A recent article entitled “TPG: The Operators” speaks volumes for how private equity (PE) is yet again, transforming itself. Although the mega-buyout shop TPG has a history of beating the market and making its investors wealthy, the economic environment is still challenging and today the buyout firm has many more competitors than when it was founded in 1992.
In addition to intense competition for funds and deals, the new dynamic that keeps PE managers up at night is the increasing assertiveness and information demands of their investors. TPG’s co-founder, Jim Coulter, characterized investors as being "much more interested today in how you're going to deliver that value you're promising." And for fund managers raising capital, this may mean providing prospective investors with a quantitative breakdown of the value drivers at each of its past investments.
What is particularly exciting about today’s challenge to create value is that nothing is off the table and that each PE firm is approaching the challenge in its own unique way depending on its culture, strategy, and resources. For example, TPG has a dedicated “ops” group of 60 people that works at the ‘front end’ with deal teams on due diligence. They also spend time searching out efficiencies to improve the performance of portfolio companies.
The Environmental Defense Fund (EDF) has had a ring-side seat in observing and participating in this latest phase of the industry’s evolution. What has been remarkable is to watch PE firms build out their traditional toolbox of rigorous financial analysis and management disciplines to include comprehensive environmental, social, and governance (ESG) due diligence as a means to deliver greater operational efficiency, and employ environmental innovation to transform businesses into cleaner, more productive enterprises.
Transparency around ESG issues is increasingly on the mind of PE investors. A recent survey of institutional investors by PEI Media found that more than one-third has turned a GP away because it had insufficient policies in place to manage ESG issues. European investors were especially demanding (or enlightened depending on one’s point of view), with nearly three-quarters saying they considered ESG policies “vital” to fund selection, versus less than 20 percent in the U.S. Still, as evidenced by the growing adoption of guidelines for responsible investment by U.S. Private Equity Growth Capital Council, an ever-increasing number of U.S. PE groups are starting to accept that managing ESG issues is just good business practice.
EDF’s experience working with Kohlberg, Kravis Roberts & Co (KKR) and The Carlyle Group (Carlyle) is that while investors stand to benefit from sound ESG policies and reporting practices, they can also benefit financially through unearthing additional value-creating potential by focusing on ESG matters in portfolio company operations.
In 2008, EDF teamed up with KKR to develop its Green Portfolio Program, an initiative designed to measure and improve environmental and business performance across the firm’s global portfolio. In its first two years, the program helped eight portfolio companies adopt innovations that eliminated over $160 million in operating costs, 345,000 metric tons of CO2 emissions, 8,500 tons of paper and 1.2 million tons of waste. Based on these results, KKR has expanded the program to include 17 companies across the globe in seven different industry groups and is developing internal systems to share best practices and measure impacts.
In early 2010, we launched a second PE partnership with Carlyle, focused on identifying opportunities for value creation during due diligence. The initial result of our collaboration is a new environmental due diligence screen – EcoValuScreen – that systematically incorporates environmental opportunities to improve operations and create value in the early stages of the investment process. Carlyle deal professionals are currently applying the process to new transactions in the U.S. – including the recent acquisition of NBTY, Inc. – to more effectively evaluate the operations of a target company, identify the most promising environmental management opportunities, and incorporate them into the post-investment management, governance and reporting plans.
And most recently we announced a pilot program with Ernst & Young – Green Ops for PE - to help PE firms harness the power of environmental innovation to improve financial and environmental performance across portfolios. Green Ops for PE will offer PE firm participants a tailored assessment of the environmental opportunities across their portfolios and suggest strategies to capture environmental and financial value.
These are just a few examples of how PE groups are harnessing environmental innovation to drive value creation and improve transparency throughout the investment process. The highly competitive nature of the business suggests other PE firms will not sit idly by and will follow suit, discovering new ways to improve due diligence, boost portfolio company performance, and uncover new growth and investment opportunities by effective management and reporting on ESG matters.
The rewards are likely to be great as higher returns and greater transparency of ESG risks and opportunities translates directly into stronger relationships with LPs and other key stakeholders. As TPG’s Coulter states in the above-referenced interview, "TPG can’t operate in the shadow anymore. It's time for us to enter the narrative." Significant upside, financially and reputation-wise, awaits those in the industry prepared to make the leap.
Tom Murray is a Washington, DC based managing director for corporate partnerships at Environmental Defense Fund (EDF), a leading US-based non-profit organization. Founded in 1967, EDF links science, economics and law to create innovative, equitable and cost-effective solutions to society's most urgent environmental problems. To maintain its objectivity, EDF accepts no funding from its corporate partners and that independence frees EDF to set ambitious goals and drive change across entire industries.
For more information about EDF’s work with the private equity sector, visit www.edf.org/greenreturns
