People power: How employee initiatives are driving value

Not so long ago, private equity data collection on employees and the contribution to the economy that portfolio companies provided consisted mainly of quantifying how many jobs each investment created. Yet things have moved on over recent times, as many firms have started measuring and managing job quality and employee engagement.

This trend is partly driven by the rising prominence of ESG factors in investment decisions and portfolio management, but also because there is a growing belief – increasingly backed by evidence – that employee initiatives can have a direct impact on business performance. Where once private equity was all about management, management, management, today people strategies and employee wellbeing are a major focus for many firms, in particular among many advanced economies where labour shortages have started biting.

“There has been a notable evolution in private equity’s approach to portfolio company employees,” says Daniela Popa, ESG manager, sustainability and strategy at sustainability-focused European asset manager Ambienta. “The industry now recognises that sustainable value creation is inseparable from holistic value creation for all stakeholders, including employees. Studies show that companies with more satisfied employees experience accelerated growth and increased profitability.”

Making the case

A recent report by Boston Consulting Group (BCG) that analyses ESG Data Convergence Initiative (EDCI) data found a correlation between companies’ injury rates and revenue growth: businesses with the lowest injury rates increased their revenues by 7 percentage points more than those with the highest rates. It also found, perhaps unsurprisingly, that median staff turnover was lower in companies where employee engagement (measured by higher employee survey response rates) was higher. This can clearly have an impact on costs – both recruitment and onboarding – as well as productivity.

It’s a finding that chimes with Richard Pearce, a partner who leads the people function at mid-market firm ECI Partners. “We’ve been focused on people and culture for a long time because we recognise that having good and motivated employees in our portfolio companies drives commercial performance. Our internal analysis has demonstrated that portfolio companies with high employee engagement scores achieve higher EBITDA growth during our ownership – there is a clear correlation between a good culture and performance.”

Ambienta has also conducted internal analysis, also with positive results. “We are increasingly emphasising the value-creation component of addressing human capital so that management teams can understand the benefits,” says Popa. “In one of our portfolio companies, for example, we demonstrated that reducing work-related injuries, employee turnover and absenteeism could lead to a 1 percentage point increase in the EBITDA margin.”

These financial implications are perhaps one of the reasons private equity firms are reporting an intensified focus on human capital among buyers for their portfolio companies. As Pearce outlines: “Buyers are increasingly looking at what employee engagement scores are, what training programmes the company offers, which HR accreditations the business has, how appraisals are conducted, whether it is tracking DE&I and what it is doing to improve this, and whether it can hire people quickly. Investment memoranda used to have, say, a single slide on people issues; today, it’s often more like 10-15.”

What’s the approach?

Private equity firms clearly need to pay more attention to employees in portfolio companies than has historically been the case. But how is the industry approaching the issue? And just how far are firms going?

For some firms, the subject of people and talent in portfolio companies sits within their broader value-creation frameworks. ECI, for example, sees people and culture as distinct from – but related to – ESG initiatives. Pearce explains the firm’s approach as having three areas of focus. “These [areas] are hiring good people, keeping them; and then helping them be better at what they do. That sounds straightforward but it isn’t, and we sometimes have to remind management teams why this is important.

“The industry now recognises that sustainable value creation is inseparable from holistic value creation for all stakeholders, including employees”

Daniela Popa
Ambienta

“A crucial part of this is having fit-for-purpose and scalable HR capability within companies, and we’ve developed a people and culture toolkit to help investee businesses implement this.”

Yet for others, such as Ambienta, this fits firmly within an ESG bucket. “Within our ESG framework, human capital stands out as a core focus area,” says Caterina Campagna Weiss, ESG manager, sustainability and strategy. “Encompassing employee health and safety, engagement, talent attraction and retention, as well as diversity and inclusion, this segment typically represents 20-30 percent of the ESG action plans we agree and define with company management teams and owners.”

For many firms, employee wellbeing and company culture include areas such as diversity, equity and inclusion. A recent AlixPartners survey on private equity’s approach to ESG demonstrates why. The majority (63 percent) of private equity respondents said that DEI&B (B is for belonging) was very or extremely important for attracting, developing and retaining employees.

