Private equity investing for a more sustainable future in the Covid-19 recovery phase

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Nathalie van Woerkom
AKD, Rotterdam
Nvanwoerkom@akd.nl

While corporate M&A transactions remain largely on hold in the first half of 2020, we are noticing in the Netherlands that wealthy individuals and family-owned investment vehicles are kick-starting new projects and investments. An interesting development is a strong focus on social impact investing. Family offices who are typically ‘investing for the next generation’ are increasingly looking for socially and environmentally responsible investments. Private equity (PE) funds are also keen to play a role in this regard and are being pushed to deliver by institutional investors.

Covid-19 – accelerating ESG goals

Covid-19 has raised fundamental questions about the nature of the society that we live in and what type of society we want to rebuild coming out of the crisis. The crisis is seen by policy makers and the general public as an opportunity to fast-track climate change goals. While the initial measures were aimed at crisis management, attention is now turning to the recovery programmes and the conditions attached to these programmes. A recent study published by Oxford University surveyed financial policy makers across the G20 who generally supported recovery packages that would help achieve climate goals.^[1] The authors of the study concluded that ‘recovery packages that seek synergies between climate and economic goals have better prospects for increasing national wealth, enhancing productive human, social, physical, intangible, and natural capital’.

Short-term returns versus long-term investment goals

Investments which are aimed at achieving sustainability goals will by definition have a longer investment horizon. Private equity, particularly family-backed investment funds, traditionally have had that longer view. Private equity houses are often accused of having a short-term management focus on cash flow. A 2017 University of Amsterdam research report on private equity, presented to the Dutch Parliament, concluded that this, excessive dividend distribution and asset stripping were all incidental and that there was no structural indication of this effect.^[2]

The UN-backed Principles for Responsible Investment (PRI) institute called on investors to support sustainable investment in response to the Covid-19 crisis, even if that limits short term returns.^[3] The decision by Royal Dutch Shell to significantly cut its dividend this year for the first time since World War II was welcomed in a number of quarters as an indication of its serious commitment to transformation to a greener energy company. At the same time, a number of shareholders have asked Shell to clarify how they intend to allocate the capital retained by their dividend decision.

ESG an important part of the investment and due diligence process

We expect environmental, social and governance (ESG) issues to become more prominent at all stages of transactions from the selection of targets, from due diligence reviews through to exit planning. PE managers report that the results of ESG due diligence have had an impact on price and price negotiations. ESG disclosure remains a challenge as it is often not clear what specific issues disclosure should tackle and what form disclosure should take. Buyers will be looking for information on supply chain management and compliance with anti-slavery legislation, data privacy compliance, corruption risks and more recently sexual harassment risks. A thorough upfront due diligence is also important as it is often difficult to translate ESG risks into warranty cover. In addition, warranty and indemnity (W&I) insurers will often seek to exclude cover for these types of risks.

On the legal due diligence side, we expect to closely review:

• supply chain contracts and compliance with international standards and laws;

• health and safety compliance (particularly with respect to Covid-19 issues);

• environmental compliance and policies;

• corruption issues; and

• the presence of solid technology licences for stable and safe technology tools.

Breaches of anti-discrimination laws are also being highlighted with ‘Weinstein clauses’ requiring disclosure of any harassment allegations against key personnel.

Aggressive tax planning is also being identified as a governance and reputational risk. Advisers are obliged under the Mandatory Disclosure Directive (Council Directive (EU) 2018/822) (now implemented in Dutch law) to file information with the competent tax authorities about cross-border arrangements that are potentially tax aggressive. The filing obligation is meant to apply from 1 July 2020 but this may be postponed. In any event, the directive is backward-looking: reportable cross-border arrangements where the first step in the implementation was taken between 25 June 2018 and 1 July 2020 must also be reported. Due diligence will no doubt also tackle this as an area of concern,

Driving economic growth in the developing world

In an interview with Ralph de Haas,the director for research for the European Bank for Reconstruction and Development (EBRD), he explained that their research concluded that PE investment in medium-sized enterprises in a range of developing economies helped these companies develop new products and invest in new markets.^[4] These investments had a direct positive impact on productivity and job creation. According to the research, PE had a far greater impact than the provision of micro-credit. The devastating impact of Covid-19 on the developing world will require large scale investment for recovery. Private equity could play an important role in this recovery.

Future trends

Following the pause introduced by the Covid-19 crisis, the first signs of renewed investment activity are being felt in the stock market and in the private equity investment community. While some resources will have gone to supporting portfolio companies through crisis, new funds are seeking to distinguish themselves with a responsible investment approach. They also aim to better manage risk arising from climate change and regulatory compliance.

Investors, particularly institutional investors, are putting pressure on PE funds to adopt a more proactive role towards ESG issues. Institutional investors are looking for data on which to evaluate private equity funds performance on ESG issues. While financial data is readily available, and environmental data is also increasingly available, there is a lack of clear data on social and governance issues. We expect that private equity will increasingly be asked to provide data on these issues and be judged on linked performance indicators. Well-managed due diligence in the acquisition phase and monitoring in the life cycle of an investment can contribute to this data provision process.