December 18, 2012
Interviewed by: David Snow
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How ESG Creates Value in Emerging Markets

Environmental, social and governance (ESG) investment mandates are especially important in emerging markets, where many rapidly-growing business need systems to improve performance and mitigate risk. Private equity firms in emerging markets are increasingly adding ESG programs to their value-add toolkits.

“How ESG Creates Value in the Emerging Markets” is the first of a three-part series with experts Jeremy Cleaver of CDC Group; Dushy Sivanithy of Pantheon Ventures; and Sandile Hlophe of EY.

Environmental, social and governance (ESG) investment mandates are especially important in emerging markets, where many rapidly-growing business need systems to improve performance and mitigate risk. Private equity firms in emerging markets are increasingly adding ESG programs to their value-add toolkits.

“How ESG Creates Value in the Emerging Markets” is the first of a three-part series with experts Jeremy Cleaver of CDC Group; Dushy Sivanithy of Pantheon Ventures; and Sandile Hlophe of EY.

How ESG Creates Value in Emerging Markets

 David Snow: We are joined today by Sandile Hlophe of EY, Dushy Sivanithy of Pantheon Ventures, and Jeremy Cleaver of CDC Group. Gentlemen, welcome to Privcap today. Thank you for being here.

We are talking all about ESG in the emerging markets. This is an important topic. And many people believe that actually the emerging markets in particular lend themselves to—or rather, it is important that ESG become a founding principle in promulgating the private equity strategy in the emerging markets.

So I’m fascinated to hear all of your viewpoints about this topic. Why don’t we start with sort of a 1,000-foot view about why ESG so defined is actually important in the emerging markets context.

Dushy, your firm, Pantheon Ventures, invests or rather backs managers who invest around the world, including in the emerging markets. Can you talk about how important this is for you as an investor? Is it a way to just feel good about yourself, or can you actually make money and preserve value by following these principles?


Dushy Sivanithy, Pantheon Ventures: Sure. I mean, Pantheon genuinely believes that ESG is a value-creation lever as well as a risk-management tool. And one of the odd things is, ESG management has actually been better in our emerging-markets program than it has been in our developed-markets program.

We’ve taken a lot of what we’ve learned from the GPs in Asia and Latin America and actually put it back to Europe and the U.S., where some of these things have been missed. And we have seen genuine cases of where value has been created but will stay preserved. And more recently, I think, you can actually get a strategic premium for good management of these issues. So we absolutely, fundamentally believe there is a value opportunity here.

Snow: Jeremy, do you agree? Your group, CDC, invests in managers across the emerging markets. How important is ESG in your mind from sort of a driving returns perspective?


Jeremy Cleaver, CDC Group: Sure. As a development finance institution, CDC is similar to Pantheon but also slightly different, in that we are definitely focused on commercial returns but also focused on development impact. So I think we look at it from three different perspectives.

Certainly the risk-management perspective that Dushy mentioned is absolutely critical. Because, from our perspective, if managers and investee companies aren’t managing the broad remit of their business—including from the financial side but also the environmental, social, and government side—actually we think that’s sort of missing the boat in many ways and missing the opportunity to create value.

More importantly, I think, as investors, we are guests in the countries that we invest in. And from that perspective, many of the countries that we invest in are either finding it difficult from a development perspective [or] have particular issues on the environmental, social, and/or governance side. So, again, it’s extremely important that we’re focused on those issues.


Snow: And just a follow-up question, Jeremy. Many people would argue that there’s a real opportunity in the emerging markets to get ESG right from the outset, because these are not well-established markets. So therefore you can kind of leapfrog ahead and sort of help create managers from the very beginning with these principles in place.

 Cleaver: Absolutely, absolutely. And we find, in general, the performance of our investee companies and fund managers—or poor performance—is often correlated to poor policies or poor implementation of ESG procedures as well. So that’s a key focus for us.


Snow: Sandile, you help private equity firms and other players in the market across Africa doing transactions. Have you seen a greater and greater attention to some of the principles that are part of ESG?

Sandile Hlophe, EY: Yeah, we definitely have. We’ve seen a marked increase in terms of the way that investee companies focus around how they address ESG from the time of doing entry investment, thinking about the strategy of how to invest in a company. Part of the strategy not only involves the returns to be derived, the exit mechanism, but also in terms of how they can improve and better their ESG compliance during the investment, up to a point of forming focused governments and environmental communities to improve the governance of a company.

