The term “ESG” has come under attack recently in various opinion pieces, reaching the spotlight. Elon Musk told his Twitter followers that “ESG is a scam”. A Bloomberg op-ed began with the headline: “America’s Political Right Has a New Enemy No. 1: ESG Investors.”

The anti-ESG narratives go on, politicizing, and frankly sensationalizing, the term “ESG,” framing it as a left-wing agenda misaligned with investors’ best interests.

For Wespath, sustainable investment practices, those that consider the risks and opportunities related to ESG factors, have absolutely no relevance to any political affiliation.

As a faith-based, not-for-profit investor responsible for the financial security of more than 100,000 benefit plan participants and 140 institutional investors, we strongly believe long-term investment success requires a sustainable global economy: one that holistically considers the systemic risks that pose serious threats to world economic development, robust financial markets, and ultimately our investment portfolios.

We focus on integrating sustainable investment through our Sustainable Economy Framework. We recognize that the world is complex and there is no “magic formula” for achieving a sustainable global economy. We accept the validity of some anti-ESG critics who point to oversimplification or overpromising related to ESG. However, we do not believe ESG is a bogeyman, lurking out of sight, waiting in the wings to say “gotcha.” It is a proactive investment strategy where investors seek to understand how sustainable investment issues can positively or negatively affect their portfolios.

Prudent asset owners must understand how public policy may impact specific market sectors, and how political instability in certain areas of the world can affect global economies. We cannot ignore the complexities of myriad environmental, social, and governance issues that, if not adequately addressed, jeopardize the financial security of our stakeholders.

Let’s take a closer look at some recent ESG critiques:

ESG is a partisan wolf in investment clothing.

By focusing on issues that represent unmitigated risks to the global economy and the future solvency of investors’ assets, we can cut out the political noise.

For example, some may perceive certain sustainability actions, such as climate change, as political. We view climate change not as political, but as an incredibly complex issue that the world must proactively address as a danger to sustainable economies and markets. Calling on the EPA to strengthen methane management, which multiple oil and gas majors support, or addressing larger universal topics, such as the Net-Zero Asset Owner Alliance’s call for thoughtful carbon pricing, are two examples. In addition, a call for carbon pricing is echoed by a large bipartisan group of prominent economists.

That said, there are plenty of sustainable investment issues not remotely viewed as political. Community development loans that serve families, seniors, veterans and individuals with special needs and demanding opioid accountability from pharmaceutical firms are issues that we all can support. While skeptics may focus on what they believe are controversial ESG topics, we believe there are many issues where we can find more common agreement.

ESG is anti-fossil fuels

The world’s transition away from fossil fuels is laden with complexities. Fossil fuels will play an important role in fulfilling the world’s energy needs for some time. We know abandoning the fossil fuels sector would cause undue hardship on broader global society, generating negative impacts on workers and communities.

To that end, Wespath does not support wholesale divestment from the fossil fuels sector, but instead we seek to use our influence as a shareholder to enact change within oil and gas companies. Wespath has successfully accomplished this, having engaged several oil and gas giants, most notably Occidental Petroleum.

The company recently stated its intentions to become the first U.S. oil and gas major to achieve net-zero emissions from its operations by 2040 and reach net-zero for all emissions by 2050 including those generated by suppliers and customers.

ESG leads to high fees and underperformance/it is a way for asset managers to increase their fees

ESG should not be an “add-on” expense. Rather it is a comprehensive approach for achieving successful investment performance over the long-term by better understanding the companies and the systemic risks that may affect them. We maintain that the integration of sustainable investment practices should not cost more or lead to underperformance.

Rather, we expect integrating sound sustainable investment practices will add long-term value to investment portfolios. In our experience, it has done just that. Integrating comprehensive sustainable investment practices into investment management is simply prudent investing.

ESG ratings are unreliable

Investors should make their own informed decisions with the external inputs they deem appropriate— ESG scores being one potential source.

This is not dissimilar to brokerage firms’ “buy/hold/sell” ratings for stocks. ESG scores should never be the sole determining factor in an investment decision.

Wespath does not use ESG scores in its sustainable investment strategies, instead choosing to apply our more holistic Sustainable Economy Framework as our core methodology.

“Shareholder capitalism” doesn’t align with the interests of asset owners

While some reject the notion that corporations must manage their businesses in a manner that serves the interests of all related stakeholders, we recognize that the overall health of the economy ultimately drives investment performance.

A narrow view that does not acknowledge the broad impact companies can have on customers, suppliers, and other stakeholders is a hinderance to achieving overall strong economies and resilient markets.

Investors must think globally about how their stewardship resources can strengthen the economy in ways aligned with their broad and long-term economic interests. In our co-authored white paper, “The Future of Investor Engagement,” we have called on other investors to pursue such a holistic and systemic approach.

For Wespath, integrating ESG considerations through our Sustainable Economy Framework is about addressing material systemic risks that threaten a robust and thriving global economy.

