Human Capital Management: A Gateway into ESG

When the Business Roundtable announced it had reconsidered the purpose of a corporation — from a purely financial and investor-centric orientation to now consider all stakeholders — it marked a significant milestone for the ESG movement. After decades of research, education, and shareholder activism, those who have been arguing for a more sustainable form of capitalism were rewarded by this acknowledgment that environmental, social and governance factors (or ESG) are indeed vital to a company’s longer-term prospects. If there’s a caveat, it’s that investors and business leaders must now rethink their approach to growth and value creation as they adopt a more inclusive lens.

Nowhere in finance is this shift more evident than in private equity, an asset class that has always had a paradoxical relationship with ESG. This is the industry, some may recall, that at various times throughout its history has been referred to as barbarians or locusts based on early perceptions, real or not, that returns through financial engineering came at the expense of employees and the stability of acquired assets. However, the asset class — perhaps more than any other corner of finance — has since evolved to become creators of value whose returns are now premised on driving growth. Extending on this evolution, a growing number of PE firms have signed the UN’s Principles of Responsible Investment, charting a new path to embrace ESG, not merely to “do good,” but rather to find more sustainable ways to create and extract value.

In many ways, private equity’s adoption of ESG represents a compelling test case to prove the power of these sustainability factors in driving long-term growth. The challenge is that if ESG efforts extend holding periods or divert attention away from other priorities – ostensibly projects aligned to more-traditional investment theses – ESG will struggle to graduate beyond merely an aspirational component of PE’s value-creation playbook.

The good news is that given the industry’s burgeoning efforts to optimize the workforces of their portfolio companies, many private equity investors have a head start in effecting ambitious ESG strategies. In fact, the Social and Governance factors of ESG are very closely aligned to many of the most pronounced opportunities private equity investors already pursue through Human Capital Management (HCM). And for those that have yet to formalize HCM processes into their value-creation plans, doing so can also represent an obvious starting point for an ESG strategy that pays dividends to all stakeholders, investors included.

ESG’s Parallels to HCM

Across HR, professionals may be acquainted with ESG through their company’s Corporate Social Responsibility (CSR) programs premised on demonstrating how business objectives can support other stakeholders beyond just the company’s investors or senior leadership. Many CSR programs, for instance, will highlight a company’s philanthropic efforts, provide transparency around environmental sustainability, or publish metrics that speak to a company’s diversity and inclusion efforts. ESG, however, refers to the lens through which investors view many of the same “environmental, social, and governance” considerations, but also provides a framework that allows fund managers (think Blackrock, Vanguard, etc.) and institutional investors (from corporate pension plans to university endowments) better understand how these factors contribute to asset values. Most fund managers in public equities have already incorporated ESG screens into their investment strategies as a way to manage risk and identify mispricing opportunities; in private equity, though, many firms are just now getting their arms around how ESG can amplify their value-creation capabilities.

Private equity, for the uninitiated, has also become a force across the broader business landscape. By some counts, there are over 4,000 private equity firms in the U.S., alone, and conservatively, over 8,000 PE-backed businesses, which roughly doubles the number of U.S. listed companies. Some estimates have quantified that the companies owned by PE firms in the U.S. collectively employ nearly nine million staff, representing wages and benefits that amount to approximately $600 billion annually.

The typical investment archetype will see private equity funds acquire assets at an attractive price (using leverage to minimize their equity commitments) and then hold onto the businesses for three to five years, away from public scrutiny. During this holding period is when growth initiatives are generally put in place, and operational improvements are pursued. Once these efforts bear fruit and the company hits certain milestones, the investors will look to sell the business for a higher valuation, which becomes far easier when the sellers can point to strong, consistent top-line expansion and catalysts for future growth. This is a hyper simplified illustration, but from this perspective, it’s easy to see why the value creation component of buyout investors is reshaping how companies think about and pursue growth. Moreover, the influence of the asset class even extends to companies well beyond those owned by private equity firms. Indeed, once companies reach a certain size, for most executives, a sale to PE often represents a baseline from which executives can assess current asset values or their ability to independently pursue and maximize market share over a period of time.

Without question, most in private equity already appreciate the role of company management in driving returns. One private equity CEO, at their annual investor meeting, noted that without exception, they’d rather own a “C” business with an “A” management team than hold an investment in which the caliber of each was transposed. And most other deal professionals will point to management as the biggest wildcard influencing their success or failure in a given investment. That said, the “people” factor has been notoriously difficult for investors of all stripes to quantify.

More recently, a growing body of research is documenting and proving out how critical the workforce is to value creation. One study out of the London School of Business, for instance, found that employee engagement and satisfaction directly correlate to company performance.

Ironically, the role of people is becoming even more pronounced amid technological change. McKinsey & Co. identified that the most important factors in effecting digital transformation are related to whether an organization either has or can develop the requisite talent and skillsets. Considering digital transformation represents one of private equity most important growth levers, it underscores the risks of overlooking HCM. Investors who perceive advances in AI and machine learning as a way to automate and cut their way to growth are doing it wrong.

Research is also proving out the benefits of cognitive diversity in the workforce – and it’s not just emanating out of academia. Recent analysis from Morgan Stanley, for instance, found that the most gender-diverse companies outperformed their benchmarks by 170 basis points, on average, annually.

Still, the risk of ignoring ESG and HCM considerations often fails to hit home until it’s too late. For instance, in testimony before Congress, Boeing’s CEO had to explain why he ignored repeated warnings from employees concerned about the safety of the aircraft maker’s Super Max plane. The CEO was confronted by one email, sent directly to him, that suggested fatigue and “schedule pressure” were contributing to worker mistakes and decisions to circumvent established processes. Yet, Boeing made no changes to its production schedule. For those keeping score, following the second crash involving the company’s Super Max plane, its market cap had lost in excess of $54 billion as of October 30, the day of the hearings.

