We are all trustees and we have a fiduciary duty to our beneficiaries, namely to To achieve the best possible returns while being prudent investors or bankers and to Guard against loss of assets entrusted to us Environmental, social and governance assessments are, on the one hand Risk mitigation – and you can only manage the risks you KNOW,…. but it is also designed as a pro active, pro business approach to financing that will help improve overall performance and add share holder value. Concern for the Environment and workers rights is not new, ADB private sector loans and equity investments have for about 20 years included in the the legal due diligence check list instructions to review applicable environmental protection, worker health and safety laws…but putting this into practice was another matter…. We all know that Emerging markets have additional risks…. Inadequate legal / regulatory framework Poorly-drafted laws leaving room for corruption Lack of knowledge of laws and poor implementation & enforcement……company owners do not always know what the law is. Environmental & labor inspectors are few, often lacking resources to carry out the inspections/monitoring and be available to advise companies Court cases may take many years to be resolved…. Inability to enforce contractual rights is a major concern of all investors/lenders Inadequate reporting & registration systems…..so searching for pending labor or environmental infractions is often next to impossible…..covenants, pledges of shares, personal guarantess and THE BEST LOAN SECURITY IN THE WORLD ARE NOT A SUBSTITUTE FOR COMPREHENSIVE DUE DILIGENCE AND KNOWING YOUR CLIENT
Due diligence tends to follow developed market practice where labor and environmental laws are established, enforced and one can have lawyers carry out legal searches etc.
In emerging markets due diligence has to be broader based to fill the gaps in the legal regulatory and enforcement regime.
A typical private equity fund is a relatively short term investor, so why risk losing a deal and adding time and expense to due diligence by doing non financial assessments? If a company is violating labor laws then ask…what else are they doing wrong?? Violating environmental laws? Cheating on tax? Creative accounting? We are all subject to Official & media, shareholder and stakeholder scrutiny and while financial loss is one thing, you can probably write it off, but none of us can afford reputation loss…….even if the private equity fund has already sold out, if they were responsible for listing the company there will be reputation damage … .and ….Sustainable financing should be a central issue for all of us and The Propagation of Best Practices among companies will contribute positively to this
As a minority shareholder we can “push”, “pull” or “persuade” management of a company but in the end, enlightened self-motivation by the entrepreneur will fuel corporate development as demonstrated by the 1000 plus companies in China obtaining ISO 14000 certification. We have a Proactive, pro-business approach to building a partnership with companies based on trust and using this to help build value. We are not there to openly approve or disapprove but rather trying to show that there is a better, more profitable way to do business. There are benefits to the investee company, at least ideally there are, such as Higher productivity…..eco efficiency Lowered costs (eg for insurance, energy, etc.) Better management, governance & controls – lower risks across the board More competitive ( ”the others all have ISO 9000, so I had to”) Wider market (meet importing country standards & regs, and supplier codes)….and….higher multiples/stock price for listed companies And of course better returns to shareholders!!
We do find a number of positives…… … ..our deal team is now adept at pre-screening out the rotten companies so we are not finding non financial deal breakers… (we carry out non financial assessments after we are satisfied financial business matters)..there are good corporate citizens out there….there is consensus that environmental laws in countries such as China are excellent….we are finding that carrying out non financial assessments gives us another perspective, or insight into the company and its management. The good news is that the great driver out there is the market place…the BUYERS…the multi-nationals who have adopted standards for supply ….and they in turn are driven largely by consumers in Europe and the USA ....AS a general rule we have found and there is various other evidence to this effect, that if an established company in SE Asia and China has been supplying major international buyers for a few years then they probably have reasonably good environmental standards and it is difficult to have good environmental standards without good labor/human resource management. However, we have found that environmental, health and safety management systems often fail to keep up with the growth of a company, particularly as a company moves from small to medium and larger. As these good companies get listed and get on the radar screen of SRI funds etc. then we can expect these funds to play an increasing role in encouraging companies to improve their standards etc. Fin 47 Early last year the Financial Accounting Standards Board (FASB) issued Financial Interpretation No. 47, (FIN 47) - “ Accounting for Conditional Asset Retirement Obligations .” FIN 47 became effective in December 2005. In brief, this new rule requires companies to estimate environmental clean-up obligations and report them as liabilities. We are just beginning to see the ramifications of this rule as the first round of public companies release their 2006 financial statements.
This slide shows the progression of the certification movement over the last 17-20 years – there is an explosive growth and proliferation of codes being applied to many different sectors and industries –but they all have a common purpose, namely… … that companies/enterprises should adopt Best Practices and certifications as this signals to the market place recognizable standards, ………standards that we come to rely on in making choices…. One revealing example: in only a few years, more than 1,000 Chinese export manufacturers have sought and received ISO 14000 (environmental) certification because of the commercial advantages it bestows….buyers feel more comfortable dealing with a supplier that has recognized international standards.
