By Peter Dunbar, CFA, Private Equity Senior Specialist, PRI
Supply chains and logistics might not be widely viewed as the most exciting topics in business. However, from an environmental, social and governance (ESG) perspective, they harbour a considerable range of potential risks to the operations of private equity portfolio companies. They are also sources of significant reputational risk to the companies and their investors.
Earlier this year as the COVID-19 crisis developed around the world, everyone’s newsfeeds were suddenly full of the emerging risks to supply chains and the impact that was having on all of us as consumers. Here in the UK, supermarket shelves began to empty of many products, partly due to demand increases brought about by panic buying, but also because of supply issues. Everyday items that you wouldn’t usually give a moment’s consideration to how they arrive in your kitchen, such as pasta, were no longer there.
Supply chains of even the most essential items are often complex and span entire countries and continents. For example, most pasta bought in the UK is manufactured in Italy – a country which was affected significantly and early by the virus. Barilla, a major manufacturer of pasta in Italy, sources 70% of its wheat from Italian farms – a staggering 5,000 of them. The remainder of the wheat comes from the US, Greece, Turkey, and Russia.
Months into the crisis, fast-fashion company Boohoo (listed on AIM in the UK) found itself at the centre of negative press coverage after it was exposed that workers in garment factories were being paid below minimum wage and being exposed to working practices which did not adhere to lockdown measures. This scandal triggered a near 50% fall in Boohoo’s share price.
Why is ESG in supply chains important?
From these examples, it’s easy to appreciate that supply chains are complicated beasts. Combine this complexity with the broad spectrum of issues that ESG professionals are expected to deal with – from human rights to energy efficiency to biodiversity – and it’s easy to appreciate why ESG in supply chains is a challenging topic for the average investor in private companies.
We can see complexity is high, but what about the risk? Most experts say, “if you look, you’ll find problems”. The majority of portfolio companies are therefore exposing GPs to hidden and uncontrollable risks, outside of their core operations, unless they take steps to manage them.
Investors and their portfolio companies face particularly severe threats to both their reputations and their business continuity. Reputational risks arise from, for example, human rights abuses in portfolio company supply chains. Business continuity risks can result from a variety of factors, from severe weather events to social unrest.
Burger King, for example, has had several private equity investors over the years. In 2017, Mighty Earth, a Washington DC-based environmental campaign organisation focussed on destructive business practices, released the report, The Ultimate Mystery Meat. It made several serious allegations against companies in Burger King’s supply chain, claiming links to deforestation and human rights abuses. And while the allegations were aimed at the supply chain, the Burger King brand, and its investors suffered this reputational risk nonetheless.
Finally, when thinking about climate, a portfolio company’s operations are often just the tip of the iceberg in terms of emissions. In most industries, emissions from direct operations are significantly smaller than emissions from its supply chain. For example, in healthcare, around 85-90% of emissions are found in the supply chain.
Lessons to learn
Boohoo was rated highly by ESG rating companies before the scandal breaking. Crucially, however, it scored poorly on supply chain transparency. However, many asset managers blindly accepted those high ratings and did not see the evidence which was in plain sight. They just needed to do a little of their own research.
The Boohoo case warrants a more in-depth understanding by private equity investors – it is clear there are lessons to be learnt.
Private equity is ideally situated to ensure that target portfolio company supply chains are competently due-diligenced, and well-monitored post-investment. Unlike in public equity, there are no ESG ratings to rely on; research and thorough due diligence are key tools that private equity investors need to use to mitigate these risks and prove their ESG credentials to LPs.
Private equity investors and supply chains
The PRIs report, Managing ESG risk in the supply chains of private companies and assets, is a reliable guide for private equity investors seeking to understand what they can do in this area.
The most appropriate way to tackle this risk is through investors engaging with their portfolio companies. The guide seeks to explore the most pertinent questions to ask, pre or post-investment, that aim to encourage the portfolio company to develop appropriate monitoring procedures where they are absent or not up to standard. When to ask the questions, and even who to ask them to are areas covered in the guide.
The guide illustrates what an investor might expect a starting point for the management of supply chain risks to look like, and what a developed approach would constitute. The journey between the two can be long and complicated, so it is crucial to begin the process early, ideally during due diligence, rather than merely ignoring the risks.
This guide is one of our most practical and is an excellent resource for ESG practitioners and investment teams alike. The disruption caused by the COVID-19 crisis is testament to this.
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