Ethical Performance
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private equity finds itself in the unwelcome glare of publicity

February 2007

Private equity's success has invited greater scrutiny and the sector is now facing demands for disclosure of its record on social responsibility. This mirrors the experience of public companies a decade or more ago.

The Financial Services Authority is worried about the private equity market. Last month it announced that it would increase scrutiny of the largest private equity firms and the banks that lend to them, sending a warning shot across the bows of the $232billion (£118bn) industry. The City watchdog explained its concerns in a discussion paper: a mix of excessive leverage, conflicts of interest and limited market access threatens 'overall capital market efficiency' .*

But it is not only the FSA that is concerned about private equity's rise. The growth - of more than a fifth between 2004 and 2005, driven partly by the emergence of clubs of funds with $10bn or more to spend, is sending shivers through the CSR world too.

In the popular mind, some private equity firms are 'locusts', in the words of Peer Steindrück, Germany's finance minister, cost-cutting through lay-offs, loading the companies they acquire with debt and extracting huge dividends before unloading them onto the market again. From this perspective, they are asset strippers inimical to two of corporate social responsibility's shibboleths - transparency and long-termism.

Private equity typically involves equity financing of unquoted companies, from start-ups to management buy-outs of established companies. Historically, the industry has provided venture capital and restored companies to health by restructuring them, but this role is now being eclipsed by the rise of clubs of funds targeting very large businesses. The industry is now in a similar position to public companies a decade or so ago: it is under pressure to reveal more of what it does, and how it does it.

'Private equity is completely transparent and accountable to its investors', says a spokesman for the British Venture Capital Association. 'Shareholders receive detailed quarterly reports and the industry has a long and sustained track record of consistent outperformance.'

However, the disclosures extend only to investors. According to the FSA, information is 'extremely limited' to non-investors, and this relates not just to financial data. In contrast to quoted companies, which are required by law to disclose details of their governance procedures and to report, through annual business reviews, on  some environmental and social matters, the only company law reporting requirement for a private equity firm is to deposit an annual report and financial statement at Companies House once a year.

Seen through a CSR lens, this combination of weak disclosure, destruction of human capital and restricted stakeholder governance looks unpromising, according to Allen White, senior adviser to Business for Social Responsibility**. To this dismal trio, he adds programme vulnerability. 'Private equity investors are best viewed as agnostic on CSR matters. They are newcomers with neither the institutional memory nor commitment to bring CSR activities to life,' he says. 'For the general partner of a private equity fund, intangible benefits such as reputation gains and attraction of top talent will likely fall in to the category of "nice to have, but will not materialize within the lifespan of the fund". The pressure to achieve cost reductions ... will place all CSR programmes under a magnifying glass. With new management and incentive structures aligned to mid-term performance, even a strong CSR culture will likely not survive'.

One of the difficulties is lack of publicly available information. No one really knows what goes on in private equity investment except the investors themselves. But the industry has now reached a size where people are starting to take notice - and not just because of the activities of a few big players.

In the UK alone, private-equity backed companies now employ a fifth of private sector workers, yet are not subject to public scrutiny. This helps to explain why we are now seeing the private equity industry beginning, belatedly, to polish its image. The newly-established Private Equity Foundation, for example, will support child, education and community charities. A dinner it held last month in London was picketed by trade unionists. The industry is now a sitting target for pressure groups, held back to date by lack of interest, difficulty of obtaining information and resource constraints.

Roberto Quarta, a partner at Clayton, Dubilier & Rice, a leading private equity firm, says: 'The industry will have to spend more time explaining itself - and not just to existing investors. The price of success is that private equity will become a little less private. It seems increasingly likely that if private equity is to sustain returns and maintain its public 'licence to operate', we will be hearing ... less about the magic of debt markets.'

Ironically, what information there is in the public domain suggests private equity firms have sophisticated risk management systems covering environmental, social and ethical issues. 3i Group is unusual in being one of the small number of publicly listed private equity companies. The FTSE 100 company scrutinizes its portfolio of 1000 investments in Europe, Asia and the US for governance, environmental and social issues. Last year it considered more than 1600 potential investments but rejected over 1500 of these 'for financial or commercial reasons (including in some cases, for social, ethical or environmental considerations.' The company monitors cases where due diligence has identified deal-breaking environmental, social or ethical issues and says it will publish a summary this year. 3i also closely monitors the CSR performance of its existing investments and publishes its investment policy***.

But this is the exception, and it may well have to change some time soon. Leon Black, chairman of Apollo Management, a leading private equity firms, says: 'It is incumbent on us to be socially responsible and to try to co-operate with regulatory noise before the noise becomes too loud.' The question now is not whether, but how, the industry will respond.

*Private equity: a discussion of risk and regulatory engagement,
**Invest, turnaround, harvest: private equity meets CSR,


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