Sustainable Initiatives in the investment World include Growth in SRI type Indexes (e.g. Dow Jones Sustainability Index funds, Domini 400 Social Index, FTSE 4 Good Global Index, Morningstar SRI Index) Growth over the past decade in SRI-type financial products, include : numerous retail ethical & SRI-oriented mutual funds (e.g. Calvert Group); Women’s funds (example: UOB’s “UNIFEM” fund); Shariah-based funds and Islamic financing ( which covers everything from insurance to stock fund). Additionally, new sustainability Risk management tools are emerging driven by Insurance companies who need to mitigate risk and therefore losses by Assessment of environmental risks……large commercial banks adopting the World Bank’s environmental and social guidelines…. Increased focus on corporate governance by institutional investors. Institutional investors reported in a recent (Wilshire) poll that they would pay a premium for companies exhibiting better governance…. and performance statistics of listed companies in many markets show that there is a strong correlation between companies with excellent good governance and the companies performance and stock price. And in the private equity World 88% of Asian Venture Capitalists surveyed by Asia Private Equity review say: “Good governance puts investees in 1 st or 2 nd quartile” for performance. There is over USD2.7 trillion World wide in funds which broadly have some form of sustainability mandate and it is growing rapidly, yet it represents only a tiny fraction of total funds under management. In the USA alone, it is estimated that USD$4 billion of funds with a sustainability mandate also have an appetite for investing in emerging markets.
… ..we have found that there are a number of negatives and that going beyond achieving compliance despite all the hype of adding value, improving the bottom line through energy efficiency etc it is not an easy walk in a green forest…. ..we do risk losing deals as generally the competition is not doing non financial assessments…we do put more demands on the companies.. … there are surprising few environmental and labor experts who understand where a private equity fund is coming from and that we have to take a pro-business, proactive approach not a policeman approach….environmental experts are not necessarily energy and water audit experts or productivity experts so if you want to add to the bottom line you need to engage more experts at more expense….. … a minority share holder has little formal power to influence a company….. … CEO are not convinced of the touted gains from resource efficiency…though higher energy prices will help change this…governments in the region seem to like to provide cheap water and low cost power……Thailand has regular droughts but little or no water conservation programs…..CEOs see little or no correlation between better standards and higher multiples when listed…
Our approach is not dogmatic and unrealistic though companies must be compliant with applicable laws and ADB/World Bank guidelines. We are a minority shareholder of the company’s we invest in and companies have choice and can select other investors, go to banks for loans etc. choose those lenders/ investors who will lend/invest without non financial assessment demands….so the pro-business approach is important. We must be realistic……..As the Asian Corporate Governance Association noted recently, can governments expect companies to be transparent and honest when they themselves are not? Can governance take root when government officials are corrupt and no independent and effective commission against corruption exists? The books of a company dealing with labor are like the accounting books, not necessarily accurate. Workers may not be receiving the amount that the company has in its Books…..How truthful the owner is with the due diligence team will be shown up by a thorough and comprehensive financial and environmental and social assessment process and this will be a leading indicator of the type of management you are thinking of investing in. ….. Wal-Mart spent $15 billion in China in 2004 which is the equivalent of 1% of China’s GDP and if it were a country it would be China’s eight largest trading partner……Wal-Mart purchases 80% of its goods from China…..it has aggressive on line bids for suppliers to ensure its lowest price at any cost business model is out in front ………..can one expect every supplier to Wal-Mart in these conditions to be a model employer? The point is, that the issues we will confront are often driven by macro circumstances that a business has little control over. Interestingly Wal-Mart has now decided to become proactive in environmental areas…. by focusing on energy effectiveness, waste reduction, and promoting environmentally preferable products. If Wal-Mart, the World’s largest retailer, is serious, they will have an enormous impact…. for instance suppliers will need to change how they package goods and ultimately they will need to rearrange their operations as to show that they too are environmentally responsible.
The risks of not doing social assessments can be great……………eg. Child workers are discovered at an investee factory and this is publicized internationally The investee company loses contracts with major US and European retail chains and sees its cash flow & profits collapse and suffers fines, loss of business license, problems with local labor authorities….the investment is written down or even off…. All suffer reputation damage Query, what is the legal position of the managers of the private equity fund that suffered an investment loss through failure to take into consideration social and environmental issues? After making an investment in the company it is found that the company has been violating labor and/or environmental laws, that it is a heavy polluter, and now faces fines, possible plant closure and has to spend a considerable amount to rectify the environmental damage and the Fund’s investment is seriosuly impaired. Certainly if the Fund managers failed to take reasonable measures to check environmental matters during due diligence the Fund manager may face dismissal and legal action for negligence.
