A new three-letter business acronym has emerged on the scene. While most public companies have become familiar with it, now family-owned businesses and employee stock ownership companies need to take notice. It’s ESG – short for Environment, Social and Governance – and these initials represent the three main pillars of sustainable investing and business ownership.
We have long held that Governance is critically important to long-term success for family and private businesses In April 2019, we wrote that “for family businesses, strong governance is the secret to managing risk.” The addition of Environment and Social factors isn’t that surprising.
Environmental criteria can include a company’s energy use, pollution and waste, conservation of natural resources, and even how it treats animals. The criteria also can help evaluate environmental risks a company may encounter and how it manages them. For example, are there issues related to its ownership of contaminated land, disposal of hazardous waste, management of toxic emissions, or compliance with government environmental regulations?
Social criteria explore the company’s business relationships. Does it work with suppliers that hold the same values it claims to hold? Does it donate a percentage of its profits to the community or encourage employees to perform local volunteer work? Does its working conditions show high regard for employee health and safety? Are other stakeholders’ interests considered?
As for governance, investors may want to know that a company uses accurate and transparent accounting methods and that stockholders can vote on important issues. Investors also may want assurances that the company avoids conflicts of interest in their choice of board members; it doesn’t use political contributions to obtain unduly favorable treatment; and, of course, it doesn’t engage in illegal practices.
Because managing a business to reflect these factors can lead to better outcomes for all stakeholders, ESG considerations aren’t simply a matter of ethical behavior – they can have a distinct impact on revenues, ROI and the long-term sustainability of the business.
Increasingly, proactive PE firms are incorporating sustainability and social responsibility in how they invest and operate. They’re doing that to respond to the concerns of their limited partners. And these PE firms, in turn, are more and more evaluating ESG factors when looking for business to acquire or co-invest. For private and family businesses that may one day want to sell their enterprise, whole or in part to a PE firm, this is another reason to pay attention to ESG concerns.
Governmental regulators have taken notice of ESG considerations. For example, in the past year, recognizing the importance of companies’ employees and culture to wealth creation, the SEC has mandated public disclosure on companies “human capital” policies.
Emerging research shows that a number of financial and other long-term benefits correlate to companies that pursue high ESG performance. Among other findings, several management consulting firms have concluded recently that strong ESG propositions can improve value and High-ESG companies register less-volatile earnings and lower cost of capital and market risk. They are more apt to record better employee and customer retention rates and brand recognition and also prove to be more adaptable to disruption from technology or regulation.
As for family-owned companies, Credit Suisse, in a February 2020 article, contended that they consider and incorporate ESG factors more than non-family-owned counterparts because they tend to take a longer-term view and often are better prepared for the future. Its Family 1000 report concludes that over time, family-owned businesses with strong ESG credentials perform better. Related, a KPMG partner in a July 2020 article maintains that a new generation of family business leaders can change the ESG mindset.
On the employee-ownership front, ESOPs consistently outperform. Employee owners possess a dedication toward their job and are more accountable for their and their fellow workers’ job performance than employees at non-ESOPs. ESOPs also tend to be more active in helping their local communities. For that reason, one observer considers employee ownership to be the solution to higher standards of ESG for public companies.
The importance of ESG won’t fade any time soon as attention focuses increasingly on intertwining profits with purpose. As BlackRock CEO Larry Fink maintains, “Profits and purpose are inextricably linked.” This is the chief reason family-owned companies and ESOPs should open a conversation about ESG.