What the Fortune 500 Know...

What the Fortune 500 know
...that Mid-Markets Should Know. ESG.

Conversations from the Dow Jones Equity Analyst Summit in NYC, October, 2012

Moving beyond risk management into value creation, ESG is becoming a mainstay for corporate board rooms and CFOs.  The surprise is that ESG -- Environment, Social, Governance -- once the domain of socially conscious investors and mission focused non-profits, is now becoming mainstream for corporations and investors. ESG is being used by multiple stakeholders to gauge how a corporation is responding to -- and reporting on -- metrics beyond the 'bottom line'.

In the 1960s Milton Friedman argued that social responsibility was bad for a firm's financial performance. He believed that the valuation of a company or asset should be based on a pure bottom line, a thought that has prevailed since the ideological shift to neoliberalism. In 1988 James S. Coleman challenged the dominance of the concept of 'self-interest' in economics, in his article Social Capital in the Creation of Human Capital, introducing Social Capital as a measure of value. For medium and large companies, many of whom are increasingly looking to private equity for capital expansion, having ESG practices in place can be the differentiator -- and the assurance to fund managers -- that the company is managing their future risk, costs and opportunities.

For investors, especially large public institutional investors like CalPERS, such metrics provide a baseline, indicating that funds and companies in which they invest are doing a level of due diligence needed in the new economy. A recent webinar hosted by Dow Jones, ESG: Is Your Firm Prepared For LP Questions? brought together a team of investors from a variety of asset classes to discuss their approach to ESG as a way of evaluating companies and funds for investment. The webinar, still available online, set the stage for an important conversation on:

  • How funds are using ESG as a gauge of business health and potential longevity;
  • The evolution of what Limited Partners are looking for when seeking to invest in new funds;
  • What the future of reporting is likely to look like for corporations; and
  • The need for universal metrics.

How funds are using ESG as a gauge of business health and potential longevity

For many investors, especially the large public funds whose employees are dependent on the funds' success for their pensions, ESG is a basic requirement. As Anne Simpson, Senior Portfolio Manager of Investments & Director of Corporate Governance at CalPERS (California Public Employees' Retirement System) said,

"Our conviction is that companies which manage these issues well typically are managing everything well. A company that is not tuned into this agenda is probably missing an enormous amount that matters on the radar screen of their corporate strategy."

CalPERS, with $235 billion in assets, includes ESG in their due diligence, asking for information on processes, what policies are in place, existing reporting procedures and more. Their policies include funds and fund-of-funds, which means that General Partners must have practices and reporting structures in place for their portfolio companies. When asked if funds or companies that did not report would be qualified for investment, she answered that a company could say, "no" to the questions, but would need a good explanation why such metrics were not relevant to its business.

Evolution of what Limited Partners are seeking

For firms looking for Limited Partners to invest in their funds, the landscape has been challenging. Tom Murray, Managing Director of Corporate Partnerships at the Environmental Defense Fund (EDF) added,

"The trend is that there will be the same aggregate capital allocation to late stage private equity, but probably to half the number of funds. So how do you ensure that you're one of the funds that can continue to raise your successive funds? We think that having these tools show that in the future of a more complex environment, you have all the capabilities necessary; [ESG] being one of those."

Mr. Murray, who has worked with large investment firms such as KKR (Kohlberg Kravis Roberts), added that ESG reporting is being fueled by:

  • Growing interest and pressure from investors for transparency at all levels.
  • An incredibly competitive fundraising environment, in which expanded due diligence is seen as a differentiator.
  • Challenging economic times, leading to longer hold times, which demands a focus on operational improvements.
  • Changing expectations about what value creation means: a growing expectation of shared value leading to strong returns for investors, higher corporate performance and more motivated employees.

A new report sponsored by Dow Jones and produced by Malk Sustainability Partners, surveyed 13 general partners and 6 limited partners. 92% of the respondents said they planned to increase ESG metrics, processes and/or capabilities in the future, while over half currently used ESG processes to increase value in their portfolio. The report results, available in the webinar, outlined the approaches being used by private equity. Andrew Malk, Managing Partner of Malk Sustainability Partners, the author of the study, (which is available free online) elaborated in further conversation. He said that it is tougher for Private Equity to get the kind of returns they had in the past, as there is:

  • More competition,
  • Not as much equity available, and
  • Not as much of a 'tailwind' from high EBITDA multiples on exit.

In addition, much of the activity in the market is around the transformation of infrastructure -- transportation, energy, water -- which is a very different model than IT. As a result, Private Equity is evolving, focusing more on organizational development. ESG is 'another tool in the toolbox.' He noted that there is "nothing resembling a standard." The UN IPC is a bit like a Hippocratic oath: a good set of guidelines to consider when forming policy. As a result, funds are looking at what the early adopters are doing, and reverse engineering their own approach, or working with consultants, like Malk Sustainability Partners, to form their own policies. For mid-market companies and funds, he believes that ESG is a source of competitive advantage. In addition to savings from operational costs, commodity risk is a looming problem that more companies are having to take into account. Policies to manage -- and in some cases profit from -- such risks can set a firm above the competition.

"Operating companies don't have to be Unilevers. The percentage of returns is the same for large, medium or small firms."