And we have seen that more and more investors that do that, there’s markedly an improved return on the investment end when they exit. Because generally it shows that when the community and employees which work with that portfolio company and in the market that they work for are shown to be responsible to the environment and socially, they tend to have a very good affinity to the products and services that that portfolio company provides. So we have seen a massive increase in companies focusing at entry-level portfolio management, even at exit, as to how those issues of ESG have been addressed.


Snow: I guess a question for anyone… I mean, it’s easy to talk abstractly about responsible investing, but can any of you give examples of a firm that is investing that follows these principles, that was able to either create or at least protect value because they paid attention to this set of considerations inside of ESG?

 Cleaver: Sure. I mean, one example that we’ve seen in Nigeria, a security-services business that was set up as a greenfield there. The original investment was about $250,000. They really focused on providing solid wages but also sort of the environment for their labor to flourish and their people to flourish in what is really a high-risk environment. So providing medical insurance, providing life insurance for the employee and their families, and other things, which really improved the well-being of the employees.

And they were able to then become the leading security-services provider in Nigeria and then sell that business not too long later for about $10 million. So from our perspective, that really shows, you know, spending a bit more time—focusing on, in this case, the social side, making sure your employees are comfortable and able to work hard and improve the value of the company—is really beneficial.

Sivanithy: Pantheon has a view about not having a negative screen. So just because a company has an issue doesn’t mean you can’t invest, but as well as you have a plan to improve that business.

We have a business in India, FMCG. Family-owned business, had grown very quickly, nice market position, but fundamentally hadn’t be specialized. Health and safety was poor. The facility itself was substandard. Part of the investment thesis was to upgrade the entire facility, bring world-class kind of health and safety standards in. And that required heavy investment up front.

But actually on the exit, which was to UK Multinational, they were willing to pay a very large premium, because it was already fit for purpose. I think that’s where you can create value. But a lot of investors would have said, “I don’t want to invest in that business. It’s not up to scratch.” Whereas actually that’s the opportunity to create value. So I think there are plenty of those.

Snow: I want to pick up on a point that we discussed earlier, which is the fact that emerging markets, because they are emerging, are at a certain stage where perhaps there’s a greater opportunity to instill some of these methods of investing using ESG. Maybe starting with Sandile, are there are challenges and are there opportunities that are unique to less-developed economies that perhaps developed economies don’t have?

Hlophe: Yeah, so there’s quite a few. And I think, if you look at a lot of emerging markets, the big drive and attraction for investment is the potential of the growth of the consumer middle class. And a lot of those involves industry that are either in mining extractive or manufacturing that, by definition, you have to actually be cognizant of ESG principles.

Over and above that, you find that in all the emerging markets, the legislation around ESG is also evolving. So being compliant from the beginning ensures that you don’t have to then retrofit strategies and policies into your business once a legislation then comes forward.

And number two, also because there’s so much entrance into emerging markets, there’s a lot more competition. So there’s a lot more focus around, sort of, responsible investing, looking after ESG issues. It becomes quite important from a perspective to focus in.

So we find, in particular, sectors like mining and metals, manufacturing, financial services, even in the sporting goods services, there is quite a bit of focus around ESG. So I would say there isn’t a sector, particularly in emerging markets, that you won’t find that. And it’s because it’s a developing country, fast growing, a lot more competition entering, a lot more different players who might be sort of more aware of ESG.

Sivanithy: Actually, one striking difference we’ve noticed is—in developed markets, actually—the management teams have a lot of the expertise to deal with ESG and are really cognizant of the issues. Whereas in emerging markets, the responsibility is much more on the GP side to actually instill that with management.

So it’s different. Because actually the GPs we speak to are actually relying heavily in developed worlds on their management teams. And actually the GPs must be, in emerging markets, much more in tune to those issues and actually mentor and teach their management teams to make sure it’s integrated into the investment thesis.


Cleaver: Sure. And then perhaps taking that one step further, I absolutely agree with what my colleague said. But also, instilling culture change within the investee companies themselves, we found, is a particular difficulty. So where—in a postconflict country, for example—people may have personal incentives that may mean that they don’t actually understand why it’s important to wear safety gear, we see that commonly. So in that situation, it’s very important to make sure that the business itself is working with those employees.

So, for example, a metal-recycling business we had in Kenya had a number of fatalities simply because, despite relatively robust ESG policies, people weren’t actually implementing them. So the company put together a workers’ group to actually develop the implementation procedures for the policies themselves. So they sort of bought in from the beginning.

