Reputational risk in the #MeToo era

Making the right choices – whether it is investing in a viable project, a company with potential, or staying true to one’s strategy – will always be part of investors’ decision-making process, not only in terms of achieving the best possible financial outcomes but also in terms of protecting their brand name.

However, in the recent past, and particularly the past year, other factors are increasingly moving to the fore.

“Reputational risk as it relates to sexual harassment, diversity and inclusion has always been there,” remarks Emily Mendell, managing director, communications at the Institutional Limited Partners Association.

“Conversations around diversity and inclusion have been going on for a while – as far back as 10 to 15 years – but what happened with the #MeToo movement is, I think, everyone was really so horrified by the extent of some of these situations that it created a sense of urgency,” she says, referring to the reaction and backlash that erupted last autumn after widespread sexual harassment charges swept through Hollywood and beyond.

Ana Lei Ortiz, a managing director at alternative investment management firm Hamilton Lane, agrees.

“Reputation has long been important to investors, but as more and more investments fall under the media lens and the industry becomes slightly more public, this becomes an increasingly big topic,” Lei Ortiz says.

“We have seen this in supply chains, for example. Perhaps an LP thought they had an investment in a US-based company and, in fact, several steps down in the chain there’s child labor. That maps back to the LP,” she says.

Revamping due diligence

Mendell confirms that ILPA’s members – approximately 450 institutional investors with $2 trillion in assets under management – are increasingly turning their attention to these issues and the association is in the process of expanding its due diligence questionnaire to address them.

ILPA is doing this in three ways: first, by adding a template that will allow GPs to provide metrics related to diversity and inclusion, such as the percentage of women and people from ethnic minorities they employ based on seniority. The second is to ask GPs for information regarding their human resources policies that prevent harassment and discrimination, while also promoting inclusion. The third is adding more pointed questions about employee departures.

“In the past, the due diligence questionnaire would say, ‘Please name the partners who have left your firm and why,’” Mendell recalls, offering an example. “It was an open-ended question. The firm could therefore say a partner left to pursue other opportunities. While that could technically be true, it could leave out a lot of important information about the fact that the partner may have been asked to leave because of inappropriate behaviour.”

The revisions are currently under way and ILPA expects to have them published by the end of the summer.

Andrew Borowiec, executive director of the Investment Management Due Diligence Association, also believes such questions will become a standard part of due diligence. “The investors are going to ask, they’re going to be pushing these questions and the fund managers have to be ready for it. Fund managers have to know what’s coming and they have to welcome it,” he warns.

Yet, a survey conducted by IMDDA between late 2017, when the #MeToo movement began, and February 2018 produced some disturbing results. Eighty-nine percent of those surveyed – including endowments, pensions, insurance companies, banks and funds of funds worldwide – said they did not specifically inquire about sexual harassment in the workplace when selecting a fund manager.

“That was not that surprising, since #MeToo had really just started,” Borowiec comments, adding that most investors were asking about the culture of the firm in general.

What was surprising, however, was that there was a small portion (4 percent) of investors surveyed that said they would still invest with a fund manager even if sexual harassment issues were revealed during the due-diligence process. Another 17 percent said their decision would depend on “the level of harassment”.

“These […] answers are very alarming,” IMDDA said in its report. “Failing to investigate further investment managers who during the due-diligence process reveal that they have had sexual harassment problems is a huge oversight of reputational and financial risk.”

But, it’s not just sexual harassment, which everyone we spoke with agreed was a black-and-white, unacceptable issue – diversity and inclusion are also important when it comes to reputational risk.

Keeping your social license

Matina Papathanasiou, deputy global head of infrastructure at Australian fund manager QIC, explains how reputation – which she says is “critical” when you’re a fiduciary – ties in to diversity. The link is social license by building trust.

“As an industry, we need to communicate the benefits of private capital ownership of infrastructure assets. When you think about who your audience is, stakeholder management is key,” she says. “How you actually engage with your stakeholders and what your culture is are key indicators of your reputation. And I think it’s critical to have diversity in that.”

Papathanasiou’s views happen to coincide with McKinsey’s findings in its latest diversity report, published in January. According to the management consulting firm, inclusion and diversity strategies can “improve a company’s global image and license to operate.”

“Even before the current climate raised the stakes on I&D, companies who were leaders in this space benefited from an enhanced reputation, extending beyond their employees to their customers, supply chain, local communities and wider society,” McKinsey states in its Delivering through Diversity report.

“Recent highly publicized issues with gender and racial discrimination highlight that, for many companies, this is also a matter of license to operate,” it adds.

The first recommendation McKinsey makes for a firm to successfully implement an inclusion and diversity strategy that will deliver a positive impact is that the initiative needs to start at the top and “cascade down to middle management.”

It is an approach that QIC also follows, according to Papathanasiou. “We have had a QIC diversity and inclusion policy for some time now. The QIC board has overall responsibility for developing a diverse and inclusive culture and implementing it. We seek to replicate that in the Global Infrastructure team and in the investments that we manage.”

She also explains why it is important to start at the top. “When you’re looking at ESG-related issues, particularly the social and governance aspects of ESG, it is really important to ask, ‘How is the company managing its social license?’ ‘How is it engaging with all the relevant stakeholders – customers, communities, employees?’ ‘How is it managing its reputational risk and does it have diversity in its workforce to build a strong track record in that aspect of its management?’” she remarks. “The board and management need to lead that discussion; that’s where it all starts.”

Evidence is mounting that having diverse teams – not only in terms of gender but also in terms of ethnicity – also leads to better financial performance.

For example, the McKinsey survey found that companies in the top quartile for gender and ethnic/cultural diversity were 21 percent and 33 percent more likely, respectively, to experience above-average profitability on EBIT margin than companies in the fourth quartile.

The National Association of Investment Companies found in its 2017 Examining the Returns report that US diverse-owned private equity firms on an aggregate basis generated a 16.15 percent IRR for the 10-year reporting period ending December 2015, compared with the 11.3 percent IRR generated by the Cambridge US Buyout benchmark during the same period.

Mendell, who admits LPs are in “various places” when it comes to diversity and inclusion, says “most members believe that this is the right thing to do but it’s also good for business. I think limited partners overall are far more mindful than they’ve ever been about this.”

The types of questions LPs are beginning to ask of their fund managers are also the types of questions GPs are – or should be – asking of their portfolio companies.

“We do a comprehensive assessment, which includes social risk and reputation,” Papathanasiou says. “If a company finds evidence of poor culture and weak governance its social license will be negatively impacted.

“It is a high priority for us to make sure we manage it well. If you don’t manage your reputation, your social license, that can lead to regulatory risk, loss of customers, loss of government support, loss of opportunities and partners.”

“So, it’s critical in this industry to build trust with the community, customers, regulators, governments, your employees. You’re not just there to make a quick buck and get out. You have a long-term infrastructure asset that provides an essential service to the community.”