By Roxanne Schnyder, Final Year LLB Candidate at King’s College London
Introduction
In a world increasingly governed by Environmental, Social, and Governance (ESG) principles, the role of private equity in sustainable development has become a topic of growing interest. Private equity firms, historically focused on maximizing returns, are now presented with an opportunity to lead the charge in sustainable economic development within emerging markets. The potential of private equity to drive positive change by financing small and medium-sized enterprises (SMEs) committed to long-term sustainability and broader societal impact is immense. By examining the challenges and opportunities of ESG integration in private equity, highlighting the importance of combining innovative philanthropy with profit-driven initiatives, and discussing the significance of stable legal and political governance in emerging markets, private equity is uniquely positioned to contribute meaningfully to the global pursuit of sustainable development.
ESG Pressure and Greenwashing
The call for adopting Environmental, Social, and Governance (ESG) principles in private equity has never been louder, as firms face increased scrutiny over job losses at portfolio companies, controversial investments, and shifting public opinion. With mega-funds such as Blackstone, Apollo, and Carlyle becoming increasingly publicly listed, the need for ESG integration is vital for societal impact and essential for maintaining the industry’s reputation.
However, a growing concern is that many private equity firms are engaging in
“greenwashing” – promoting superficial and performative ESG initiatives that do not create
tangible impact. For private equity to genuinely lead in sustainable development, a deeper
commitment to ESG principles must be embedded at the core of their investment strategies.
Greenwashing is not exclusive to private equity; it is a widespread issue throughout the financial sector. Examples of superficial ESG initiatives include mission statements, training programs, and certifications that carry less weight than the profit-driven investment decisions made by these companies, often with little or no regard for environmental concerns. One such example involves a large well-known investment company with USD 12 billion in assets under management, one of whose current ESG policies is sending company managers to a sustainability certification course at NYU (Eccles, Shandal & Young, 2022). While such programs may raise awareness, they fall short of driving meaningful change within the firms’ core investment strategies. To truly become leaders in sustainable development, private equity firms must prioritize ESG as the cornerstone of their investment approach rather than treating it as a peripheral consideration or marketing tool.
Bridging the Finance Gap
Private equity can play a pivotal role in providing much-needed financial support in emerging economies, where SMEs often struggle to access capital. Traditional sources of funding, such as debt financing and capital markets, are frequently underdeveloped or inaccessible in these regions. As a result, SMEs face difficulties in obtaining the necessary resources to grow and innovate, ultimately hindering economic development and job creation.
The size of such investments is often unattractive to private equity firms, as the due diligence costs on a USD 5 million loan may amount to 10% of the loan value (IMF 2019). Private equity firms and their employees are incentivised not by the quality of their investments but by the size of the return. A USD 500 million loan to a large conglomerate ticks far more internal boxes as opposed to a “tiny” USD 5 million loan to an emerging market which may be perceived as high-risk and financially inconsequential. One strategy may be to create a more streamlined approach to these smaller sustainability loans, thus reducing the due diligence costs and therefore instantaneously opening a vast new market for private equity to explore: smaller projects, smaller loans, cheaper due diligence, and thus many more opportunities (Lerner, 2016).
Their flexible investment structures and governance models make private equity firms
uniquely suited to bridge this finance gap. By investing in environmentally and socially
responsible SME projects, private equity firms contribute to these businesses’ financial success and promote sustainable growth in emerging markets. This approach fosters job creation, supports local communities, and encourages innovation, all of which are vital for long-term economic development.
Moreover, private equity firms can offer invaluable expertise, strategic guidance, and access to broader networks, which can help SMEs overcome operational and market-related challenges. These resources can empower SMEs to scale their businesses, improve efficiency, and enhance their competitive edge, further driving sustainable growth in emerging economies. In addition, private equity investments in sustainable SME projects can generate positive externalities, such as improved environmental stewardship, better working conditions, and enhanced social inclusion. By prioritizing these values, private equity firms can contribute to the achievement of the United Nations’ Sustainable Development Goals (SDGs) and help create a more equitable and prosperous global economy (UN, 2023).
Merging Philanthropy and Profit-driven Initiatives for Sustainable Impact
“The highest use of capital is not to make more money, but to make money do more for the betterment of life.” – Henry Ford
The traditional separation of philanthropy and business has limited the potential for long-term, sustainable impact. By recognizing the synergy between profit-driven initiatives and social good, innovative solutions can emerge that drive lasting, positive change for communities, individuals, and societies. Investments in microfinance and SMEs in emerging markets have the potential to be a powerful catalyst for this transformation.
With their long-term investment horizons and strong governance control, private equity firms are uniquely suited to drive this merger of philanthropy and profit. Unlike public equities, private equity firms often have virtual control over their portfolio companies from an ownership and governance perspective, allowing them to shape the strategic direction and ensure alignment with broader social and environmental goals. Additionally, private equity investors typically have a long-term commitment, with lock-up periods ranging from 3 to 7 years, facilitating a focus on sustainable growth and impact (Eccles, Shandal & Young, 2022).
Case Study: Sustainable Housing in Jamaica
One such instance of this form of impact investment is Craig Hartwell. A UK and Caribbean
a based visionary entrepreneur, with his company Wots Hot Energy he has embarked on a mission to create affordable and sustainable housing in Jamaica. His innovative concept, the Eco-Village on Mahogany Hill, aims to build 211 affordable homes that integrate a variety of sustainable features, such as solar panels, water recapture systems, and on-site natural effluent treatment plants. The treated effluent is then repurposed to support the growth of new trees in an adjoining nursery. These eco-friendly homes are designed to harmonize with the land and utilize sustainable materials, with natural airflow patterns to maintain comfortable temperatures for residents.