“Our ESG survey shows a strong endorsement for the ‘S’ [in ESG] among both private equity firms and portfolio companies,” says Ted Bililies, a partner and managing director at AlixPartners. “They see it as attractive for retaining people in what is a war for talent. This is particularly true of retaining Generation Z employees, who want to work for organisations with a strong commitment to DEI&B.”

The impact angle

While employee ownership structures are expected to become more common in private markets, work needs to be done to demonstrate how these relate to specific impact goals, according to panellists at New Private Markets’ Impact Investor Summit: North America. Charles Avery reports.

“Due to the current silver tsunami – the ageing baby boomers – there are opportunities to support employee ownership transition,” Mission Driven Finance co-founder and CEO David Lynn said on a panel at the Impact Investor Summit: North America in late 2023. “There are founders who want to exit. If we can help engineer that exit so that the employees become owners, whether partially or entirely, that’s phenomenal.”

Mission Driven Finance is a Californian social impact manager that provides commercial financing to small businesses, social enterprises and non-profits. The firm is developing capital solutions that increase shared ownership opportunities, according to its website.

There are a variety of different structures available to managers looking to adopt employee ownership strategies, including employee stock ownership plans (ESOP), employee ownership trusts, perpetual purpose trusts and co-operatives. External financing can be provided through debt or equity; Mission Driven Finance frequently provides capital to support ownership transitions by lending to the company itself, rather than employees.

“There’s different structures, there’s different mechanisms in order to deploy that capital, but it all becomes a highly investable asset in a small business that, at the end of the day, rewards workers too,” Lynn said.

Philip Reeves, a founding partner at Apis & Heritage Capital Partners, a US mezzanine debt private equity fund, said: “The way we think about employee ownership is that it’s obviously great for [reducing] inequality and generating impact metrics, but it’s also great for generating outcomes. We find that, particularly in the service sector, when the largest line item in your profit and loss is labour, if you can get alignment between the front-line workers, the front office and the boardroom, that’s powerful.”

Through its employee-led buyout strategy, Apis & Heritage finances the conversion of companies with substantial BIPOC workforces into 100 percent employee-owned businesses. The firm uses an ESOP when changing the ownership of its companies, Reeves explained, as 100 percent ESOP-owned businesses do not pay federal or state tax in the US. As a result, “you have cash going out of the business that was going to the IRS that now we use to create value, one way or another”.

Some institutional investors look at ownership structures as a way to meet their racial and social equity goals, Lynn said. However, in practice it is difficult to know at the outset what benefits changing ownership will have.

“How many [BIPOC] employees do they have?” Lynn said. “What’s the wage increase going to be? Most of that is future state and you may not even know the day you invest in the company. I think that’s where the work is needed. It is important to draw the connections, particularly for the racial and social equity-motivated investors, to see how that investment can directly change lives in the long run.”

To help with this, The Predistribution Initiative, a non-profit focused on developing investment structures that promote equality, is conducting research on the relationship between different forms of employee ownership and impact, according to co-founding partner and executive director Delilah Rothenberg. “We are undertaking some exercises where we’re starting to map the space and say: what’s the menu of options available for institutional investors within existing and emerging asset classes? What sort of return profiles? What are the pros and cons in terms of impact depending on if the investor has a particular impact lens or criteria?”

On the other hand, investors with different motivations may have an easier time. “If institutional investors are thinking about human capital management, then employee ownership fits very clearly into that framework,” said Jack Moriarty, executive director at US non-profit Lafayette Square Foundation. “It’s a proven driver of performance, it’s a driver of employee retention and [of] resilience during a downturn.”

Owning it

Some are going several steps further, by implementing employee ownership and value-sharing initiatives for employees, as Popa explains. “We’d like employees to benefit from potential upsides at exit to recognise and encourage their active role in achieving this. We have traditionally focused incentive plans at managerial levels, but we are working to expand them to impact a larger share of employees.”

France-headquartered investment firm Ardian has had profit-sharing programmes in portfolio companies since as far back as 2008. In fact, this was, according to the firm’s head of sustainability, Candice Brenet, the starting point of Ardian’s sustainability programme and a way of “contributing to a fairer society”. Since then, 33,000 employees from 45 exited portfolio companies have received between one and six months of salary in profit-sharing. The firm also recently joined Ownership Works, a non-profit organisation that promotes employee share ownership, established by KKR partner and co-head of global private equity Pete Stavros.

