Private Equity (PE) firms are powerful and wealthy companies that use a strategic business model that aims to attract outside investors and high-net-worth individuals by promising time-limited high returns and invest this capital in buying companies. The aim is to make these companies more profitable, return the necessary gains to their investors and then sell the company, usually in a short amount of time. According to McKinsey & Company, Private equity markets assets under management totalled $13.1 trillion as of June 30, 2023, and have grown nearly 20 percent per annum since 2018.
Private equity (PE) firms, among many others, often employ leveraged buyouts (LBOs) as a core business strategy. LBOs involve acquisitions funded partially through debt, which is secured against the assets of the target company. This business approach enables PE firms to acquire businesses with minimal equity investment, typically financing up to two-thirds of the purchase price through debt, as evaluated by Morgan and Nasir in their 2021 research.
A leveraged buyout (LBO) occurs when a buyer purchases a business primarily using borrowed money, aiming to repay the debt with the company’s future profits. For instance, someone buys a $1 million bakery with only $100,000 of their own money and borrows $900,000 from a financial institution. To repay the loan, the buyer must maximize profits. This shareholder-focused approach prioritises financial returns by keeping shareholders at the core. However, this strategy now exposes this unique PE business strategy to risk of human rights violation in their supply chain that could directly harm the employees, customers, suppliers, and related stakeholders discussed further in the article.
The inextricable systemic failure:
While multiple researchers have examined the economic impacts of PE, Dr David Birchall and Dr Nadia Bernaz in their recent article argue that there is a notable gap in assessing PE compliance with business and human rights (BHR) standards. This gap is critical, as PE practices are increasingly associated with adverse human rights impacts under the UN Guiding Principles on Business and Human Rights (UNGPs). Addressing this issue is essential to understanding the broader implications of the PE business model.
Following a leveraged buyout (LBO), private equity (PE) firms often implement cost-cutting measures to repay debt and maximize returns. These measures typically include workforce reductions, wage cuts, and weakening union influence that shift the debt burden onto employees, leading to job insecurity, lower incomes, and diminished worker protections—examples of potential human rights violations. While these initial acts due to increased debt burden may not directly violate human rights, they create inescapable situations where rights violations become inevitable. Therefore, applying the UN Guiding Principles on Business and Human Rights (UNGPs) requires identifying and addressing these root causes, even before any overt harm occurs. Human rights protections must, therefore, target the business structures and methods inherent in the PE model to prevent such harms comprehensively.
So, what next?
Risk Management Through mandatory HRDD?
As mentioned earlier in the article, LBOs inherently expose businesses to risks of adverse human rights impacts. The UN Guiding Principles on Business and Human Rights (UNGPs), particularly the Human Rights Due Diligence (HRDD) framework could potentially provide a structured approach to managing these risks without enforcing outright prohibitions. This article aligns with Dr. Birchall and Dr. Bernaz's 2023 research, highlighting critical gaps in the private equity’s business model that contribute to such risks and supports their argument that mandatory HRDD is a critical step forward.
What exactly is HRDD?
Human Rights Due Diligence (HRDD) framework, defined in Principle 17 of the UNGPs, is a process to identify, prevent, mitigate, and address adverse human rights impacts linked to business activities. This includes:
Step 1 : Assessing Impacts: Evaluating actual and potential human rights risks in the business. Step 2: Integration: Incorporating findings into business strategies and decisions. Step 3: Tracking: Regularly Monitoring responses to identified risks. Step 4: Communication: Reporting how the identified risks are addressed.
HRDD should begin early in any activity or relationship and be conducted prior to major decisions, such as business entry to market, product launches, operations, restructuring or other organisational changes. It involves assessing the human rights context and projecting potential adverse impacts.
Addressing identified Human Rights Risks
As per UNGPs, human rights risks must be either prevented or mitigated. Prevention ensures risks do not materialise, while mitigation reduces the extent of adverse impacts, with residual impacts requiring remediation. Decisions like LBOs and restructuring should undergo HRDD to anticipate and address potential harms.
Key Actions after LBOs and increased debt burden:
Identify cost-cutting measures and employee exploitations that could harm human rights and modify them. Apply HRDD to all major company decisions, ensuring risks to stakeholders are minimized and potentially mitigated. By Embedding HRDD in Private Equity (PE), this can help map human rights risks stemming from business decisions, not just operational or supply chain risks. It is important for PEs to publish HRDD analyses and reports for business activities, such as LBOs, enabling transparency for stakeholders that also includes the local governments. On a bigger picture, the states and governments may need to mandate PEs to such practices to uphold their duty to protect against human rights abuses.
Conclusion
Private equity (PE) firms often employ business strategies like LBOs to generate short-term profit, yet the UN Guiding Principles on Business and Human Rights (UNGPs) have not been widely considered and applied to their unique business model. This oversight is critical, as strategies like LBOs can result in severe adverse human rights impacts. Applying the UNGPs to PE investments offers a framework for aligning shareholder actions with human rights standards and addressing the root causes of potential harm.
My article concludes by stating that the UNGPs indeed apply to PE industry like every other corporation and these shareholder-focused strategies often lead to human rights risks, and that Human Rights Due Diligence (HRDD) is a potential tool to mitigate these risks. Mandatory HRDD legislation should explicitly address PE practices, focusing on a few things. This calls for further research on how HRDD can be applied into the PE industry. This powerful sector could be held accountable for its broader impact by identifying, addressing and embedding human rights due diligence and principles into their strategy.