Serious reputation damage to a large counterparty / issuer like Nike or Wal-Mart etc. will spread to many aspects of an institutional portfolio. Example: A Vietnamese company is a major supplier to Nike…..the financial institution in the middle is ADB….it has a direct loan to and a direct investment in the Vietnamese company…ADB also is an investor in a private equity fund that independently is an investor in the Vietnamese company…so ADB is hit three times. ADB pension fund holds Nike stock and Nike bonds….now hit five times….the ADB Treasury Department holds Nike short term commercial paper….six hits….and ADB may even have extended a guarantee to facilitate a loan to the Vietnamese company….7 hits. The lesson: damage travels quickly through portfolios, following hidden connections …with international repercussions…so the failure of a supply company in eg Vietnam to have good environmental and labor standards and comply with local law may have consequences far more serious than is obvious.
An integrated approach to credit analysis and due diligence not only facilitates risk mitigation but can lead to better financial results for the company/borrower and credit provider…YOU CANNOT MANAGE RISK IF YOU DO NOT KNOW WHAT THEY ARE….carrying out environmental, health, safety and labor assessments of a potential investee company/borrower is low cost, relatively simple and is basic prudent investing and banking. If you are not doing it, you are probably negligent and not acting in the best interests of your financial institution and you are certainly not acting in a SRI manner …….
Presentation by Richard Eyre
ASEAN China Investment Fund L.P. <ul><li>Non-Financial Assessments Program </li></ul>Does pushing SRI risk killing private equity deals? What is achievable?
Environmental, Social & Governance Assessments <ul><li>Fund managers are trustees and have a fiduciary duty to their beneficiaries ie their investors to achieve best possible returns and guard against loss of assets entrusted to them. </li></ul><ul><li>Environmental, Social and Governance Assessments provide extra risk mitigation in emerging markets -- traditional due diligence ignores market realities: </li></ul><ul><ul><li>Inadequate legal / regulatory framework </li></ul></ul><ul><ul><li>Poorly-drafted and –enforced laws leave room for corruption or just ignoring the law </li></ul></ul><ul><ul><li>Inability to enforce contractual rights </li></ul></ul><ul><ul><li>Inadequate reporting & registration systems </li></ul></ul><ul><ul><li>Opportunity to add value to clients/borrowers </li></ul></ul>
Traditional Investee Company Due Diligence <ul><li>Legal, financial business analysis </li></ul>Legal, Financial business
Why should we bother? <ul><ul><li>Knowing whether the management of an investee company are good corporate citizens makes good business sense……. </li></ul></ul><ul><ul><li>If a company is violating labor laws, what else is it doing wrong? Violating environmental laws? Accounting fraud? </li></ul></ul><ul><ul><li>Fund managers and bankers are all fiduciaries and as such have legal responsibilities and hence liability risk </li></ul></ul><ul><ul><li>Official, media, shareholder and stakeholder scrutiny </li></ul></ul><ul><ul><li>Adoption of recognized international standards, enables companies to compete internationally </li></ul></ul><ul><ul><li>Encourages outside investment at the company level and in the stock market by mitigating risk….better to invest in, or lend to, a company with internationally recognized standards </li></ul></ul><ul><ul><li>The World is changing rapidly so get with it!! </li></ul></ul>
How does it work <ul><li>Fund managers taking a minority interest in a company can “push”, “pull” and “persuade” an investee company to adopt best practices </li></ul><ul><li>Proactive, pro-business approach to build trust and shareholder value NOT a policeman enforcing the law </li></ul><ul><li>Enlightened self-motivation by owners/management will fuel corporate development </li></ul><ul><li>Possible attractions to investee companies.. “ the ideal, the vision”: </li></ul><ul><ul><li>Higher productivity </li></ul></ul><ul><ul><li>Lowered costs (insurance, energy, etc.) </li></ul></ul><ul><ul><li>Better management, governance & controls </li></ul></ul><ul><ul><li>More competitive (”the others all have ISO . . .”) </li></ul></ul><ul><ul><li>Wider market (meet import regs, buyers’ codes) </li></ul></ul><ul><ul><li>If a listed company, higher multiples, better stock prices </li></ul></ul><ul><li>Environmental, social and governance assessments should be coordinated with financial due diligence at the outset </li></ul>
Results…the positives.. <ul><li>Effective pre-screening has resulted in 8 comprehensive non financial assessments with no major compliance issues. </li></ul><ul><li>All investees have minor compliance needs but generally ‘good corporate citizens’ in need of improving EHS management systems. </li></ul><ul><li>The legal regulatory framework in the region for EHS and labor, despite some gaps, is generally in good shape. </li></ul><ul><li>Non financial assessments are a cost effective Risk Mitigation tool….you can only manage the risks you know! </li></ul><ul><li>The main current driver ? </li></ul><ul><li>The massive buying power of the multi-nationals who have adopted standards that must be met as a condition of supply. </li></ul><ul><li>Future drivers in Asia? </li></ul><ul><li>SRI Index funds, Ethical funds, SRI and Governance funds all with an estimated appetite at over $4 billion for emerging market listed companies that meet their investment criteria. </li></ul><ul><li>Accounting and other standards. </li></ul>
In the commercial sphere, assessment use has grown exponentially: <ul><li>Commercial benefits: more sales & higher prices for companies who have adopted . . . </li></ul>1987 2002-3 ISO 9000: Quality Management ISO 14000: Environment OHSAS 18000 : Occ. Safety/Health Healthmark : Healthcare SA 8000 : Social Accountability Green Globe : Eco-Tourism GMP / SQF 2000 / HACCP: Food Safety BS 5750 British Standards Board (Procurement) ?????
