Barbarians at the gate: do private equity funds help or hinder responsible business?
A ‘responsible business’ adopts a purpose that goes beyond maximising returns to shareholders in order to achieve environmental, social and governance (ESG) goals in the interests of all its stakeholders – employees, customers the local community and the general public, as well as shareholders. The purpose may be underpinned by a social contract or compact that is explicit (as in the case of some UK water companies) or implicit with its stakeholders.
Ideally, a business’ purpose should be informed by the UN’s Sustainable Development Goals (SDGs) and the COP26 climate commitments and co-created with the stakeholders. It should also entail a series of medium- to long-term dynamic objectives, along with measurable targets and indicators, so that the performance of the business can be monitored. Representatives of the various stakeholder groups might have a place on the company board in order to improve its governance and to help ensure that purpose is put before short-term profit and that capital is allocated to enhance the contribution of the firm towards wider society and the environment.
Similarly, under ‘responsible capitalism’, responsible or sustainable investment by institutional investors (such as insurance companies and pension funds) and asset managers plays an important role in the overall allocation of capital to promote social or public good and in assuring good corporate governance through their stewardship role. They are increasingly lobbied by ESG activist organisations, such as ShareAction, to increase the social and environmental impact of their investments. Along with asset manager Candriam, ShareAction is pushing Unilever to produce healthier food products with less salt, sugar and fat.
In contrast, activist shareholders (often hedge funds) tend to focus on shorter-term goals associated with cost reduction and profit maximisation. They usually seek to persuade larger institutional shareholders of the merits of breaking up a conglomerate in which they have an interest by selling some of its constituent parts. Purpose-driven conglomerates, such as Unilever and Danone, have recently come under such pressure to put profits before purpose.
More generally, there is a time inconsistency problem in pursuing purpose, since there will often be opportunities to increase short-term profits by deviating from medium- to long-term paths. Hydrocarbon fuel producers, such as BP and Shell, that have adopted ‘net zero’ targets that they aim to hit by diversifying into green energy production could come under pressure to split the green energy and hydrocarbon businesses – with the latter perhaps taken over by private equity companies, famously dubbed ‘Barbarians at the Gate’ by Bryan Borrough and John Helyar.
Private equity thrives in times of low interest rates, which makes debt cheap, such as the period since the 2007-9 global financial crisis. The shares of a growing proportion of companies have ceased to trade on publicly quoted stock exchanges. They have become private companies as a result of buy-outs, sometimes following demergers and divestment. Private equity funds (PEFs) tend to invest for a short- to medium-term, loading the firms under their management portfolio with debts with the aim of floating them on the stock exchange and making huge profits before exiting the business. In preparing a firm for sale, they tend to cut costs and employees, trying to enhance its financial value in various ways.
Encouragingly, there are a few recent cases where PEFs have declared a goal of enhancing financial value through the promotion of ESG credentials. CVC, for example, recently won an auction of Unilever’s tea business (which includes Brooke Bond and PG Tips), promising to resolve the long-running social problems at a major plantation in Africa, which Unilever’s institutional and ESG activist investors had notably not forced it to resolve. Furthermore, large PEFs, such as TPG and KKR, have signed up to the World Bank’s IFC Impact Investing Principles. There is, however, a risk that divested hydrocarbon businesses that come under the ownership of PEFs have an incentive – especially with the currently high energy prices – to accelerate extraction, and thereby increase carbon emissions in the short-term, in order to reduce the potential stock of ‘stranded assets’ as green energy becomes relatively cheaper.
PEFs (and hedge funds) currently enjoy favourable taxation, reporting and governance regimes, though the latter are being tightened somewhat in the UK and an increase in their taxation is frequently mooted in the UK and the US. Institutional investors (particularly pension funds) have increasingly invested in these ‘alternative’ investment funds to increase their returns. But along with asset management companies, such as BlackRock, they have also been increasing their focus on the ESG impacts of their investments as a means of attracting funds and meeting their members’ preferences. So they do have an interest in the ESG credentials of the PEFs and hedge funds they choose to invest in.
The Bank of England adopts inflation targets that have the effect of discouraging the Government from creating crowd-pleasing short-termist policies, especially ahead of elections, in order to address this ‘time inconsistency problem’ in interest rate setting policy. So perhaps responsible and purpose-driven businesses also need similar mechanisms that require them to fulfil their social compacts, rather than get diverted or pressured into a short-termist focus on increasing shareholder value or profit. This can be done by enshrining the purpose of the business in its articles of association, perhaps using a special legal status, such as B-Corp in the US or Entreprise à Mission in France.
Nevertheless, Danone – which became the first publically-listed Entreprise à Mission in June 2020 – came under pressure from activist shareholders to cut costs and improve profitability, leading to the CEO being ousted by the board last year. Unilever is currently facing similar pressures and its senior management was recently quoted in the Financial Times as saying that purpose is the ‘icing on the cake’ that comes on top of ‘getting the basics right’!
So is it to be profit before people and planet, or should it be people and planet before profit? Or is being a responsible business more complicated than that?
Andy Mullineux, Emeritus Professor of Financial Economics