David Korngold, Associate, Advisory Services, and John Hodges, Director, Financial Services, BSR

In the wake of the tragedy in Newtown, Connecticut, headlines in the New York Times and the Wall Street Journal have focused on the private equity firm Cerberus, a leading investor in the firearms industry. On Monday, the California State Teachers’ Retirement System (CalSTRS), a major investor in Cerberus, joined calls by pundits for the firm to rethink the social responsibility of its investment in the Freedom Group, which owns gun brands Bushmaster and Remington. On Tuesday, Cerberus announced it would sell its stake in the company.

This is only the latest story to highlight the social responsibility of private equity firms, following a year of headlines about Mitt Romney’s work at Bain Capital. Cerberus’ Freedom Group divestment also the demonstrated the real-time, rapid-response influence of a private equity firm’s major limited partners (LPs).

There are four important lessons that private equity firms can take from these events:

1. Firms should adopt more formal policies for sectors and geographies with high environmental, social, and governance (ESG) risks. For example, many investment banks have publicly disclosed lending policies covering environmental and socially sensitive sectors, such as arms and cluster munitions, natural resource extraction, and forestry. Similarly, private equity firms should look for ways to adopt formal ESG policies to guide their participation in high-risk areas.
2. Firms often lag behind other investor classes in transparency and reporting. BSR’s recent publication, “Reporting on Environmental, Social, and Governance (ESG) Considerations in the Private Equity Sector,” focused on how private equity firms measure, monitor, and disclose ESG issues. Although ESG issues are increasingly on the agenda for LPs and the general partners (GPs) who manage firms, BSR found that the quantity and quality of ESG reporting by GPs often fails to meet investor and stakeholder interests. While a limited number of firms (such as KKR and the Carlyle Group) publish sustainability reports, it’s time for the rest of the sector to catch up and report on ESG impacts.
3. LPs are increasingly adopting their own ESG management and transparency policies.  As Anne Simpson, CalPERS' senior portfolio manager for corporate governance, noted in a 2012 interview: “Our view is that ESG factors ought to be a routine part of the financial reports that companies make.” To meet those expectations and develop stronger relationships with LPs, private equity firms should consider how they can better develop and disclose their own ESG management strategies to LPs.
4. “S” is lagging “E” and “G.”  While some firms have more experience with environmental and governance issues, social issues are playing a bigger role in ESG analysis. Private equity firms are exposed to the social risks—community impacts, labor practices, and more—of all sectors in which they invest. That’s why BSR is collaborating with EDF on a new ESG Management Tool for Private Equity, which provides a comprehensive framework for assessing and improving ESG performance in the private equity investment process and portfolio management. BSR and EDF will be partnering in 2013 on a variety of events to help private equity firms improve their ESG analysis.