Private equity — though usually outside the public glare — is just as exposed. On the same day in October, the buyout of G/O Media (owner of Deadspin, the Onion, and other media titles) hit turbulence when the bulk of Deadspin’s reporting staff quit en masse. The investment encountered bumps almost immediately when Deadspin’s journalists began reporting on the hiring practices of the sponsor, sketching a picture in which experienced women and people of color were overlooked for open management roles that instead went to predominantly white males from outside the company. While these are certainly extreme cases, outside of public view, we would estimate that 70% to 90% of failed initiatives are, in part, attributable to similar cultural and personnel issues that are often ignored.

The impact of human capital management will likely be even more pronounced in the wake of the COVID-19 pandemic. Some industries, quite obviously, have been hurt far more than others, leaving executives and investors very little choice when it comes to difficult workforce decisions. In other industries, though, there does seem to be a growing appreciation for a more thoughtful response. In one survey of CFOs, for instance, far more indicated they would be scaling back or delaying capital investments (49%) to shore up their balance sheets versus those resorting to layoffs or furloughs (35%). Anecdotally, many in private equity are using the disruption to “upskill” their workforce through online training initiatives or even recruit and onboard hard-to-find roles that will facilitate growth once the economy restarts.

Beyond just mitigating risks, companies that overlook HCM and ESG factors also absorb opportunity costs. Again, we see this every day in private equity. In one instance, an investment was premised on building out the company’s business development capabilities. But the strategy overlooked the causes behind an existing 25% backlog. The investor instead adapted their approach to marry any marketing and sales initiatives to added IT resources and personnel, allowing the company to keep pace as the sales funnel filled. Available synergies can also be missed without understanding the hidden aptitudes within the organization. In another buyout, we uncovered lean six sigma capabilities that could be further leveraged to improve supply-chain planning and oversight and drive efficiencies in procurement and inventory management.

Every situation, of course, is unique, which makes it hard to deploy a standardized approach. There are a few principles, however, that apply to both HCM and ESG strategies.

Don’t Boil the Ocean

As investors attempt to get their arms around everything that goes into Human Capital Management, it can seem overwhelming. To suddenly add ESG considerations on top of everything else is more likely to create despair and a sense of hopelessness. We continually remind our clients to avoid the tendency to try to boil the ocean. The most successful investors determine the issues that are most important to a given business and then prioritize the initiatives that will have the biggest impact. This prioritization is what’s driving ESG investors’ focus on materiality, and the same rules apply to human capital management. It’s often the case that what matters most in driving “people alpha” can be determined by understanding how it impacts the end customer or market.

Measure What Matters

Almost all executives claim their people are the most important asset of their company. Some would argue that it has become a cliché. Yet, from a financial standpoint, employees are only recognized as an expense line on the balance sheet bundled in with “other” intangible items. This not only conceals the impact of people in driving company growth but characterizes employees solely as a cost. One of the biggest advances in HCM and ESG, however, has been the development of new metrics that re-orient analysis to focus on the latent opportunity within the workforce.

In HCM, for instance, more sophisticated programs will measure the return on human capital investments or track the total cost of the workforce (TCOW) as a percentage of operating expenses. Investors, meanwhile, have begun looking at the productivity of workers (versus profits alone) as a driver of value. In ESG, alternatively, relevant metrics might include days lost to illness per full-time employee or statistics around gender balance and diversity across the organization. And some investors have taken great pains to track and even publish these figures, highlighting their role in addressing these social factors and emphasizing the impact on the stability of the companies under their watch. Apax Partners, for instance, publishes an ESG report that also tracks at the portfolio company level the percentage of its companies with health and safety policies, anti-corruption guidelines, environmental and waste management protocols, and supply-chain transparency.

Follow Through

It’s one thing to know what’s material and what isn’t; it’s another to track and measure progress, but none of this will create the desired impact without following through. This goes without saying, but in our experience, the impact is often far greater than most anticipate.

Employees, ultimately, want to be heard and empowered. Just by formalizing a process to gain 360-feedback demonstrates their voice matters. Other initiatives to foster this dialogue might include group sessions in which staff can help identify strengths, weaknesses, opportunities, and threats. Just as private equity investors want to align interests with management through shared ownership, compensation is equally important to incentivize the workforce. If stock is not available, other alternatives, such as a phantom equity plan, can fill the void. The importance of transparency also cannot be understated. In a vacuum, employees will let their imaginations get the best of them. Trust, however, translates into retention, productivity gains, and ultimately financial performance. While the private equity industry at large has often been scapegoated for the sins of a few, the truth is that most firms do indeed take pains to create stable and growing companies that can foster opportunities and improve the wellbeing of their employees. It is, however, an evolutionary rather than a revolutionary process. The fact that investors are actively exploring how human capital management can improve investment outcomes, and adopting ESG principles that will advance those efforts, is a momentous shift that has the potential to create a new model for businesses both inside and out of the private equity’s growing universe.

It was Adam Smith in The Wealth of Nations who noted that “no society can surely be flourishing and happy of which the far greater part of the members are poor and miserable.” The same is true at most companies. And investors who are able to drive improvements in ESG and HCM across their portfolio will help these businesses deliver a better competitive alternative, enhancing returns in the process. It’s not a compromise; it’s a win/win scenario in which the fortunes of all stakeholders can be enriched.