Where E, S and G collide in private equity…and implode

Wars are said to be accelerators of history. So are pandemics. Both unmask the fragility of our ways of life, notably our flimsy assumptions. The Covid-19 crisis has exposed the unresolved fundamental contradictions of sustainability. The environmental, social and governance (ESG) concept lacks a clear and generally agreed upon definition, as well as common and effective operational approaches.

Lower ESG returns, higher risks

ESG is even muddier in private equity. Private equity focuses on financial performance, while ESG costs money – there is no free lunch. The “triple bottom line” – a theory that recommends companies to commit to financial, social and environmental concerns – approach is a way to apply ESG criteria by placing financial performance on a par with environmental and social returns. The problem is that we cannot measure the last two easily because there are no standards. The value of the trade-off cannot be assessed. The lack of transparency in PE compounds the issue.

The listed world shows that sustainability indexes underperform the mainstream and have a higher risk due to narrower investment universes limiting their diversification. The Dow Jones Sustainability World grew at a compound annual rate of 0.38% from its launch in 1999 to 2019, according to Refinitiv data. Its maximum drawdown – measured from the starting point of the considered period – is 42.4%. The Dow Jones Industrial Average on the other hand delivered 0.59% and 40.7%. The Euro Stoxx Sustainability Index performed at 0.18% and 47% from 1998 to 2019. In comparison, the Stoxx 600 figures were respectively 0.26% and 41% over the same period.

A common argument is that diffuse ESG value (“positive externalities”) cannot be captured by indexes. This is not convincing. A rigorous analysis from “cradle-to-cradle” – a comprehensive end-to-end analysis focusing on process efficiency – can provide the certainty that only necessary resources were used optimally to reach a specific goal. This approach, described by American architect William McDonough and German chemist Michael in their book Cradle to Cradle: Remaking the Way We Make Things, requires adopting a holistic economic, industrial and social framework that seeks to create systems that are efficient and waste-free. This circular approach is the real acid test of the application of ESG criteria to investments.

Governance and performance

Comprehensive and detailed due diligence provides the opportunity to apply a full circular ESG analysis. American economist Michael Jensen famously made the case for the superiority of the LBO ownership. LBO managers can steer their investments thanks to a powerful governance framework. However, it is ruthlessly efficient because of its unique aim: extracting cash-flows from a business to refund the debt contracted to acquire it. Reconciling this with a cradle-to-cradle approach is challenging, to say the least.

Socially criticisable

The fiasco of Toys ‘R Us is a clear demonstration that the triple bottom line approach cannot stand up to a dividend recap. In this case, financial returns superseded any social concern, until a public outcry forced investors to support employees laid off by their profitable company. This minimal severance package remains an isolated event and a missed opportunity for the industry to set new best practices. The risk is that legislators will eventually take things into their own hands, with all the uncertainties associated with such a process. Although the decision was reversed on appeal, judges already took action in the case of Sun Capital III v New England Teamsters when they decided that the private equity funds were accountable for $4.5m in pension fund withdrawal liability owed by a portfolio company when it went bankrupt.

Environmentally challenged

Venture capital poses as the poster child of ESG, financing start-ups “changing the world” (i.e., for the better). The environmental credentials of VC investors are supposedly pristine, since start-ups should do better with less. They see themselves as good social stewards, creating highly paid jobs while changing the economic fabric.

They do not use debt. Their governance combines monitoring with advice and mentoring.

The reality is quite different. Industry-wise, the ramifications of VC investing challenge ESG compliance. Sustainability-focused investors exclude military technologies, tobacco, gambling, alcohol and the adult industry. Since 2000, 43% of the capital collected by VC funds has been dedicated to information technologies, which is often born out of military contracts. Moreover, its products and services are often for civil and military (“dual use”) purpose: drones, software, or 3D printing are examples. It is difficult to apply ESG filters to VC investments in this context.

Information technology is not environmentally friendly. The electricity (1% of global consumption expected to reach 3% to 8% by 2030) and water consumption, as well as carbon emissions, of data centres is staggering. The crypto-asset industry has a high environmental impact for no demonstrated benefit. Nanotechnologies generate environmental liabilities as recycling chains are non-existent. Planned obsolescence is a stain on the ESG credentials of innovative industries. Even so-called “cleantechs” consume highly polluting rare-earth metals.

The only way forward is circular
If it took a cradle-to-cradle approach, private equity would address the full scale of the environmental and social consequences of its investments. Private equity’s first aim should be the empowerment of citizens (independently assessed by themselves) with effective and durable choices. Private equity should shoulder the unintended consequences of its actions. Employees of portfolio companies should be treated with care. Ultimately, private equity managers should aim to systematically and consistently produce demonstrable and convincing cradle-to-cradle-based returns.

Cyril Demaria is partner and head of private markets at Wellershoff & Partners. He is also affiliate professor at EDHEC and author of multiple books, including Introduction to Private Equity, Debt and Real Assets.

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