Social risks and impact in private markets transactions
- Investment Support
Social risks and their impact in private markets transactions – three key questions
The conversation driver in the ESG agenda tends to be environmental issues, which garner plenty of media and regulatory attention. But mismanaging social issues can do just as much damage to your investment as other factors and may mean you miss critical opportunities for impact and value creation.
Read three essential questions that private markets investors should be asking when considering their approach to social risks in new deals or existing assets.
1: Why are social risks important to my investment?
Social factors are relevant to all organisations irrespective of their industry and geographical footprint. They manifest in a broad range of the most sensitive areas: human rights; occupational health and safety; training and education; diversity, equity and inclusion (DE&I); community engagement; labour standards; and security practices.
Social issues are now rightly at the heart of conversations about corporate strategy and purpose. There are several reasons for this: rising employee activism, consumer and investor scrutiny and awareness, and wider-ranging reporting obligations. But what is the biggest trigger moving social risks up the investor agenda? New legislative proposals, including the EU’s mandatory human rights and environmental due diligence regulation. This will require specific disclosure on how businesses are managing social factors and will include sanctions for non-compliance, similar to laws already in place in France and recently introduced in Germany.
The reputational risks associated with mismanaging social issues are high and controversies are increasingly being played out in public. Recent examples include a high-profile initial public offering being affected by concerns over treatment of workers and ex-employees publicly calling out their former company for its “toxic” work environment. These cases tell us that the impact on brand and value is direct and immediate. In the longer-term, it may affect an organisation’s ability to attract talent or to market themselves to potential clients.
Social risks also represent a value creation opportunity, resulting in more profitable exit valuations and more resilient businesses that sustain their value in the long term. Investors can bring experience and funding to remediate social risks, often quite simply compared to environmental issues, which may need a bigger commercial and strategic overhaul.
2: How can I factor social risks into deal diligence?
The nature of social risks means that you can identify, assess and plan for most critical issues at the beginning of a deal cycle.
Deal diligence should identify and evaluate material social risk factors that account for a combination of factors specific to you and the target:
- your assessment and reporting standards
- the target company’s industry’s best practice
- the different regulatory obligations you and the target are exposed to
- the target’s operational footprint and any local contextual considerations
Third party relationships in the form of suppliers and clients also pose a major vulnerability in relation to social risks. Your pre-deal diligence should cover priority suppliers and clients, either in higher risk countries or in relation to their importance to the target, rather than just focusing on the principal investment target.
There is no single universal standard for ESG. There are broadly and internationally accepted leading ESG principles and targets (such as the UN’s Principles for Responsible Investment - PRI), risk assessment models and materiality standards (such as the SASB standards) and reporting frameworks (such as the Global Reporting Initiative - GRI) can provide useful points of reference to help identify and evaluate relevant risks by industry or issue. How these are applied will vary depending on the nature of the transaction and profile of a target. You should avoid taking a “tick box” approach and use frameworks and guidance that suit your internal sustainability strategy, sector exposure and the profile of your investments.
There is a strong link between poor governance and social non-compliance. Social risk due diligence should therefore also capture social ‘governance’- how well your target is set up to align with social risk-specific regulations and whether there is a track record of non-compliance. We now see private markets clients regularly asking us to focus on understanding the culture and leadership of a target company during their pre-deal diligence. These funds know that evaluating an organisation’s progress on social factors such as DE&I, and the management team’s response to and management of Covid-19, are two areas that can give them critical insight into how a business is governed and how the ‘tone from the top’ is set.
Different perspectives are important and can be captured in pre-investment due diligence. We have worked on several large buyout transactions where the target was headquartered in western or central Europe, but much of the supply or underlying manufacturing was happening in eastern Europe or outside of the EU. This posed a different and often heightened set of social risks. In these cases, our clients needed to understand whether corporate policies and messaging set at headquarters were matched in practice on the ground. This required us to gather feedback from in-country networks, particularly with current or former employees and workers unions. The perspective of employees is often crucial to getting a good qualitative assessment of an organisation’s approach to social risks.
3: How do I spot value creation opportunities?
If you factor social performance into pre-deal diligence, it will be easier to manage risks and identify opportunities for value creation.
Start with a clear roadmap based on your due diligence that differentiates between “quick win” corrections to the target’s governance controls framework and internal processes, and longer-term shifts such as changes in culture and improvement of management practices. Some small but significant adjustments can be made in the post-deal period that will not affect a company’s commercial model but can still have a tangible impact. For example, implementing new health and safety policies or increasing training opportunities.
Independent auditing and monitoring that goes below the surface is essential. While it can be challenging to measure social risk and impact (unlike environment and climate change risks which tend to follow science-led measurements and targets), there are a range of indicators that you can use: gender pay gap; diversity; executive remuneration; workforce and key stakeholder sentiment; retention statistics; and controversy tracking.
You should consider what measures and KPIs are useful to assess progress and to demonstrate that improving social standards are creating value over the investment cycle. It is important to select indicators that are transparent and verifiable, and then be honest about where progress is lagging, or metrics are not proving useful. You may be left counting your losses if your investment doesn’t comply or improve its performance on social issues.
- Employee activism, shifting consumer and investor preferences, and new mandatory disclosure and regulatory requirements mean more attention is being paid to social risks.
- Deal diligence should identify and evaluate material social risk factors that account for several factors relevant to investor and target: assessment and reporting standards; industry best practice; different regulatory obligations; and the target’s operational footprint and its third-party relationships.
- Factoring social performance into pre-deal diligence makes it easier to identify post-deal opportunities for risk mitigation and value creation. Changes can be short term “quick wins” or longer-term structural improvements, with KPIs used to monitor performance and measure impact.