Scandals at companies owned by private equity firms hurt these managers’ ability to raise money from investors in the future, but the misconduct doesn’t necessarily hurt the performance of the funds.
New research shows that the more frequently a private equity fund’s companies have an environmental or social “incident,” the less likely it is that allocators commit capital to their funds. This is especially the case for current investors.
But the researchers found that these environmental and social scandals do not affect a fund’s short- or middle-term performance. What’s more, a private equity firm is likely to be more stringent with its companies in the years following an incident.
Research published late in November by HEC Paris’s Teodor Duevski, World Bank Group’s Chhavi Rastogi, and Singapore Management University’s Tianhao Yao dug deep into how ESG incidents can affect private equity firms.
“Scandals are costly for PE firms as they lose relationship investors and this, in turn, hampers their ability to raise a follow-up fund,” the authors wrote in the paper.
This work comes on the heels of another paper, which showed that taking action on ESG can bolster private equity fund performance by up to 12.4 percent (internal rate of return) over the life of the fund.
The researchers for this paper, entitled ESG Incidents and Fundraising in Private Equity, used the Preqin and RepRisk databases to construct a set of 781 buyout funds, all of which raised another fund after the incidents occurred. RepRisk tracks issues like illegal fishing, asbestos, and gender inequality, among 28 total factors.
The researchers chose to focus solely on environmental and social factors, as governance has been studied much more in depth, according to their paper.
The researchers found that nearly half — 40 percent — of firms with funds with an ‘above-median-number’ of scandals among its portfolio companies were unable to raise a follow-up fund. The researchers note that 25 percent of all funds can’t raise a follow-up fund — no matter the number of ESG incidents. Still, 40 percent is a statistically significant portion of firms.
As the research notes, limited partners who have previously committed capital to an investment manager are typically more likely to invest in a follow-up fund. However, when a fund’s portfolio company experiences a scandal, limited partners walk.
According to the paper, LPs are 7 percent less likely to commit capital to a manager’s next fund per one standard deviation increase in the number of environmental or social incidents at portfolio companies.
It’s worth noting that the decision not to re-up with a manager is a difficult one for an allocator. “For investors, not committing to the follow-up fund managed by these GPs could entail significant costs,” the paper said.
For all the difficulties in raising capital these funds face after portfolio company scandals, their performance actually is unchanged on average. Controlling for fund size and fund series number, the researchers found no significant correlation between incidents and fund performance.
“LPs may believe that experiencing a high number of incidents may hurt the GP’s future performance, through affecting its deal flow,” the paper said.
But they shouldn’t worry. The researchers showed that managers whose funds experience a high number of incidents see fewer in the following years. In the two years following a scandalous period, these firms have a 20 percent lower number of incidents.
“Overall, the evidence above suggests that PE firms respond to incidents by doing more ESG screening,” the paper said. “This effort, indeed, turns into a lower number of future incidents, in both new investments by the same fund and in the follow-up funds.”