For Ardian, shared ownership is an additional layer of alignment of interest that builds “long-term value creation and contributes to attracting and retaining talent and employee commitment to the company, which drives productivity”, says Brenet. The firm says 70 percent of its buyout, expansion and infrastructure portfolios have at least one value-sharing programme, and 31 percent have an employee share ownership scheme. The firm also works with the GPs it backs through its ESG monitoring to promote value-sharing mechanisms in their portfolio companies.

Ardian is not alone. Ownership Works now has 26 private equity firm signatories that have committed to the organisation’s programme. While this takes in the aims of attracting, retaining and motivating employees – with the financial benefits this can bring – the organisation’s creation reflects a wider move among some firms and investors to address social inequality.

“There are clear benefits for businesses when employee ownership schemes are well implemented,” says Anna-Lisa Miller, executive director at Ownership Works. “But among many firms that use these schemes, there is also a broader interest in helping address growing wealth concentration. This is a meaningful way for private equity to help workers get ahead in a way that is familiar to the industry and beneficial for businesses, private equity firms and their LPs.”

Firms that sign up commit to putting in place schemes in at least three portfolio companies (fewer for ­smaller firms) that offer between six and 12 months of salary to full-time employees at exit – if the company meets its base case – at no cost to employees.

To make the most of these schemes, Ownership Works encourages firms to foster a culture of ownership so that employees understand what the company priorities are and how their jobs contribute to this. The organisation’s programme also asks firms to provide financial education and resilience training to workers, as well as initiatives such as emergency savings programmes. “The companies that have done this well have created a people-first culture that fosters employee wellbeing,” says Miller. “Employees feel more connected to their jobs, so the benefits are not just financial, but about having better quality jobs.”

In future, there could well be more impetus for other firms to sign up or consider implementing some form of value sharing with a wider employee base as income inequality rises up the LP agenda. At the Impact Investor Summit: North America 2023 held by New Private Markets late last year, Brian Kernohan, chief sustainability officer for private markets at Manulife Investment Management, urged private markets investors to do more to address global social inequality, saying it is “a great source of risk and missed opportunity”.

With a proposed Task Force on Inequality and Social-related Financial Disclosures looking to create a framework to evaluate company and investor performance on social inequality, it seems likely the interests of company employees – alongside those of other stakeholders – will move up the agenda in private equity still further.

Where are all the workers?

The lasting effects of the pandemic and the tight labour market have had a significant effect on portfolio companies’ employment practices.

“We have seen a massive disruption in the workplace,” says Matt Brubaker, chairman and CEO of human capital advisory firm FMG Leading. “Since the pandemic, employers have been trying to work out how they can create a different relationship with their employees. It’s no accident that 2021 was an explosive year for the growth in human capital hires among private equity firms.”

ECI’s Richard Pearce agrees that the pandemic had a profound effect on people strategies. “Covid put the responsibility for employee wellbeing firmly at the employer’s door in a way we hadn’t seen before. People who were working from home, for example, were inviting their employer into their home. Employers needed to ensure their employees were safe. That’s already hard to unwind, but then we had an intense war for talent in 2021 and 2022, when employees could ask for almost anything they wanted. That’s rowing back now, but some of this has stuck.”

The shortage of workers has eased in some areas over recent times – in white collar jobs, for example. But the situation for blue collar positions is very different. One reason is that higher educational attainment among younger generations means they are less likely to enter manual jobs than their parents. In the US, for example, the National Association of Manufacturers’ Q4 2023 Manufacturers’ Outlook Survey found that 71 percent of leaders considered attracting and retaining a high-quality workforce to be the biggest business challenge.

It’s also an issue that will likely intensify, which means that attracting and retaining portfolio company employees – including, and possibly especially, those lower down the pay scale – will be an ever more vital part of what makes a company successful and able to grow. “The trend towards nearshoring will require a readjustment of the economy and workforce – the US and many other countries are not set up for this,” says Adam Fless, a partner and managing director at AlixPartners. “If we move pharmaceutical manufacturing, for example, it’s a highly skilled area and needs to be valued accordingly. Overall, we will see the competition for blue collar workers intensify. Employee engagement and initiatives such as employee ownership will become even more important over time than it is today.”