Hlophe: Yeah, that’s true. And we’re seeing quite a big trend, that the GPs that focus on making sure that the governance is at the board level, there is a committee focused on working on ESG issues, which they are much more successful in implementing. Because I think my colleagues are right in that [in] the companies themselves, management is not that fully aware or cognizant of ESG.

So you have to have that investee give that insight and oversight through the board involvement. So you find a lot of our successful clients that have brought in specific non-exec directors onto the board to focus on ESG have been much more successful in getting that right.

Snow: I want to get to a final topic. And that is all about the institutional investors who back private equity firms. Obviously a very important topic, something that every manager should care about. And maybe we could start with Dushy, since you’re sort of in between both worlds, the GPs and the LPs.

Are you finding that institutional investors increasingly are requiring their managers to get with it, to have ESG programs, to care, to monitor? And if the managers do not have anything to show by way of ESG, institutional dollars may be withheld from them?

Sivanithy: Oh, absolutely. We signed up to the PRI back in 2008 as the first fund to funds. I think over the last five years you’ve seen a huge wave of investors—mainly in Europe, but now in North America, too—signing up to this. And that shows you how committed they are to this.

I think weakness in ESG isn’t a deal killer for a lot of people. But there has to be a willingness to either engage or improve. And if you’re not willing to do either of those two, dollars definitely will be withheld. And that’s only going to get more severe as we go forward.

I think it’s just something… The ultimate source of capital cares more about these you know, pension schemes. Their trustees are asking and putting more pressure on them to explain where their capital is going and what stewardship there is around it. So I think it is going to be a bigger issue.

Snow: Do you agree?

 Cleaver: Absolutely. As a development-finance institution, ESG is absolutely critical to us for a number of the reasons that we discussed earlier. So for CDC and for the other development-finance institutions, we would absolutely withhold capital where there was deficiencies.

Having said that, as Dushy rightly pointed out, we’re all very keen and willing to work with fund managers to get them to the point where they’re able to effectively implement the policy. So it isn’t a closed door. But it is a gating issue for us. And until we’re happy with the quality and level of the systems, we would find it difficult to invest.

Hlophe: Yeah, I think that that’s also very true. Because we find that as also as EY, as we commission due diligence work, there’s a lot more focus around ESG in the pre-investment phase to make sure what is in place. And I think Dushy is correct that even if it’s not in place, just the recognition of saying “This is what we’re going to implement” and then having a plan as you actually execute the investment makes it much more palatable.

Snow: And in your private conversations with some of your clients, are they aware that their own investors are paying attention? And is that somewhat of a motivation?

Hlophe: I think it is a big motivation, especially if you’re using a sort of development of DFI institutions. Because for them, they are there to drive development. Which in a sense, there’s a new phrase coming up called “responsible development,” which focuses on making sure that you do the right things to the community, the environment, and the country in which you’re operating from the perspective.

So a lot of DFI-funded sort of investors are finding that paying attention is quite important. And you find it comes through a lot in terms of the diligence-focused areas, and saying, you know, how ESG is being handled, even to post-investment, to coming through doing what progress around the ESG implementation.


Expert Q&A With Sandile Hlophe, Africa Service Line Management Partner, Transaction Advisory Services, EY

 Privcap: What investment framework is required for successful private equity investing in Africa?

 Hlophe: The ability to understand the social governance issues related to a particular sector and the drivers of growth and drivers of value in the particular sector become important. And these you learn and improve. You understand your sector as you do more portfolio-company investments in that particular sector and as you evolve. So we found that PE firms that focus in particular between three and five specific sectors are quite successful.

And then, number two, having a good understanding in terms of which parts of the African continent are you going to invest in. There’s always a perception that Africa is just one big country. It’s actually 54 different countries, and with probably about five different regional and economic zones. So having good sector focus, good understanding of which countries and which regions, and as to what the returns expected for that sector would be, gives you a better understanding of the investment horizon.

Privcap: What is the importance of local knowledge when investing across Africa?

Hlophe: Africa’s become quite a big investment destination, so that a lot of companies are finding that they are aware that there are a lot of suitors out there. So it’s become quite competitive. So unless you have a local partner to assist you in focusing and engaging almost exclusive discussions with particular targets, it could be quite difficult in actually doing an investment. You might find the premium is much more significant.

Number two, Africa growth is driven by a lot about family-owned small-to-medium-size businesses that are not traditionally listed, that have grown exponentially, that have the ability and power to grow across various countries and regions. Those aren’t publicly listed. There’s very little information available in public around them. And that is where we’re finding that a lot of PE firms are leveraging our footprint and network.

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