In the “mainstream” investment world, this has taken the form of: <ul><li>New investment products: </li></ul><ul><ul><li>Indexes (e.g. DJ, FTSE) & screening of public companies </li></ul></ul><ul><ul><li>Ethical, SRI and Green funds </li></ul></ul><ul><ul><li>Governance funds </li></ul></ul><ul><ul><li>Social issue (e.g. Women’s) funds </li></ul></ul><ul><ul><li>Shariah-based funds and Islamic financing </li></ul></ul><ul><li>New risk management tools: </li></ul><ul><ul><li>Focus on environmental risks by insurers </li></ul></ul><ul><ul><li>Focus on corporate governance by institutional investors </li></ul></ul><ul><ul><li>Major commercial banks adopting the Equator Principles (World Bank environmental/social guidelines) for project finance </li></ul></ul>
...the negatives! <ul><li>Risk of a private equity fund taking minority stakes losing deals as other lenders and investors are not doing non financial assessments. </li></ul><ul><li>Lack of environmental and labor experts who comprehend the needs of a private equity fund taking minority stakes. </li></ul><ul><li>A minority share holder has minimal influence to achieve much beyond compliance. </li></ul><ul><li>Companies unconvinced of gains from resource efficiency and see no correlation between better standards and higher multiples when listed. </li></ul><ul><li>Failure of the markets in Asia to adequately reward listed companies with good SRI and governance practices. </li></ul><ul><li>Failure of governments to price water and energy to reflect the real market price. </li></ul><ul><li>Countries often lack resources to effectively implement environmental, health, safety and labor laws. </li></ul><ul><li>Failure of pension funds, IFIs and bi-laterals to effectively implement their policies at the investee company level and recognize and facilitate market forces. </li></ul>
Difficult issues are sure to arise: <ul><ul><li>Firing an under aged 14-year-old worker may throw her entire family back into poverty </li></ul></ul><ul><ul><li>Can you have transparent accounting for all companies if the tax regime is corrupt? </li></ul></ul><ul><ul><li>What if demanding factory improvements beyond its peer group or national standards to meet ADB / World Bank standards would make an investee less profitable? </li></ul></ul><ul><ul><li>If all of a business’s competitors are paying below market rates for labor, should an investee pay more and not be competitive? </li></ul></ul>
But the risks of not doing anything are greater . . . <ul><li>Without assessments, non-financial risks cascade . . . </li></ul><ul><li>Child workers discovered in investee company factory! The immediate impact to the Fund: </li></ul><ul><ul><li>The investee company loses supply contract with major US buyer and cashflow & profits collapse </li></ul></ul><ul><ul><li>The investee company is fined, loses business license </li></ul></ul><ul><ul><li>Outstanding loans are called, security realized </li></ul></ul><ul><ul><li>The fund writes down its investment </li></ul></ul><ul><ul><li>The Fund manager and lenders suffer reputation damage and are probably in breach of their fiduciary responsibilities and </li></ul></ul><ul><ul><li>Are called to account, perhaps dismissed or even sued for negligence </li></ul></ul>
The unfortunate results . . . Nike/Wal-Mart Loan Book Own Pension Fund Treasury Wealth Management Institution Deposit- taking Insurance subsidiary Private Equity Guarantee Issuance
Conclusion: an integrated approach to due diligence facilitates risk mitigation and can lead to better financial results for the company and investors Workplace Health & Safety Environmental Management Productivity & Management Systems Financial Management Labor Governance & Controls