We believe every asset owner has a fiduciary obligation to their stakeholders to identify and mitigate these risks. Through action, investors can create and support a sustainable global economy, one that delivers healthier financial markets, more resilient companies and greater financial security for various stakeholders.

Is this “harmful” ESG investing? We think not.

Dave Zellner is chief investment officer of Wespath Benefits and Investments.

Institutional investors are embedding illiquid alternatives ever more deeply into their portfolios in the hunt for returns. But Henrik Olejasz Larsen, CIO of Denmark’s DKK354 billion ($47 billion) Sampension, the country’s fourth largest pension fund, counsels on the importance of waiting for liquid markets to recover before adding more to alternatives.

For sure, Sampension’s alternative allocations continue to outperform listed instruments (particularly real estate and energy and transport infrastructure) and long-term, the fund will continue to allocate more to illiquids.

However, the portfolio is now un-balanced relative to set targets, and until listed markets recover, Larsen is planning to slow the build-up in alternatives. “Returns on some of the alternatives are inconsistent with moves in liquid assets,” he says. “When listed assets fall sharply and illiquid allocations don’t, we worry that less liquid markets haven’t built all that information into their pricing.”

The price differential manifests particularly in private equity fund valuations, he continues. In a bid to better measure what is really happening in its 4.7 per cent allocation to private equity, Sampension takes the last quarterly NAV from its fund managers and compares it to liquid reference indices over the same price point. “If there is a drop in liquid markets, we make a top-down adjustment in the value of our illiquid investments,” he says.

Although a crude measure of what is going on, he says this approach offers an insight into what would be the true valuation if the asset was sold today. “Private equity has a direct link to what is going on in listed markets,” he says. “I am concerned that the value set by our managers is a market transaction price that wouldn’t be realised.”

Positively, the concept applies the other way around too. It leaves him anticipating an upward spike in illiquid valuations that have still to mirror positive moves in liquid markets. None more so that Sampension’s holdings of renewables infrastructure (part of an 11.4 per cent allocation to real estate, land and infrastructure) set to benefit from sharply higher electricity and gas prices.

Tactical tweaks

Larsen espouses the importance of building a portfolio that can withstand large movements without necessitating short term corrections in an investment approach that draws on a rich store of experience. He joined Sampension in 2007 on the eve of the GFC. Back then the fund had traditional defined benefit guarantees and the crisis triggered a swathe of portfolio adjustments.

More easily said that done, avoiding all forced liquidation at the worst time is now deeply carved into his construction philosophy. “When markets go down you should not retain your risk. But you should have the option to be fully invested and increase your exposures.”

Nonetheless, the current investment climate is prompting a few tweaks here and there. Over recent years he has steadily added inflation protection. Linkers have been included in the strategic asset allocation since the start of the year and he’s gradually shifting a portion of the low-risk bond allocation to global real estate.

The process has required manpower and careful consideration around not concentrating investments in particular yields, he says. “We will continue with the strategy, but it does depend on where you enter the market so we want to spread this over several years.”

The fund has also moved towards less liquid instruments in the traditional bond portfolio in response to elevated spreads. Favoured allocations include AAA CLO tranches over investment grade corporates or European government bonds, for example. “The spread between mortgages and Danish government bonds has widened, as it has for asset swaps and Danish vs German government bonds,” he says.

Value bias

Larsen continues to favour Sampension’s value bias as a fundamental driver of equity returns at the fund. The allocation has become closely linked to interest rate movements where rate rises continue to cause value to outperform growth, thanks in the main to rate rises tending to hurt growth companies more because their cash flows are longer duration.

“It’s benefited us,” he reflects. Still, if the value allocation continues to perform as well at the end of this year as it did in the first half of 2022, he may begin to take the allocation down.

That decision will also be informed by the fact today’s underlying driver of the value allocation doesn’t fit with Sampension’s overarching philosophy: to find out-of-favour investments that provide value for money in the listed space. It’s why, for example, Larsen doesn’t like crypto or gold, both assets that lack strong underlying cash flows and rely more on market increases.

“Our value strategy is not about buying everything indiscriminately,” he continues. “In equities we use statistical key numbers derived from equity valuations as an investment guide and we assess if structural factors could give rise to numbers being skewed.”

In a final reflection, he advises on the importance of board and senior management buy-in to the thought-process underlying value investment. At Sampension this proved key when the pandemic struck. “This saved us a lot; we weren’t forced to sell in the spring of 2020,” he says.

ESG

The value bias also helps protect the portfolio from the risk of over valuations in ESG and companies puffing up their green credentials. Sampension is pouring more resources and time into ESG data collection and analysis (using internal and external expertise) than any other investment process in a bid to measure its 2050 net zero progress.

“ESG is where we are doing most new stuff. We want to use granular ESG data in a more systematic fashion that will give insight on the portfolio at an aggregate level. We are spending money on this, putting in manpower and buying data and systems.”

