Increasing the number of companies.
Influencing specific industries.
Encouraging development of new industries and companies.

Most socially responsible investment (“SRI”) strategies and products are focused on public equity securities. Negative screening eliminates holdings in companies based on specified criteria – e.g., companies that profit from tobacco or weapons. Positive screening builds a portfolio of companies that reflect certain criteria or best practices – e.g., companies that are more progressive than industry peers on environmental or labor matters. Shareowner advocacy seeks to use investors’ legal rights as shareholders and their ability to influence stock price to lead companies to desired action, whether by submitting proposals to be voted on at the annual meeting of shareholders, by soliciting proxies for alternative candidates for the board of directors, or by less formally engaging management in discussion on certain issues. Investors can choose from several mutual funds and separate account managers applying one or more of these strategies, and SRI-oriented research is increasingly available on larger public companies.

Despite the variety of approaches, the impact of public equity SRI strategies is necessarily limited to the universe of public companies, and often only at the larger cap end of the spectrum. Adding private equity strategies to an investment program can expand investor choices and influence in several ways:

An obvious consequence of investing in private companies is the substantially larger universe of companies from which to choose. In the U.S., there are approximately 10,000 public companies but several million private companies.

While many private companies are small enterprises, a significant percentage are quite substantial. The Forbes 500 largest U.S. private companies in 2001, for example, in the aggregate employed 4.5 million people and generated estimated revenues of $946 billion (averaging 9,000 employees and $1.9 billion in revenues per company). Larger private companies are in a position to influence industry standards.

In addition, the market structure of some industries may require more flexible tools. Some industries – solar cell manufacturing, for example – are dominated by multinational corporations where the target industry segment is but a tiny fraction of each company’s entire operations. It is sometimes possible to negotiate private investments in specific segments of larger companies, allowing investors to target those segments in ways that are not possible by investing in public securities of the same companies.

Privately held companies and younger companies have greater freedom to innovate. Public market focus on short-term earnings targets can stifle new approaches that might be more beneficial financially, socially and environmentally in the longer run. Large well-established companies may have legacy investments in fixed assets, business models, market positions, or cultures that tip the cost-benefit equation against what would be better ways to do business if starting from a blank slate. Private equity capital supports the creation of new companies, new business models, and entire new industries. Private equity investment can be also be used to fund spin-outs of promising technologies and subsidiaries from larger, diversified companies -- allowing businesses that suffered only from lack of resources or poor strategic fit to thrive as stand-alone companies. Allocating capital to companies with strong environmental and social as well as financial returns draws entrepreneurs to develop and pursue such opportunities.

Socially responsible investors whose experience is mostly with public companies may underestimate their ability to influence private companies.

On the public market side, some in the SRI community believe it is more difficult to engage smaller public companies than larger ones. Larger public companies often have more resources than smaller ones to devote to investor relations and sometimes appear more attentive to their image in the investment community. Smaller public companies also have fewer shareholders, making it more difficult to build critical mass to engage management on matters of shareholder interest. In discussing his experience with companies in the U.K., Will Oulton, Deputy Chief Executive of FTSE, observed that large cap companies have the resources to market corporate social responsibility to their advantage, but mid and small cap companies are more likely to view it as a cost.

If smaller public companies are less attentive to shareholder wishes than larger ones, small private companies must be even worse, the thinking goes – private companies may not hold annual meetings or be required to accept shareholder proposals. Private equity investors do not operate in a vacuum, however, and have other mechanisms for shareholder control.

Private equity securities are created by contractual documents where the rights and responsibilities of the company and its investors are defined by mutual agreement. This ability to negotiate terms often gives private equity investors greater control and influence over their investment than is possible with public securities. For example, private equity investors can influence the company’s legal structure and require board approval of certain actions, such as buying or selling significant assets and compensating, hiring, and firing management. Investors can negotiate for the right to appoint one or more directors to the board. Investment documents may limit management’s ability to pursue opportunities outside the company and require investor approval of conflict-of-interest transactions. Private equity investments are typically structured as preferred equity securities, giving investors a liquidation preference over management. In short, the company and its investors have substantial flexibility to allocate rights, responsibilities, risks, and returns between themselves however they choose.

Any factor important to the investment decision is fair game for negotiation in private equity transactions. For socially responsible investors, deal points may include requiring consideration of environmental and social factors in business decision-making and reporting on environmental and social impacts of business activities. The ability to define custom investment terms should not be overestimated, however, as company managers like and need the flexibility and discretion to be able to respond to changing business conditions. Micromanaging managers is rarely efficient or in investors’ best interests. That said, there is ample middle ground for socially responsible investors to influence companies in which they make private equity investments.