A New Direction
Currently, ESG and impact investors mainly focus on addressing economic inequality in activities at the portfolio company level. Examples include, but are not limited to:
Investing in products and services for the underserved
Paying a living wage (which essentially helps workers earn just enough to get by)
Building wealth for workers and employees through paying more than a living wage
Narrowing executive-to-average-worker compensation ratios
Distributing some equity
Establishing profit-sharing programs
However, such solutions will not work in a vacuum. If large funds are also charging the standard 2% annual management fee to its investors and collecting the typical 20% of the profits from portfolio companies as carried interest, then the wealth of the fund manager grows at an exponentially faster rate than the wealth of the workers in or beneficiaries of the portfolio companies, potentially offsetting positive impacts at the portfolio company level.
Potential for Systemic Change
Annual executive compensation at some of the largest private equity houses, including those launching impact funds, can hover around or exceed $100 million.
In terms of the sector’s scale and reach, the author and professor, Ludovic Phalippou, notes:
“Eight of the largest ten employers in the U.S. are private equity firms.”
“Eleven million people work for a private equity sponsored company in the U.S. (as of 2016).”
“Globally, private equity firms manage a fast-growing pool of assets which reached $5 trillion in 2017 – the equivalent of one-fifth of the total value of the U.S. stock market in that year.”
Can Investors Make Competitive Returns in the Predistribution Initiative’s Proposed Approaches?
For limited partners, particularly public and union pension funds, high management fees cut into their beneficiaries’ returns. This point can also be made for carried interest. Data shows that companies which pay and treat their workers better perform better. Based on this logic, portfolio company growth and profitability may be stronger if more compensation or profits were shared with workers, thereby producing greater returns for asset owners and their beneficiaries.
Are Traditional Compensation Structures Needed to Attract Strong Talent to Private Equity Investment Teams?
At large funds, compensation is so significant that there is room to share more wealth with workers in portfolio companies and still attract talent. One might even argue that excessive compensation may attract investment professionals with values at odds with addressing economic inequality. Furthermore, private equity compensation is typically very top-heavy, so in many cases, there should be significant room to narrow compensation ratios within investment teams themselves.