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PE’s planetary alignment

‘Men are from Mars, Women are from Venus’ describes gender differences in cognition. Having attended three major private equity events – PEI Responsible Investment Forum (for ESG-friendly PE), Coller Institute Private Equity 2013 Symposium (for mainstream PE) and PEI Operating Partners Forum 2013 (for portfolio companies) – we propose transposing the metaphor to PE, adding Jupiter.

Venusians (the RI Forum) were concerned about E and S but these were largely ignored by Martians (Coller) and Jupiterians (Operating Partners). Conversely, Martians worried that the core model might be unfit for purpose and acknowledged, discreetly, the prevalence of financial engineering. Venusians and Jupiterians, however, didn’t see any link between ‘pump and dump’ and the challenges they faced – mainstreaming ESG or creating sustainable businesses. Martians and Jupiterians accepted, discreetly, that G was far from sorted, yet many Venusians said this was the one thing that was.  

Of course, the people at these events weren’t from different planets. And the controversy about private equity’s role in the water sector is just one example of the need for more joined-up thinking. Three actions are critical: sort out the main misalignments between LPs and GPs, focus on innovation and fix the governance.

Misalignment problems (such as over-complex and non-standardised metrics, excessive focus on final returns and net performance benchmarking) are considered to undermine long-term returns but weak transparency prevents any definitive conclusion. Corrective action to date – for example, the ILPA guidelines – is recognised, in private at least, to have had little impact. LPs must collaborate more to send clearer common signals.  

Innovation is inescapable. Good GPs are now asking for more clarity about long-term (including post-exit) expectations and the trade-offs LPs are willing to accept in the shorter term. As fundraising becomes more competitive, and as direct investing by LPs shows greater promise, only strategically innovative GPs will thrive.  

Leverage – a potent financial tool in the right circumstances – cannot compensate for poor innovation and industrial incompetence over time. The old model that says: abandon long-term opportunities to venture capital, obsess over exogenous growth and quick-fix cost cuts, and boost short-term sales volume, is past its shelf life. Box-ticking ESG is better than ignoring ESG altogether but is unlikely to deliver the returns that come from aligning operating partners with fundamental socio-economic trends.

The new model is increasingly clear to academics like Clay Christensen and practitioners nearing a tipping point: leverage existing human and organisational capital, invest in R&D, secure well-aligned suppliers, then scale up sustainable technologies and business models that drive breakthrough solutions. This new buyout model – one that generates sustainable cashflows based on core competitiveness – will trigger Schumpeterian creative destruction of the sector itself.

The difference between success and failure is better governance. Dogmatic complacency about PE’s governance model plus lack of awareness about behavioural governance are two big challenges. Those who best understand the critical importance of the pedigree of chairmen and directors are reflective former executives of operating partners. They are also among the most articulate about why the two and 20 fee structure fails to deliver durable value creation.

Whether LPs and GPs – and the advising investment intermediaries – can make the needed systemic transformation in time is uncertain. With water, for example, some governments, pushed by angry customers, are already embarking on re-municipalisation.
LPs and GPs who face unexpected losses or are excluded from new long-term opportunities will have only themselves to blame if they miss the perfect occasion of transforming. Starting at home will be key. Can asset owners stop behaving like remote fiduciaries and embody the business owners that they actually are?

Raj Thamotheram is an independent strategic adviser, co-founder of PreventableSurprises.com and president of the Network for Sustainable Financial Markets and Guiv-Roger Morin is an ESG/private equity analyst

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