Steward Redqueen: PE boosts developing economies

17 December 2014 Consultancy.uk

The private equity (PE) model is increasingly being used as an instrument for sustainable growth of the private sector in developing countries. This article from Matthijs de Bruijn (Steward Redqueen) and Som Toohey (SOVEC) discusses four main characteristics of this model that drive private sector development in developing countries: a long-term horizon, a focus on value creation, a flexible investment approach and a strong position of influence to improve environmental, social and governance (ESG) standards.

Private equity investing has been utilised for well over two decades by development finance institutions (DFIs) such as FMO. The DFIs paved the way for new commercial private equity firms in developing countries, such as Actis or Abraaj, which rose up in the early 2000s. These firms are more focused on financial returns than DFIs, but also view the realisation of economic and social change as a critical a part of success. The most recent development is the adoption of the model by ‘impact investors’, who specifically aim to realise a beneficial social and/or environmental impact alongside a financial return. Examples of these types of investors are Triodos, Acumen and SOVEC.

Sovec

So what makes the PE model specifically suited to enhance the private sector in developing countries? We have identified four main characteristics of the model which could explain this.

Long-term investment horizon
Firstly, PE fund managers have a long-term investment horizon, with the regular life of a closed-end PE fund being ten years and the average holding period of an investee company being five years. The long-term commitment and involvement of a private equity investor can ensure that there is sufficient time and a stable environment to put an expansion or professionalisation plan to work. This is a prerequisite for successfully growing a business in developing markets, as constraints in the business environment – such as bureaucracy, access to energy or unreliable tax regimes – call for patience.

Value creation
Secondly, a strong focus on improving a company through active management such as through board seats is key to the PE model, simply because it is a major factor that determines financial return – and the fund manager’s share of it. In other words, there is a strong incentive for the investor to help grow the company. Fund manager team members often have previous boardroom experience, a good business network and specific sector or technological expertise. Companies can tap this expertise and use the network of its investor. This focus on growth and knowledge transfer is unique to the PE model and is in great demand in developing countries.

private equity

Flexible investment approach to fill the financing gap
A third important characteristic is the flexibility of PE, which can provide tailor-made financing solutions appropriate for the individual company’s cash flows. It can target companies in all stages, from start-ups to mature companies. Notably, it means that PE can target SMEs in emerging markets. As banks are wary to give out loans due to a lack of fixed assets at SMEs or charge excessively high interest rates, up to 68% of all (formal) SMEs in developing countries are severely underfinanced or even unfinanced. In the large company segment, PE has the ability to target and boost all sectors in developing economies – unlike investment through the stock market, which is often dominated by specific sectors, such as commodities and financial services.

Opportunity to improve ESG
Finally, PE investors are well-positioned to improve the environmental, social and governance (ESG) management of a business. This is mainly for two reasons. Firstly, PE fund managers can play a crucial role in introducing or improving ESG management due to a general lack of knowledge of the business case for sustainability in developing markets. Secondly, PE’s long-term horizon provides the prerequisite for ESG improvements to substantially materialise. Patience and time are needed, as improvements in this field are not usually quick. They may even require a change of culture among employees, such as in the case of enhanced health & safety procedures. Managing ESG not only concerns downside risk, but also upside potential. There is often potential for substantial cost savings (through energy efficiency or improved waste management), improving labour productivity (through better working conditions) or improving management quality (by setting up board committees or establishing performance indicators). These are ESG issues, but also clear business concerns.

PE boosts developing economies

Effective private sector development
A shortage of capital is still considered as one of the major constraints to private sector development in developing countries. As this article shows, PE can be a highly effective model for providing capital and growing businesses sustainably in developing economies. The long-term investment horizon, strong focus on business growth, ability to target underfinanced business segments and opportunities to improve sustainability all contribute to this fact. Government agencies, impact investors and institutional investors such as family offices and pension funds should therefore consider committing to specialised emerging markets fund managers. It could provide an opportunity to not only generate attractive returns by tapping rapidly growing economies with a diversified portfolio, but also to effectively contribute to private sector development.

