Private equity funds for investment in small and medium-sized enterprises in developing countries are starting to flourish. In fact, according to the Social Investment Forum of the US, socially responsible mutual funds saw net inflows of over US$185 million in the first quarter of 2003.
But in this era of sustainable development and corporate responsibility, their proliferation poses questions which have long troubled what might be referred to collectively as the socially responsible investment community: does the pursuit of development objectives – also known as “non-financials” or “intangibles” – compromise the commercial viability of an investment by clouding the risk-reward nexus, or does it in fact improve the prospects for good returns?
The growing interest in the social, environmental and economic dimensions of investment in developed markets has not been accompanied by a clear articulation of the trade-off deemed acceptable (if any) between commercial and other non-financial objectives. In the developing world, the term “sustainability” – a sometimes nebulous idea which seemingly uses high socio-economic benefits as an apology to explain disappointing returns – has added an extra dimension to the discussion. In neither context, however, is the investment community entirely comfortable with the relationship between the financial and the intangible.
The problem partly lies in the current parameters of the debate. At best, developmental objectives are presented as extraneous and secondary to commercial ones, but increasingly deserving of attention; at worst, the commercial and development goals are seen as dichotomous, with the latter forced onto the agenda for political reasons and detracting from the profit-making motive. But there is an alternative perspective – that until development objectives are treated as means to enhancing commercial outcomes rather than ends in themselves, development and commercial goals will remain uncomfortable bedfellows.
The case for socially responsible investment, or SRI for short, is compelling and the benefits espoused by its practitioners are considerable: consumer loyalty, enhanced brand and reputation, improved access to capital, product and service innovation, increased ability to attract and retain staff, and so on. Business enlightenment is the leitmotiv – the company becomes aware that achieving satisfactory returns for shareholders in the long term depends on the sanctioning of the company and its products by a range of stakeholders: employees, consumers, suppliers, competitors, communities, local authorities, governments, and others. The idea is that there is a homologous relationship between producer/stakeholder and consumer/stakeholder, and incorporating this interface into the business strategy will help the company to harmonise its commercial objectives with socio-economic and environmental considerations.
But does this approach show up in generating returns? The SRI community concedes that it is too early to draw firm conclusions. There is, however, compelling evidence that some SRI funds and projects in the developed world have weathered recent market turbulence better than ordinary ones. In fact, companies on the new FTSE4Good Index and the Dow Jones Sustainability Index consistently performed above average in recent financial market downturns.
Nonetheless, the case against SRI is also persuasive, though just as hypothetical, for instance, in the key contention that once the risk-return imperative is combined with non-financial considerations, it distorts resource allocation and becomes a cost to the investor.
Critics of SRI also argue that company structures inherently make intangibles difficult to achieve. After all, shareholders retain the services of management to maximise profits, and incentive arrangements usually reflect this priority. Consequently, allocating resources to perceived “non-core” areas in SRI fashion can have personal and commercial consequences for management.
Of course, there is the cynical view that SRI is little more than a public relations exercise that lacks a coherent set of values and is often reactive and ill-conceived. Experiences like those of Union Carbide in Bhopal, India, and Shell in Ogoni, Nigeria, in the 1980s simply spawned lip service to issues like environmental degradation, human rights, poverty alleviation and so on, in part to pre-empt litigation, but also because of the growing prominence of non-core issues on the global agenda and in the media.
Like other private equity investors in developing countries, our firm, Aureos Capital – which is a joint venture between the Norwegian Fund for Developing Countries (Norfund) and CDC Capital Partners (formerly the Commonwealth Development Corporation) – must strike a delicate balance between commercial and development objectives. Although 97% of investors in Aureos funds are so-called “soft” institutions – development finance institutions, multilateral development banks, regional development organisations, local financial institutions and the like – this does not diminish the commercial imperative of its activities. On the contrary, such institutions feel keenly that the viability of private equity funds in the developing world, the participation of the private sector in such funds, and the augmentation of investment flows of this type to developing markets, particularly to Sub-Saharan Africa, is predicated on the achievement of commercial returns.
At the same time, given the nature of these investors, commercial objectives cannot be pursued to the exclusion of development considerations. Indeed, the mandate is simultaneously to maximise commercial and developmental benefits. Is this feasible?
The answer is “yes” and the solution lies in a broadened definition of sustainability, which encompasses both commercial viability and development durability, and illuminates points where these converge.
Sustainable development is frequently defined as a development path that meets the needs of the present without endangering subsequent needs and aspirations of future generations, allowing for the conservation of nature to be part of this path. Although a useful starting point, this definition is cast in terms of minimising negative outcomes, such as environmental degradation and threats to future livelihoods. It seems there is much to be gained from building into sustainability the concept of means and ends.
This wider notion of sustainability sees developmental objectives or intangibles – improved management capacity and sound corporate governance, training and staff development, environmental best practice, and so on – as integral components of business strategy (means) aimed at maximising value, as opposed to incidentals (ends) to be pursued often half-heartedly alongside returns. This way, sustainability not only diminishes the gap between commercial and development objectives, but also presents them as mutually reinforcing dynamics, not mutually exclusive ones.
In other words, commercial objectives are best conceived as one of several building blocks on the trajectory of sustainability. And they should not be downplayed. On the contrary, for private equity investors like Aureos, investing without attaching serious commercial terms would be nonsense. Indeed, such investments would be little more than thinly veiled subsidies which, once withdrawn, would likely cause investee companies to collapse or stagnate. Moreover, financial viability is vital to an investee company’s ability to withstand external shocks like price declines, as well as ad-hoc policy reversals that are commonplace in developing countries. Commercial pressures also help to professionalise investee companies and to ensure that appropriate financial architecture is put in place.
The critical point, however, is that intangibles must also be integrated into company strategy as basic building blocks of sustainability, so that the interplay between the financial and the non-financial is viewed as a complementary and fundamental process geared to generating company value.
This is where the SRI debate is particularly instructive and where an enhanced definition of sustainability sheds light on reconciling commercial and developmental objectives. It is clear even from a cursory glance at the SRI literature that both the “pro” and the “anti” camps focus on the relationship between SRI and profits and that sustainability is seldom mentioned. SRI is invoked almost as an ideology that has resource implications which either increase or jeopardise profits, depending on one’s attitude to SRI.
The focus implied by SRI is usually on the relationship between intangibles and profits, whereas it should be on intangibles and company value. As recent corporate collapses in OECD countries have shown, company value is a multi-faceted concept which embodies far more than the strictly financial dimensions of business. Profit, in turn, is a function of company value, which goes beyond the balance sheet to the socio-economic and environmental capital which underpins a given business. And good public relations are no substitute for proper management.
The challenge for private equity funds like Aureos in developing countries is to better understand and illuminate the synergies between the development and commercial dimensions of investment, and the way in which the former reinforce the latter. The broadest possible definition of sustainability is a crucial step on this path. By highlighting the primacy of value over profit, sustainability helps companies realise a range of beneficial outcomes, of which profit is but one.
*Aureos is an emerging markets private equity fund manager.
©OECD Observer No 238, July 2003