One of the most prominent investing principles for the private equity (PE) industry is the focus on long-term business strategies that set portfolio companies up for success five, ten, or even fifteen years down the road. Contrary to popular belief, PE funds aren’t solely concerned with extracting the most dollars from an acquired company, or reducing headcount overnight merely to increase the bottom line. In fact, today’s funds—particularly in the middle market—are acting more like partners. They are prioritizing human capital and looking for ways to maximize profit with minimal negative effects on communities and the environment. In other words, funds are taking more of a stakeholder capitalism approach: doing business in a way that encompasses the needs and priorities of various stakeholders, from investors to consumers to local communities.

But how do these priorities play out within the realm of PE-backed companies? As someone who regularly fields requests from middle market PE funds looking for expert resources, two of the most relevant examples of how these funds are holding leaders accountable are a renewed focus on diversity, equity and inclusion (DE&I) and environmental, social, and governance (ESG) initiatives. 

While reporting on these initiatives has long been a standard in the industry, they now rank among the most important elements of the move toward a forward-thinking PE sector. This isn’t just because PE firms and their companies are increasingly recognizing the necessity of diverse representation— it’s also because focusing on a “triple bottom line” has consistently proven to be among the most powerful engines of growth and innovation. 

Why DE&I matters for PE-backed companies
During a recent event hosted by Harvard Business Review (HBR), BlackRock CEO Larry Fink argued that DE&I is a “key component of stakeholder capitalism.” Furthermore, companies that reflect the communities in which they work (as well as the rest of the country) on average perform better than those more homogenous in nature.

As Fink puts it: “Companies with a more diverse employee base generally have better outcomes,”  which is why he says DE&I is critical for what he calls “long-termism.” This observation has been borne out repeatedly in the data. For example, a Boston Consulting Group study found that diverse management teams make companies more innovative than their peers. A 2020 study conducted by McKinsey reports that companies with high levels of ethnic and gender diversity had better financial performance than their less diverse competitors. 

It makes sense that the prioritization of DE&I leads to positive business outcomes—it doesn’t just reveal that a company is focused on developing an inclusive culture where all employees’ voices are heard and respected (a major contributor to engagement and morale); it also means a company is serious about embracing diverse perspectives, which leads to the development of more innovative products and services. 

Stakeholder capitalism is built around ESG
The core mission of any successful PE firm is to put its portfolio companies in the strongest possible position to succeed—not just over the short term, but years and even decades into the future. Investments in sustainable assets have surged to more than $30 trillion worldwide. This is a tenfold increase from 2004 to 2018. According to a McKinsey report, 63 percent of the studies that have investigated the impact of ESG initiatives on equity returns found that these initiatives had positive effects, while just 8 percent found negative effects. One reason for the success of ESG investments is the fact that they’re often intrinsically innovative—many of the emerging technologies, products, and services that will help society address our most urgent problems are also transformative for their industries. 

Meanwhile, more and more consumers are becoming belief-driven buyers: people who won’t do business with brands that don’t take a firm position on social, political, and environmental issues that matter to them. Edelman has found that almost two-thirds of consumers fall into this category, while investors are increasingly shifting resources to companies that prioritize ESG. 

The new era of PE is driven by people and profit
At their best, companies aren’t simply machines for maximizing profit—they are agents of social, cultural, and political change. They are organizations that have a huge impact on our quality of life and integral parts of communities across the country. The PE industry has the potential to be one of the most effective catalysts of stakeholder capitalism, because they often forge long-term relationships with their portfolio companies. 

According to a 2021 report by Bain & Company, the average holding period for portcos is 4.5 years, with many firms maintaining their relationships for much longer. If PE firms continue to uphold the principles behind “long-termism” and future-oriented investments, the focus on DE&I and ESG is only going to become more central to their investment strategy.

As companies become more concerned about their impact on the environment, economic inequality, and an array of other issues that go beyond mere profit, they’re declaring their commitment to stakeholder capitalism. Considering the PE industry’s vital role in funding and sustaining companies, it will continue to be one of the most significant forces in the emergence of this ideal.