Posted by Stuart Bell

How can private equity funds manage labour risks in portfolio companies?

Private equity (PE) investors are among the largest providers of capital to private companies in emerging economies and many aim to have positive sustainability impacts alongside generating investment returns. However, investment opportunities in emerging economies, where regulation and management experience may be lacking, come with heightened social risks, such as non-compliance with labour standards or even serious cases of labour exploitation or modern slavery.

How can private equity fund managers (FMs) avoid these risks and actively use their ownership positions to leverage improvements? As part of the ‘Moving the Market’ programme, funded by Humanity United, Freedom Fund, and UBS Optimus Foundation, Ergon has been working with several such funds over the past year to support their due diligence and portfolio engagement strategies.

The resulting practical guidance is based on the typical PE investment cycle and explores how labour risk identification and management can be integrated at each stage. We have also produced a podcast with contributions from two PE funds operating in sub-Saharan Africa, Verod Capital Management and Cepheus Growth Capital, who explain the challenges they face and their strategies for identifying and managing labour risks.

What are the relevant labour issues?

Labour risks are likely to be present wherever workers are employed, irrespective of investment type, size, or relevant geography. However, the level and source of risk varies according to certain contextual or workplace-specific factors, such as:

  • Local labour laws or regulatory frameworks that contain ‘gaps’ (e.g. labour laws that do not specify maximum daily / weekly working hours) or are inadequately enforced.
  • Economic and social context such as informal labour markets, low prevailing wage rates, prevalence of vulnerable migrants, negative cultural attitudes towards certain groups or women.
  • Company management capacity and practices, for instance poor employment policies, inadequate HR practices, lack of training for staff on health and safety, lack of grievance processes.
  • Workplace characteristics such as geographic isolation, hazardous nature of any tasks, seasonality, remote working, irregular shift patterns, or prevalence of low-skilled work.
  • Workforce characteristics, particularly if elements of the workforce may be disadvantaged or vulnerable to exploitation such as migrants, women, temporary workers, and individuals from ethnic minority groups.
How can these issues be integrated into investment cycles?

The guidance is structured around a typical investment cycle and explains how labour issues and risks can be integrated into due diligence and monitoring activities through:

  • Establishing clear policies with respect to investment decisions and portfolio management.
  • Identifying potential investments and early screening to detect issues that are contrary to investor standards, or which entail risks that cannot be mitigated or addressed through capacity building.
  • Undertaking due diligence to identify risks and incorporating these into an action plan for prevention and mitigation.
  • Ensuring that investment decisions take into account due diligence findings and adequately consider risks and the cost of addressing risks.
  • Drawing up investment agreements which integrate ESG commitments, including ESG roles, responsibilities, actions, and monitoring / reporting requirements.
  • Undertaking monitoring which allows tracking of commitments and identification of new and changing risks.
  • Engaging with portfolio companies to enable fund managers to support portfolio companies through capacity building.
  • Undertaking a responsible exit which considers the ESG implications of exiting an investment.
Tools and guidance

The guidance includes various checklists, templates and other tools which we developed in the course of our collaboration with the FMs, including:

  • A workforce questionnaire for use by portfolio companies
  • A sample terms of reference for a specialist on-site labour assessment
  • A sample social action plan template
  • An example agenda for a labour issues workshop with portfolio companies

The guidance is intended for use by PE fund managers in their day-to-day work. We also hope it proves useful for development finance institutions (DFIs) that typically invest in PE funds. We are grateful for the assistance of three such DFIs, Norfund, Swedfund and CDC, which supported the project. We are also very grateful to both Verod Capital Management and Cepheus Growth Capital for their participation and open collaboration, as well as the ‘Moving the Market’ grantors and broader cohort.