will
respond.
*Private equity: a discussion of risk and regulatory engagement, www.fsa.gov.uk
**Invest, turnaround, harvest: private equity meets CSR, www.bsr.org
***www.3i.com
