Business lessons in development: Sustainability and profit

Noah Beckwith, OECD Observer, Paris

Socially responsible development is becoming a buzzword among private equity funds. But can this business community reconcile commercial and developmental objectives in investment? Yes, though there are certain conditions.

Private equity funds for investment in small and medium-sized enterprises in developing countries are starting to flourish. In fact, according to the Social Investment Forum of the U.S., socially responsible mutual funds saw net inflows of over US$185 million in the first quarter of 2003.

But in this era of sustainable development and corporate responsibility, their proliferation poses questions which have long troubled what might be referred to collectively as the socially responsible investment community: Does the pursuit of development objectives -- also known as non-financials or intangibles -- compromise the commercial viability of an investment by clouding the risk-reward nexus, or does it in fact improve the prospects for good returns?

The growing interest in the social, environmental and economic dimensions of investment in developed markets has not been accompanied by a clear articulation of the trade-off deemed acceptable (if any) between commercial and other non-financial objectives.

In the developing world, the term -- sustainability, a sometimes nebulous idea which seemingly uses high socio-economic benefits as an apology to explain disappointing returns -- has added an extra dimension to the discussion.

In neither context, however, is the investment community entirely comfortable with the relationship between the financial and the intangible.

The problem partly lies in the current parameters of the debate. At best, developmental objectives are presented as extraneous and secondary to commercial ones, but increasingly deserving of attention.

The case for socially responsible investment, or SRI for short, is compelling and the benefits espoused by its practitioners are considerable: Consumer loyalty, enhanced brand and reputation, improved access to capital, product and service innovation, increased ability to attract and retain staff, and so on.

The company becomes aware that achieving satisfactory returns for shareholders in the long term depends on the sanctioning of the company and its products by a range of stakeholders: Employees, consumers, suppliers, competitors, communities, local authorities, governments, and others.

The idea is that there is a homologous relationship between producer/stakeholder and consumer/stakeholder, and incorporating this interface into the business strategy will help the company to harmonize its commercial objectives with socio-economic and environmental considerations.

But does this approach show up in generating returns? The SRI community concedes that it is too early to draw firm conclusions. There is, however, compelling evidence that some SRI funds and projects in the developed world have weathered recent market turbulence better than ordinary ones. In fact, companies on the Dow Jones Sustainability Index consistently performed above average in recent financial market downturns.

Nonetheless, the case against SRI is also persuasive. Critics of SRI argue that company structures inherently make intangibles difficult to achieve. After all, shareholders retain the services of management to maximize profits, and incentive arrangements usually reflect this priority.

Of course, there is the cynical view that SRI is little more than a public relations exercise that lacks a coherent set of values and is often reactive and ill-conceived. Experiences like those of Union Carbide in Bhopal, India, and Shell in Ogoni, Nigeria, in the 1980s simply spawned lip service to issues like environmental degradation, human rights, poverty alleviation and so on, in part to pre-empt litigation, but also because of the growing prominence of non-core issues on the global agenda and in the media.

The solution lies in a broadened definition of sustainability, which encompasses both commercial viability and development durability, and illuminates points where these converge. Sustainable development is frequently defined as a development path that meets the needs of the present without endangering subsequent needs and aspirations of future generations, allowing for the conservation of nature to be part of this path.

Although a useful starting point, this definition is cast in terms of minimizing negative outcomes, such as environmental degradation and threats to future livelihoods. It seems there is much to be gained from building into sustainability the concept of means and ends.

This wider notion of sustainability sees developmental objectives or intangibles--improved management capacity and sound corporate governance, training and staff development, environmental best practice, and so on-- as integral components of business strategy (means) aimed at maximizing value, as opposed to incidentals (ends) to be pursued often half-heartedly alongside returns.

This way, sustainability not only diminishes the gap between commercial and development objectives, but also presents them as mutually reinforcing dynamics, not mutually exclusive ones.

In other words, commercial objectives are best conceived as one of several building blocks on the trajectory of sustainability. And they should not be downplayed.

On the contrary, for private equity investors, investing without attaching serious commercial terms would be nonsense. Indeed, such investments would be little more than thinly veiled subsidies which, once withdrawn, would likely cause investee companies to collapse or stagnate.

The critical point, however, is that intangibles must also be integrated into company strategy as basic building blocks of sustainability, so that the interplay between the financial and the non-financial is viewed as a complementary and fundamental process geared to generating company value.

This is where the SRI debate is particularly instructive and where an enhanced definition of sustainability sheds light on reconciling commercial and developmental objectives.

The focus implied by SRI is usually on the relationship between intangibles and profits, whereas it should be on intangibles and company value.

As recent corporate collapses in majordeveloped countries have shown, company value is a multi-faceted concept which embodies far more than the strictly financial dimensions of business.

Profit, in turn, is a function of company value, which goes beyond the balance sheet to the socio-economic and environmental capital which underpins a given business. And good public relations are no substitute for proper management.

The writer is an adviser to Aureos, an emerging markets private equity fund manager.