ESG is increasingly front of mind for private equity, but why do some find it difficult to integrate into their practices? What are the main barriers? In this article, EBS Advisory, a leading ESG and impact consultancy based in South Africa, Nigeria and Kenya, shares some of their insights for private equity’s integration of ESG at a fund level.
Barrier one: varying reporting standards
The first observation is a view that is commonly expressed across the sector. It particularly pertains different reporting standards by different LPs (limited partners) between the commercial investors, DFIs and impact investors, that is, if the GP (general partner) is looking for a blended funding solution.
The overall majority of reporting, due to the prevalence of DFI funding (80% of private equity funding is sourced from DFIs and, in particular, the 11 European DFIs), is based on the IFC performance standards. While comprehensive in providing very important context and structure, they were developed with their last update in 2012 in Washington by experienced professionals for all emerging markets. As such, there are discrepancies in how they might apply to the African context. For example, transformation or indigenisation of management and shareholding at a local level is not discussed or considered a local legal requirement in many companies when setting up a business and being awarded projects and tenders.
Barrier two: inconsistency in ESG enforcement
Second, the high variability in the enforcement of local legal standards for environmental, social and health and safety requirements results in very inconsistent application of these by portfolio companies. Because these companies are largely family owned and poorly monitored by the local authorities, they frequently raise significant gaps when the due diligence is performed by an ESG consultant against the IFC Performance Standards (IFC PS).
The ESG due diligence is usually the last one to be performed prior to the investment committee while the GP focuses on the financial, corporate governance, legalities and technical due diligence. This gives very little opportunity for the GP to ensure buy-in by portfolio company management prior to going to the investment committee. Hence, the 100-day plan is not able to accommodate ESG issues which are phased in gradually over the first few years of the investment.
Barrier three: lack of resource
The third barrier is a lack of available resource in country. The overall predominant expertise at a local level across the continent, from an ESG point of view, is performing EIAs or ESIAs if one includes the social impact assessment. These are prescribed by government departments prior to development being approved by the regulatory authority and are quite procedural.
This is because there are many consultants competing in a small market, and they tend to be either very small companies or individual operators. Due to the purchase being a grudge purchase by the entrepreneur, the only means for these consultants to compete is via price. The technical capabilities are not really invested in, nor is the ability or the courage developed in the consulting community, to change the way the project is designed in accordance with best international standards, as the consultants fear losing the clients as this is their revenue. So, when a portfolio company is requested by their GP, or the GP is requested by the DFI to hire an ESG manager, the available pool of local consultants is very shallow. This is especially true for people of experience and people who have the technical and, more importantly, commercial insights to be able to shift management decisions to align ESG outputs with shareholder returns over the short to medium term.
As a result, ESG managers tend to be expats or sourced from industry where the salary bands are much higher. As the GPs seeking these services are generally in their first or second funds, their management fees are being squeezed, or they need to recoup significant costs via their management fees so that the scope for affording a senior ESG manager is not adequately budgeted for. If they can afford a senior ESG manager, such a person generally becomes frustrated with the level of DFI administration and compliance reporting to the DFI community. They would either want to join the deal team or leave for more exciting opportunities.
Barrier four: risks in supply chain and distribution
Lastly, the normal economic structures of supply and demand, particularly in the supply chain and distribution networks, offer a portfolio company few options and tend to have a high concentration of risk within the portfolio company. Thus, we find that the suppliers are supplying companies with almost 80% or more of their output, while distribution chains derive almost all their revenue from selling or distributing the product from the portfolio company.
As such, the supply chain and/or distribution network of the portfolio company is a virtual extension of the portfolio company itself, and the sphere of influence imposed by the portfolio company on the supply chain and distribution network is almost absolute. Because the DFI funders are predominantly concerned with governance and reputational risk originating from domestic NGOs in the source country of the funding, any ESG transgressions caused by the distribution chain such as money laundering or, in the supply chain such as health and safety or human rights issue for example, would reflect very badly on the reputation of the investee company and hence on the GP and DFIs.
Case study: saw mill company in West Africa
A case and point example that EBS has experienced is with a saw mill company in West Africa which sources 80% of its exotic hard woods from three logging companies. These companies, which comprise a team of 5-7 individuals, operate with a truck and some chain saws in very poorly regulated market. Inclusion of these loggers/suppliers would be a natural extension of the risk mitigation framework for this particular investee company but is one for which the GP probably hasn’t budgeted. The same would apply with the ESG management system that the system would need to include the supply chain and govern them as though they were part of the investee company. Similarly, in the distribution of eggs from a poultry laying facility where the agents represent selling the products, although not directly employed, might be granted credit facilities by the poultry company and would be directly responsible for collecting the cash from the multitude of secondary and tertiary distribution informal networks and channelling that cash back to the poultry company. And in so doing need to be vetted and screened and contractually managed fairly by the investee company as though they were the marketing or distribution division of the company in their absence of regulatory enforcement.
In order for integration to be successful EBS Advisory highlights the importance of developing enduring relationships with the respective portfolio companies (PCs). This is in order to accurately articulate what ESG is and how its entrenchment can lead to cost-saving efficiencies. In EBS’ experience, it is most effective when one shows up in person, engages with the teams and encourages repeat work to establish a level of trust between the consultant and PCs. As the level of comfort increases, the PC becomes more trusting of ESG initiatives and receptive to the dual benefits of social and environmental improvements as well as long-term financial savings. Sometimes these positive results take time to materialise and patience is required.
How can companies break down the barriers?
Prioritising ESG integration, especially in the world of private equity and venture capital, provides a unique opportunity to promote shared value creation and enhance performance. When firms only focus on ESG at acquisition, they miss out on opportunities to enhance their ESG business thesis, which limits their ability to celebrate the spoils of outperformance at exit. The key take-aways from the above article are that fund manager willingness to creatively problem solve is needed in conjunction with ESG training and the development of trustworthy, enduring relationships. An amalgamation of diverse solutions will serve to alleviate some strains, but as of yet there is no ESG integration panacea. This provides an opportunity to develop a model for emerging markets. Achieving a stronger, long-term return through ESG implementation can only be truly successful through integration. As ESG becomes integrated into daily business, its impact can be monetised.