Published by GARP (Global Association of Risk Professionals)
An investor class with a clear sense of the value of ethical conduct.
With total assets under management now in excess of $3 trillion, private equity has grown from a cottage industry into a substantial percentage of the global capital markets. With maturity comes impact on compliance standards, and that includes best practices for workplace culture, ethics and respect at portfolio companies.
The ethical rationale for doing so is clear. As stewards of businesses, private equity is uniquely positioned to positively influence the culture of the organizations they oversee. They stand to focus their efforts on eliminating harassment, bias, discrimination, bullying and other harmful behaviors because it is the right thing to do, it’s often the law, and they have the power to have a real and positive impact. Proactively investing to improve the working environment for the employees who generate value for limited partners (LPs) is a top priority.
There is also a substantial financial incentive to do the right thing on workplace culture, ethics and respect. When private equity officers think about return drivers for a given deal, they typically think about raising prices; investing in new products and markets; expanding the sales team; optimizing working capital; streamlining operating expenses; and making value-enhancing add-on acquisitions to drive multiple expansion.
Let’s consider something else – the value private equity derives from improving the workplace culture for team members. We call this #CultureIRR. In terms of costs, the direct costs of harassment, bias, discrimination, bullying and other bad workplace behaviors are relatively easy to define and quantify – legal costs, settlement expenses and rising EPLI premiums. On their own, these may seem like relatively small dollars over the course of an investment hold period, but, as we all know, even small dollars count, especially when you attach a multiple to them.
Market Cap Impact
Now, let’s talk about the big dollars.
pelotonRPM analyzed the market capitalizations of 10 public companies that experienced allegations of bad workplace behavior and misconduct. On the day the negative headlines hit the press, these companies lost, in aggregate, $19 billion of market capitalization. Over the course of a week, that number increased to $44 billion.
These astounding numbers reflect the fully loaded cost of bad workplace behaviors and misconduct – brand impairment (especially in a viral social media age); customer flight; lost productivity; higher turnover and difficulty recruiting talented employees; severe management distraction; and a range of other considerations that detract meaningfully from enterprise value.
Now imagine what these costs would amount to across a private equity firm’s entire portfolio. And let’s attach a multiple to them and consider how valuations and returns can be impacted. Never mistake “immaterial” direct costs with the all-in costs of these cultural issues. Now, #CultureIRR really starts to mean something to private equity and LPs.
Finally, as a buyer of businesses, private equity firms have three fundamental concerns with every deal: price, terms, and certainty of close. Bad behaviors in the workplace can clearly impair valuations. A whiff of harassment, bias, discrimination or bullying (especially by senior executives) will impact escrows and other important deal terms (including, potentially, clawbacks). And an 11th hour claim or senior executive resignation will introduce a great deal of uncertainty into whether a deal will actually get to the finish line.
Being proactive and addressing these workplace issues at portfolio companies will certainly cost some money (every IRR calculation starts with a negative value). But given all of the costs and risks detailed above, one can be highly confident that the return on this investment will be substantial. In this environment, one workplace complaint can go viral in minutes, devastating a brand and diminishing valuation.
Private equity professionals are experts in risk versus reward – the trade-off seems obvious. #CultureIRR really makes a difference.
I lived in this industry as a banker and private equity principal for nearly 20 years and saw, firsthand, the impact these issues can have on companies and transactions. We all have our horror stories to tell about things that have been said around a conference room table. Private equity investors are looking further at diligence on how these issues are identified and handled at the portfolio company level.
Do not underestimate the impact that #CultureIRR can have on the success (or failure) of investments. Think of it as another powerful lever that can be pulled to deliver value to LPs and to our society as a whole.