Matthijs de Bruijn is a consultant at Steward Redqueen, a consultancy firm specialising in impact and sustainability. He advises financial institutions in emerging markets on development impact and ESG management. Som Toohey is an investment manager at SOVEC, a fund investing in SMEs in Africa for financial and social return. Areas of focus for the fund currently include education, health and housing.

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Private equity firms ramp up sustainability focus

19 April 2019 Consultancy.uk

In line with business leaders across the industrial gamut, private equity firms are increasingly on board with sustainability projects. According to a new study, the investment arms for major funds are implementing a number of strategies aimed at supporting sustainable economic development in line with global goals.

While the business world has finally begun to acknowledge the danger of climate change, effective action plans remain difficult to achieve. The Paris Agreement has stipulated a clear target for the decades leading up to 2100, although massively reducing emissions while not crashing the economy could be a tall order.

Businesses that are able to acquire capital can use it to boost productivity and output, thereby creating a virtuous cycle of development. However, some businesses are better able to utilise resources than others, both in terms of their relative productivity, as well as the value of the respective outcomes relative to costs (including environmental harms). Financing can therefore provide an avenue to select businesses that are aligned with various global sustainability goals, while shunning those that drive little or unsustainable social value creation.

Top moves made by investment arms towards responsible investment

Profit has for the longest time been the central criterion for investment decisions. Yet profit at any cost is increasingly seen as creating considerable social harms, while often delivering only marginal value. As a result, the private equity sector, which was initially sluggish to change its ways with regards to sustainability, has started to see the topic as an opportunity as much as a challenge.

A new study from PwC has explored how far sustainability goals have become part of the wider investment strategy for private equity (PE) firms. The report is based on analysis of a survey of 162 firms and includes responses from 145 general partners and 38 limited partners.

Maturing sustainability

Top-line results show that responsible investment has become an issue for 91% of respondents. For 81% of respondents, ESG (environmental, social, and corporate governance) was a board matter at least once a year, while 60% said that they already have implemented measures to address human rights issues. Two-thirds have identified and prioritised Sustainable Development goals that are relevant to their investment segments.

Change in concern and action on climate-related topics over time

While there is increasing concern around key issues, from human rights protections to environmental and biodiversity protection, the study finds there are mismatches between concern and action. For instance, concern among investment vehicles around climate change has increased since 2016.

In terms of risks to the PE firm itself, concern has increased from 46% of respondents in 2016 to 58% in the latest survey. However, the number who have taken action remains far below those concerned, at 9% in 2016 and 20% in 2019. Given the relatively broader scope of investment opportunities, portfolio companies face higher risks – and more concern – from PE professionals, at 83% in the latest survey. However, action is less than half of those concerned, at 31%.

Changing climate

In terms of the climate footprint of the portfolio companies, 77% of respondents state concern in the latest survey. 28% of respondents are taking action through the implementation of measures to mitigate their concerns.

Concern and action taken on ESG issues

In terms of the more pressing issues for emerging responsible investment or ESG issues, governance concern of portfolio companies comes in at number one (92% of respondents), while 60% have taken action on it. Firms have focused on improving awareness – setting up policies and a range of training modules for their professionals around responsible investment decision making. Cybersecurity takes the number two spot, with 89% concerned and 41% implementing strategies to mitigate risks.

Climate risks take the number three spot in terms of concern for portfolio companies (83%), but falls behind in terms of action (31%). Health and safety track records are a key concern at 80% of businesses, with 49% implementing action. Gender imbalance within PE firms themselves ranks at 78%, which is being dealt with by 31%. A recent survey from Oliver Wyman showed that there is gender balance at 13% of GP teams in developed countries.

Biodiversity is also an increasingly pertinent topic, with risks from pollution and chemical use increasingly driving wider systematic risks around environmental outcomes. It featured at number eight on the ranking of most likely global risks for the coming decade, with its impact at number six. As it stands, biodiversity is noted as an issue at 57% of firms, with 15% implementing action.