October 26, 2022
The growth of sustainable investing and “ESG” in private equity (PE) signals important progress in the financial industry as investors begin to appreciate how sustainability creates risks and opportunities.
Yet the ESG field is now under fire—for inadequate “greenwashing” strategies or politicized accusations of “bias.” As investors navigate this conflict and seek to maximize the business and societal benefits of sustainable investing, it is imperative that they put impacts on people at the center of their approaches.
The Current State
Common approaches to ESG in PE follow a formula: firms identify material risks to business based on a limited set of pre-determined criteria. If they go ahead with an investment, they encourage portfolio companies to address gaps. There are advantages to this formula, as it fits neatly within a “traditional” understanding of fiduciary duty and is relatively easy to scale.
Yet this formula is not producing adequate results for investors or society. For investors, social issue assessments are often simplistic, “check the box,” murky, and of limited value. These checklists reduce complex issues to simplistic criteria (e.g., having a modern slavery statement or DEI statistics), missing the broader business risks related to the intersection of governance, business models, business relationships and, crucially, real-world impacts of business on people.
Even when an investor looks to address identified risks, the formula often focuses on reducing the financial risk (e.g., by having compliance policies) rather than on the root cause of risk to people (e.g., lack of familiarity with human rights standards, limited engagement with potentially affected people, or regulatory gaps).
For society, the result is often companies that check the right ESG boxes but still have a pernicious effect on workers, communities, customers, and others.
Shifting to a Human Rights-Based Approach
To address these shortcomings, PE firms can strengthen their ESG efforts by adopting a human rights-based approach in alignment with the UN Guiding Principles on Business and Human Rights (UNGPs).
Endorsed by governments in the UN Human Rights Council, the UNGPs offer PE firms a process-based roadmap to respect internationally recognized human rights as a part of core business. This means conducting human rights due diligence to identify, prevent, mitigate, and account for how firms and their portfolio companies address risks to people (not just business).
Adopting a human rights approach helps PE firms to:
- Identify social risks and opportunities. Investors should ask tough questions: how do a company’s business model, products and services, and relationships impact people? These questions highlight real-world risks far better than generic questions about policies. For example, an investor recently lamented that using an ESG checklist for software companies was meaningless. The checklist might treat a company that makes accounting software the same as one that surveils employees. By focusing on harms to people, the firm would be better able to distinguish among companies, technologies, and end-use impacts.
- Anticipate legal risks. Investors consider proximate regulatory and legal risks to a business. By assessing the full range of a business’ harm to people, investors can anticipate and avoid the harms that lead civil society and communities to advocate for regulatory and legal action. For example, a 15-minute delivery service may have ESG policies, but its business model relies on precarious working conditions and increases congestion and traffic accidents, leading workers to strike and city officials to consider strict regulations.
- Align with emerging human rights regulations. Governments are adopting policies that reflect the expectations set out by the UNGPs. The proposed European Due Diligence directive will create a de facto Board-level obligation for companies to conduct human rights due diligence to address risks to people. The EU’s movement to “double” or “impact-based” materiality is also grounded in the human rights-based approach. Meanwhile, the US Government is updating its National Action Plan on Responsible Business Conduct to promote uptake of the UNGPs.
- Get ahead of geopolitical risk. Investors should consider human rights risks—especially severe civil and political rights risks—as an early warning system for geopolitical risk. For example, many investors were shocked by the economic withdrawal from Russia following the invasion of Ukraine. Going forward, they should consider, “How should we conduct business in countries where the government systematically violates human rights?”
- Respond to social harms and crises. A human rights approach offers principled and pragmatic guidance that helps companies navigate and respond to broader societal challenges and crises, such as the widespread assault on trans people’s rights across US state legislatures.
Actions for Private Equity
Investors in other asset classes have realized the value of a human rights approach. Investors representing US$7 trillion in assets under management have called on companies to conduct human rights due diligence, while others have called on governments to mandate such due diligence. Human rights are also a focus for the PRI.
To begin integrating human rights into their investment strategies, private equity firms should:
- Build capacity on human rights throughout the firm. Starting with sustainable investing leads and proliferating to portfolio managers and investment teams, firms should understand human rights standards and frameworks.
- Assess current portfolio companies and investment practices. Firms should identify existing or potential adverse human rights impacts before investing and on an ongoing basis once invested and develop plans to address them.
- Develop a go-forward plan for systematic integration of human rights into ESG approaches. Firms should include a human rights lens into investment themes, ESG policies, diligence, portfolio stewardship, etc.
BSR looks forward to building on its decades of work with companies on human rights to help private equity firms use rights-based approaches to build the next generation of sustainable investing.
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