Dear MCG… Reputational risks

Dear MCG,As part of broader discussions around ESG and “softer” investment criteria, one of the partners at our team-building retreat brought up “reputational risk”. In her opinion, reputational risk should be an agenda item for every deal at investment committee level and be analysed with the same care and attention to detail we apply to any other investment variable. Obviously, there are certain vice industries to avoid if looking to attract Mid-Western LPs, but I’m assuming it goes further than that, now. What do I need to know about reputational risk? Is my colleague right?

Yes, she is right. Reputational risk is not to be ignored. Good reputational risk management, just like good management of any other type of risk, is more than just figuring out the likelihood of something terrible happening and the damage it would do.

Active risk management measures the likelihood and impact of negative events but also develops (and revisits) strategies to soften the blow, should a particular risk get through the defences and land with full force.

Reputational risk is particularly interesting, because it tends to act as an amplifier to the impact of other risks. It never exists in and of itself – which can make it harder to spot and assess, of course. So what does reputational risk look like? Here are two manifestations that students of private equity will recognise:

THE UNWITTINGLY IMPLICATED

Let’s pretend you are a high-profile member of the clergy, with very clear and outspoken views on the behaviour of pay-day loans companies. These firms can be very profitable and some are backed by VC and private equity.

Whilst an investment in such a firm may be very lucrative, were it to be discovered that, indirectly, the investment arm of your church held a stake in the very firm you were so keen to denounce (and with what passion!), there is going to be trouble – and your reputation is going to take a hit.

What can you do?
LPs: investing into private businesses indirectly can make you vulnerable. Every LP should fully understand how its own ethical investment criteria are reflected in any fund. The situation is challenging to police if investing through a fund-of-funds.

It’s worth trying to negotiate investment exemptions where you can (difficult in practice!), but otherwise, securing the ability to transfer your equivalent stake in a downstream portfolio company to an investor with less sensitive tastes is a smart move.

LET THEM EAT HORSEMEAT

Let’s pretend we are partners at a GP with a speciality in the food and beverages sector. Maybe we invested in a business that provides ready meals to leading supermarket chains. And let’s pretend we are based in a major Western European market, but not in France. It’s important that we are not in France. In many European countries, most, perhaps, the consumption of horsemeat is not considered “the done thing”. Chicken? Fine. Lamb? Fine. Horsemeat? No thank you.

Now suppose it were discovered that a supplier to your portfolio company had been supplying horsemeat instead of the beef your company had ordered… and suppose a national newspaper found out and put you and your company on the front page? That’s going to hurt.

What can you do?
GPs: In sectors with news interest (consumer brands, healthcare, etc.) in any scandal, the impact of any wrongdoing is magnified many times over. And it won’t matter how much you “knew” about said scandal.

The only way to protect yourself is to make sure the governance structures in your portfolios are sufficient, and to ensure you provide portfolio companies with enough support and resources to identify and put a stop to corner cutting at every level in the business – and this includes its entire supply chain.

REPUTATION MATTERS

That’s just two examples of how reputational risk can manifest. In these cases, its arguable the LP or GP was a victim of events beyond its easy control, but reputations can also be put at risk by the use (or, sometimes, just the presumed use) of sharp practices.

Typically, this is an issue when a well-known, private equity-backed brand fails. Many will look to the owners and, driven by prejudices around “asset-stripping” and “profiteering”, throw rotten fruit and vegetables. And that can leave a nasty stain.

If your reputation matters, make sure you give reputational risk the priority it deserves.

MCG (Matthew Craig-Greene) is Managing Director | IR& Marketing for MJ Hudson, the asset management consultancy. He can be reached at matthew.craig-greene@mjhudson.com