Another driver is that large companies, which are often the customers for mid-market companies, are driving mid-market adoption by setting their own targets, along with developing a supply channel code of conduct. He concluded by saying, even the mid-market funds, like Oakhill Partners, are starting to develop policies. And this will drive the need for ESG practices further down the supply chain.

What the future of reporting is likely to look like for corporations

In some ways, ESG is a moving target as it measures both intangibles -- such as community good-will and employee satisfaction -- along with tangibles, such as energy and water use, waste management, chemical processes and so forth. Many CSOs (Chief Sustainability Officers) are using one or more evolving reporting protocols (see next page), but those are continually evolving as more information is available. Some won't have their new forms available until 2013.

Don Anderson, Chief Sustainability Officer at Blackstone, a Private Equity firm with over $161 Billion in investments, started as a consultant. He first looked for no cost, low cost, fast-turn-around dollar savings with environmental benefits within Blackstone's existing portfolio. He was aided by a good operations department. It seems that Mr. Anderson's work had clear benefits, as he was hired on as CSO.

One of his approaches is to develop best practices that can be used throughout similar portfolio classes. For example, he mentioned that Blackstone has more hotel beds than 'anyone'. As a result, he has been able to find criteria that work for a wide variety of corporations, with both savings and efficiencies. Another approach has been to introduce practices into a small division of a larger company, evaluate the successes and failures, and then bring those practices industry-wide.

He went on to say that "54% of our portfolio companies now have ESG practices that go beyond risk management and cost savings, by addressing access to new markets and driving innovation. 93% expect to increase their focus in the coming months."

He told of one instance where the fund of a noted organization included a right to suspend capital calls if the organization failed to meet agreed-upon ESG targets. Tom Murray has been working with investors at EDF for some time. He believes that mid-market adoption is critically important as the policies of the Fortune 500 trickle down along their supply chain. His ESG lens is formed by working with large funds, like KKR and the Carlyle Group, which started looking at reducing emissions and waste as early as 2008. Using the EDF's 25 years of partnering with the likes of Fedex, McDonalds, and Wal-Mart, Mr. Murray found that Private Equity was a faster way to help convince companies that incorporating ESG metrics is a better way to invest for higher returns. KKR has over 60 companies in their portfolio, of which they have helped jump-start 23.

"This kind of leadership is setting the pace, using ESG as a proxy for a 'well run company'."

What is exciting for EDF is to see the way that Private Equity, from the mega firms to the mid-market, is looking at generating value for the long term. He sees a trend to move toward operational improvement over financial engineering. The goal is to find transparent metrics that can be duplicated, echoing Mr. Anderson's approach at Blackstone.


The need for more transparent metrics is a major problem for many starting to look at ESG. There are five widely used public protocols, such as the UN PRI (Principals on Responsible Investing), CDP (Carbon Disclosure Project), the Global Reporting Index and The Climate Registry. Many firms work with consultants from companies like KPMG, PWC and nonprofits like Ceres, and those organizations are also working with companies to help them develop best-of-class approaches to ESG. Mr. Murray sees the GRI (Global Reporting Initiative) as a first step. "It's where the rubber meets the road," he said. He cited a project with Oakhill Capital Partners, a mid-market firm relatively new to ESG. EDF and Oakhill developed a process to evaluate 3 metrics for operational processes: Environmental Performance, Energy Efficiency, and Waste Management. They also looked at companies positioned to take advantage of operational savings, that also had a committed customer base ready to support new initiatives. Developing a 2x2 matrix, they selected 20 mid-market companies that fit the profile, and that's where Oakhill invested. He added that every year EDF trains Business School graduates and deploys them in various companies throughout the summer. This year, 97 students, their largest group, trained in organizations ranging from Google to the Boston Public Schools.

"Three to four years ago, these approaches did not exist. Today they are becoming a normal part of doing business," He said.

Another nonprofit providing guidance for corporations is Ceres, which recently published its 20th Century Roadmap for Sustainability. Taking a slightly different tack, they look at governance, disclosure, stakeholder engagement and performance. Focusing on performance, Andrea Moffat, VP of Corporate Programs at Ceres, said

"Corporations need to have their targets in place, but that those targets should be tied to compensation so everyone from the CEO down the line is driving toward the same goals."

She added that different sectors have different objectives among operations, supply chain, product and services, transportation logistics, and employees. She mentioned that the driver for mid-market companies, is the larger corporations including ESG measurements in their RFPs or supplier questionnaires. Companies like Intel and Bank of America are looking to clean up their supply chains, and those that are ready for the questions are in a better position to compete. Although they primarily work directly with large corporations, they recently produced a set of guidelines for smaller companies, "The Supplier Self Assessment," which can be downloaded from their site.

Legislative Head Start

While ESG is 'just good business', companies that start building capacity now are likely to get a head start on coming regulations. Cities like New York, Philadelphia and Chicago are imposing fines and codes on new construction or retrofits for existing buildings. As water quality and shortages become prevalent, municipalities are creating mechanisms to charge corporations for water use and storm water runoff. Large corporations, with a stake in new legislation, are likely to have significant input that will protect their investment or policies. As the 'stick' in the ESG equation, figuring out what metrics work best for a given corporation can make them ready to have their best practices incorporated into local codes.