Private Equity Investors Should Look to Environmental and Social Sustainability

Investors of all stripes are moving more of their money into developing countries, including the poorest and least developed countries. It makes sense. Economic growth in the developing world has outpaced that of the developed world for several years. Rising middle classes in emerging markets will likely accelerate this trend in the decades to come. So it is no surprise that private equity firms are following stock market investors into the frontier markets.

IFC and the Emerging Markets Private Equity Association (EMPEA) are hosting almost 800 private equity investors at our 7th Annual Private Equity Conference this week. An EMPEA survey of investors found that emerging markets captured 15 percent of the total private equity capital raised in 2011, up from only four percent of the global total in 2004. Three-quarters of limited partners plan to increase emerging market investments, and almost as many -- 72 percent -- expect the investments they made in 2011 to deliver net returns of at least 16 percent. Only a quarter of investors predict their investments in developed markets to perform so well.

It is clear this upside potential for growth in the developing countries offers huge upside for investment returns. At the same time their weak institutions and incomplete regulatory and legal frameworks create huge risks and obstacles to success. These risks are even greater for private equity investors who invest in a broader range of smaller and lesser known companies than the typical stock market investor in a developing country.

There is a growing body of data which shows firms with strong environment and social performance can overcome these barriers. So whether you care about the impacts your investments have on the communities where you invest, want to manage risks, or boost your bottom line -- strong environment and social standards can help in these risky markets.

According to a Harvard Business School study that tracked performance over the last 18 years, companies with strong environment, social and governance performance financially outperformed companies with weak performance.

This tracks with our experience. IFC has been investing in developing countries since 1956 and is now one of the world's largest equity investors in developing countries. For more than a decade we have applied environment and social standards for all of our investments. We apply an exclusion list of sectors where we do not invest, environmental and social sustainability standards, as well as corporate governance and integrity due diligence. Over time, we have seen that investments with good environment and social risk ratings also carry lower credit risks.

The reasons are simple. Strong environment and social standards help clients lower production costs, manage potential social and environmental issues to avoid damage to reputation, and in some cases, obtain certifications that create access to new markets. Good corporate governance protects investors, enhances reputation, and reduces cost of capital. A number of studies have shown that strong corporate governance correlates with stronger stock performance, higher profitability, and higher dividend payments.

Commercial banks recognized these benefits long ago. Seventy-six financial institutions around the world have adopted the Equator Principles, a framework for managing the environmental and social risks of financing projects, which reference IFC's performance standards. In March, Aterios Capital, based in Africa, became the first private equity fund to adopt the Equator Principles.

Given the long-term nature of equity investments, it is in the self interest of the private equity industry as a whole to embrace the Equator Principles. Some large private equity firms are hiring dedicated sustainability officers. This is a good first step. Guiding principles for integrating environment and social standards into equity investments would be another step forward toward managing the risks inherent in projects.

This would create benefits for the environment, more profits for investors and improve the quality of life for communities in developing countries.