A Sustainable Strategy for Private Equity

After my initial post via the Wharton Magazine site, I received several questions from readers about whether sustainability can create value in the private equity realm. As luck would have it, I spent time with three private equity (PE) firms over the past three weeks regarding just this topic. Here are my thoughts.

Cash is king. Cash provides agility, enabling your firm to swiftly move when presented with time-sensitive opportunities. The pursuit of sustainability has proven to generate free cash flow for companies small and large.

Yet private equity firms cast a wary eye toward sustainability, viewing it either as altruism or clean tech. The challenge with altruism as the rationale for new initiatives is self-evident; clean tech has a stigma attached that the investments are too costly and take too long to pay off. With few exceptions, neither view will spark valuation increases among portfolio companies. As long as these flawed views persist, PE firms like Kohlberg Kravis and Roberts (KKR) and TPG will continue to wield a strategic advantage over their competition. If your firm isn’t embracing sustainability, then you are at a disadvantage.

Before showing why, let’s first define “sustainability.” Sustainability is the pursuit of prosperity in perpetuity. Every component of your growth, from natural resources to labor and capital, can become so pricey, so disenchanted, or so scarce as to prevent you from achieving prosperity in perpetuity.

Do private equity firms focused on sustainability have the deck stacked in their favor?

Do private equity firms focused on sustainability stack the deck in their favor?

The smartest PE firms are pursuing sustainability to strengthen their hand in three ways:

Enhance Suite of Services

In a heated battle for a company to add to a private equity company’s portfolio, every advantage counts. Sustainability impacts every company’s procurement, supply chain management, manufacturing and distribution functions. PE firms with a clear sustainability management vision are proving to have an advantage in the battle to acquire prospect companies over their PE brethren that do not.

Cash Generation and Risk Mitigation Within Portfolio Companies

KKR and TPG are mastering the art of generating cash by applying sustainability within their portfolio companies. Between 2008 and 2011, 25 KKR portfolio companies have reported saving a total of $644 million as a result of a reduction in natural resource consumption. TPG has reported millions of dollars in savings along with increased preparedness across its portfolio for natural resource scarcity.

PE firms that successfully pursue sustainability within their portfolios also search for, spot and apply the best practices of one company across their portfolios.

Strengthened Exit Strategies

Portfolio companies will, whether in three years or in 10, eventually exit their PE firm’s portfolios. Some will do so via acquisition, while others will trade in the public market.

Almost $4 trillion of assets under management in the U.S. are managed with social responsibility (aka sustainability) in mind. That’s more than 10 percent of U.S. investable assets. Where’s the advantage in reducing demand for your exiting company’s stock?

So the question shifts from why to how to embrace sustainability within your portfolio. One way is to employ a dedicated full-time sustainability executive, most often at the portfolio management level, in a shared services role. In other words, the private equity firm employs one or more executives with responsibility for sustainability to work as needed with each of the portfolio companies.

Some PE executives resist this idea, citing their unprofitable experience of centralized purchasing operations—for good reason because both sustainability and purchasing approaches are organized to shave costs for portfolio companies.

But the similarity of approaches ends here, as centralized sustainability within a PE portfolio is focused on identifying and sharing best practices across companies, not standardizing hard goods purchases. So, shared services sustainability is designed to improve quality levels for individual portfolio companies and shave costs in the process.

Full-time employment of a shared-services team is not for every PE firm. It might be too costly and require too much upfront investment. A full-time executive rarely has the staff of experts who can cover the range of environmental and social issues faced by portfolio companies. In addition, the executive usually does not have the political clout to effectively move the shared services effort forward. 

More and more PE firms are employing an advisory board for sustainability. An advisory board approach solves these issues by providing à la carte expertise to the board of directors and C-suite levels. These advisory board sustainability teams have been called upon to set up, monitor and advise sustainability efforts and strategies across PE firms’ portfolios of companies.

The reliance on the superior model of sustainability management is driving value creation within the smartest PE firms and their portfolio companies. Is your firm among them?

 

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