In addition to its environmental impact, the project also supports a local school, promoting
ecological advocacy and community leadership by involving students in the nursery’s operations. Although Hartwell has secured a construction loan from a commercial bank to finance the development, he would ideally prefer funding through private equity. Unfortunately, private equity firms remain hesitant to invest in SMEs, particularly those operating in emerging markets and focusing on social change.
However, this reluctance to invest in social change presents a unique and profitable opportunity for private equity firms. By embracing projects like Hartwell’s Eco-Village, they can generate competitive returns on their investments and align with the growing emphasis on ESG principles within the finance industry.
The Role of Legal and Political Governance
One of the challenges private equity faces in emerging markets is the lack of stable legal and political governance, which can significantly impact investment opportunities. (Lerner & Schoar 2005). Stable governance is crucial for ensuring that investments are protected, contracts are enforced, and disputes are resolved fairly and transparently. In countries with weaker governance structures, private equity investments may be exposed to higher risks, including corruption, political interference, and regulatory uncertainty.
Economists Lerner and Schoar (2005) found that a common-law legal system significantly determines private equity investments’ success in developing countries. The study emphasizes the impact of legal and political governance on the viability of such investments and the importance of a stable regulatory environment and robust institutions for attracting and retaining investments. The World Bank report (2011) further underscores the importance of stable legal and political governance for sustainable investment in emerging markets. The report argues that a sound legal framework and well-functioning institutions are crucial for building investor confidence, mitigating risks, and promoting long-term growth. It also points out that legal and political stability can help reduce the perception of risk associated with investing in emerging markets, potentially leading to increased capital flows and economic development.
Jamaica exemplifies an emerging market bolstered by its Commonwealth membership and a common-law parliamentary democracy. Hartwell credits the Jamaican government’s support for the National Housing Trust, which offers mortgages to citizens looking to purchase property, as a significant factor in the potential success of his project. In a 2015 meeting with the Jamaican Prime Minister, Hartwell inquired about the country’s most pressing needs, to which the response was “renewable energy and affordable housing,” demonstrating its commitment to equitable domestic growth. By investing in strategically positioned projects like Hartwell’s Eco-Village, private equity firms can navigate governance challenges while contributing to the broader goals of renewable energy, affordable housing, and sustainable development in emerging markets.
As noted in a discussion with Lerner, however, an unprecedented boom in private equity investments in the Asian market, particularly China, has started to challenge traditional
conceptions about the indispensability of stable legal and political governance as prerequisites for successful investment. Despite China’s unique blend of a state-controlled legal system and a semi-command economy, the nation has attracted significant private equity capital. The allure stems from several factors, including rapid economic growth, immense market size, burgeoning middle class, and the government’s strategic push for innovation and technology (Klonowski, 2013). Therefore, it seems that potent economic opportunity can sometimes override concerns about governance structures. Yet, this does not entirely dismiss the relevance of legal and political stability. While these investments have shown impressive returns in the short-to-medium term, concerns about regulatory unpredictability, lack of transparency, and issues related to intellectual property rights continue to pose potential long-term risks. These factors could influence the sustainability of this trend and highlight the complexity of the relationship between private equity investment and governance considerations, which may not be as linear as traditionally perceived.
Conclusion
As global attention increasingly turns toward Environmental, Social, and Governance (ESG) principles, private equity firms are uniquely positioned to drive sustainable development, particularly within emerging markets. The potential for these firms to catalyze positive change by financing small and medium-sized enterprises committed to long-term sustainability is immense. However, navigating the challenges of ESG integration, combatting greenwashing, bridging financial gaps, and leveraging the synergy between philanthropy and profit-driven initiatives necessitates a profound commitment to these principles. In the coming years, we hope to see private equity adopt such change and consider ESG as the cornerstone of their investment strategy, as Franklin would have it doing well by doing good, enabling a more equitable and prosperous future for both developing nations and PE alike.
With special thanks to Craig Hartwell and Darek Klonowski for taking the time to be
interviewed.
Sources:
- Blancher, Nicolas R, et al. “Financial Inclusion of Small and Medium-Sized Enterprises in the Middle East and Central Asia.” International Monetary Fund Middle East and Central Asia Department, IMF, Feb. 2019.
- Eccles, R, Shandal, V & Young, D. “Private Equity Should Take the Lead in Sustainability.”
Harvard Business Review, July 2022, https://hbr.org/2022/07/private-equity-should-take-thelead-in- sustainability. - Klonowski, Darek. “Private Equity in Emerging Markets: The New Frontiers of International Finance.” The Journal of Private Equity, vol. 16, no. 2, 2013, pp. 20–37.
- Lerner, J., et al. “Private Equity in Emerging Markets: Yesterday, Today, and Tomorrow.” The Journal of Private Equity, vol. 19, no. 3, 2016, pp. 8–20. Lerner, Josh, and Schoar, Antoinette. “Does Legal Enforcement Affect Financial Transactions? The Contractual Channel in Private Equity.” The Quarterly Journal of Economics, vol. 120, no. 1, 2005, pp. 223–46.
- “Private Equity Investors and Sustainability.” World Economic Forum, 1 April 2022,
https://www.weforum.org/agenda/2022/04/private-equity-investors-sustainability/. - United Nations: Department of Economic and Social Affairs 17 Goals for Sustainable
Development, 2023 https://sdgs.un.org/goals
