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Private Equity Needs To Up Its Game To Address Systemic Risks

Are private equity firms doing enough to address systemic and systematic risks at both the firm level and the fund level in order to be the change agents that they have the potential to be? A new report from consultancy firm 17 Communications says no, and that there is much more work that still needs to be done.

Private Inequity: How the Private Equity Industry Needs to Improve When Addressing Systemic and Systematic Risks analyses how private equity firms have publicly responded to recent crises, including climate change, racial injustice, and the Covid-19 pandemic. The research team created eight categories of response and found that more than a third of the firms analysed (100 of the biggest private equity firms) took no action at all; they issued no public statement of support, nor did they make a donation to a charitable organisation related to the crisis. Of the range of potential responses available to private equity firms, only 11% - 264 out a potential universe of 2,400 responses - of these were made.

The lack of action belies the bigger picture, however. Delilah Rothenberg, Founder and Executive Director of The Predistribution Initiative, and a contributing author for the report, says that the study focuses on private equity firms as opposed to hedge fund managers, for example, because of their potential to be instigators of change.

“Private equity is well positioned to work on these issues,” she said. “The industry has a lot of potential for positive reform. As compared to, say, most hedge funds and public equity investors, they can influence the governance of their portfolio companies as well as the capital structure to implement change related to systemic risks such as income inequality, climate change, and systemic racism.”

In addition to the idiosyncratic power of private equity firms to be change-makers, their influence in global economies is set to increase in the coming years, thus expanding their importance in the societal change zeitgeist. Numerous data providers have produced research showing that allocations by investors to private equity funds are increasing, and there exists currently a record amount of dry powder available for these firms to deploy. Add to this the sheer number of private companies in existence, and the fact that they are staying private for longer (and in some cases not going public at all), then compare that with a shrinking universe of public companies, means that the private equity industry has still plenty of room to grow. This projected growth means, however, that both private equity firms and by association, their investors, will become more exposed to systemic risks than they were previously.

“Even though private equity firms might have a 10-year closed end fund, they are still under pressure to return profits to investors quickly. There is a risk that PE firms might cut costs related to ESG-related topics – such as quality jobs or stakeholder engagement - to achieve those goals. Other techniques like over-levering a portfolio company or doing a dividend recap that over-levers a portfolio company might generate returns in a short time horizon, but they weaken the underlying companies and put stakeholders including workers at risk in the case of bankruptcy or other forms of restructuring. We’re getting into a situation where these risks can weaken the economy and therefore financial system, and end up boomeranging back to the original investor – the LPs – thereby jeopardizing their returns and the people they represent in the medium to long term,” said Rothenberg.

The report makes eleven recommendations that private equity firms can implement in order to address the various societal, environmental and economic issues that the industry contributes to; These recommendations range from those which are more straightforward to implement to those which requires something of a more planned, considered approach that needs to be rolled out over many years. There is some low hanging fruit, according to Rothenberg, which private equity firms can take action on swiftly.

Quick wins can be had in diversity, equity and inclusion, as the issues are now well-understood, and there are plenty of approaches to improvement. Stronger integration of ESG, such as policies, procedures, roles, responsibilities, reporting and accountability, targets with timelines, and alignment of incentives and performance metrics are also tangible goals,” she said.

For Dmitriy Ioselevich, Founder of 17 Communications and lead author of the report, the key message is that private equity firms need to be more transparent so that stakeholders can hold them accountable for any progress, or lack thereof.

“What we want to see is more transparency in communicating what their intention is to address these issues. We want to see specific projections and targets for things like diversity-based hiring or incorporating climate considerations into their portfolio. We’re not asking them to implement all of these recommendations overnight. They don’t need to get 100% of the answers figured out by tomorrow. They just need to start taking tangible steps,” he said.

The beginning of the report makes reference to what the authors call the ‘thoughts and prayers’ communications model – statements suggesting empathy and compassion towards a situation or cause, but with no real effort to contribute to the change needed to ensure that these situations don’t happen again, or that these causes aren’t required going forward. Ioselevich says that, going forward, more firms offering these statements of support isn’t enough.

 “Just because a firm publishes a statement or makes a donation doesn’t mean that they’re actually doing anything meaningful about an issue. This type of behaviour ensures that we’ll just keep repeating the same cycle until the system changes. That will only happen when we see changes at both the firm and portfolio levels. When they say something, they need to back it up.”

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