In a whole portfolio approach, strategy is focused on buying and engaging with companies it thinks it can improve and only screening out those it doesn’t believe will change. “We stay invested in the sectors that matter the most,” he says.

Emerging equities

Of late Larsen’s focus has also honed on Sampension’s 15 per cent, externally managed allocation to emerging market stocks. For years he’s favoured a structural overweight to emerging markets on the basis that economies that grow fast experience high returns in equity markets – but now he’s not so sure.

“I see no evidence of a link between the growth of an emerging market economy and the listed market – this is not something I am optimistic about anymore,” he says.

He is also wary of large China weightings in emerging market equity allocations given governance issues in Chinese corporates and geopolitical tensions. Instead, he favours allocations to developed market corporates with exposure to emerging markets. “We are tilting the portfolio this way,” he concludes.

 

 

 

 

ESG has enjoyed uninterrupted growth as a factor in the investment mix since its early days almost two decades ago. But this year it has been going through an identity crisis, dogged by doubts, with some commentaries suggesting that it could be in retreat. Some of these arguments are welcome as they point to the need for change as we adapt to its limitations and continue to develop.

However, dismissive and often oversimplistic talk about ESG implies a misunderstanding of what it stands for at best and, at worst, risks derailing the many industry efforts towards greater sustainability. Executing on sustainability impact is a primary industry goal and ESG activities are still the best route we have for achieving it, despite its limitations.

ESG limitations

As a very broad-based concept, ESG’s relevance and potential influence is likely to be forever contested. The versions described by various commentators vary widely and straddle both financial value and non-financial values and it is easy for ESG talk and thinking to be muddled and its outputs pigeonholed. It is also heavily embroiled in politicisation, witness its current place in the eye of a particularly challenging US political storm. It is also heavily engaged in regulation, with the SEC particularly active at present in promoting corporate reporting of climate risks and challenging industry overclaiming of ESG credentials.

Critics legitimately draw attention to all these issues and ESG advocates should be prepared to respond and mount a defence by thinking through these critiques, engaging to raise their game and adapting. This critical chatter has built up precisely because ESG has become so central and can no longer be ignored. Indeed, those that contest its value often do so from a concern that it will permanently divert attention, and business, from their version of the industry. So rather than criticising ESG in areas where it still has far to travel, more airtime should be given to refining its role and relevance for the coming era.

For a start, we must find a better way of labelling the conversation; position it within constructive and effective regulatory footprints; and connect it to real-world impact in which investing genuinely moves the needle on the environment and other key societal goals.

ESG RIP?

We start where others have, in suggesting that the term ESG may be coming to the end of its useful life. The simple concept we should foster is what does it mean to invest sustainably – achieving long-term success with inter-generational fairness built in. The three-letter moniker ESG does not represent this.

ESG of old worked on shareholder capitalism whereas investing sustainably is set to work with an increased weight on stakeholder capitalism, where fairness must be considered more widely and more inclusively alongside increased attention to the systemic risks, where these are rising especially in relation to climate change.

Investing sustainably reflects asset owners and asset managers justifying their license to operate – the social code of behaviours that governs them – and earning the trust of stakeholders by doing ‘the right thing’. This contrasts with ‘the right thing’ from a past era, which was centred on successful investment performance. This past version looks flimsy in the future era of mutual flourishing in which financial outcomes are balanced with environmental and social outcomes, and not just a dogfight for bragging rights on performance.

Here we confront a critical crunch. Moving beyond the impact of these ESG risks on the portfolio to consider the impact of the portfolio and the assets in it on the world. ESG of old only fought climate risk, whereas sustainable investing of the future means ESG must evolve to fight climate change if it is to maintain its relevance. This is certainly true for asset owners with net-zero pledges but is also relevant for others too that have broadened their organisational purpose.

Sustainability 2.0

What is needed is a step up of sustainability commitments by investment organisations. This is not to unwind what has gone before. The integrated ESG approach, with all its imperfections, has been a positive journey and those activities will continue to provide investors with return and risk benefits. These will gather strength as regulations reinforce the reporting transparency and discipline that are critical for this type of investing to be genuinely effective.

But integrating ESG is too simple a discipline for aligning investment strategies with sustainability realities, which requires making a real-world impact directly or via investee companies, so fighting climate change not just managing climate risk. To be effective ESG should effectively funnel together sustainability, impacts and longer time horizons in a significant step forward in our existing practices.

This step forward should come from a new mind-set, model and measurement framework, consistent with the theory and principles of universal ownership. The mindset shift is about seeing opportunities as if from the perspective of large asset owners whose portfolios own a slice of the world market. This involves seeing company externalities as portfolio-wide and system-wide risks and costs and seeing systemic risks as needing to be addressed because the returns required can only come from a sustainable system.

The model shift means employing the 3D investment model in which risk, return and real-world impact are integrated. In this model fiduciary duty is covered as there is no diminution of the primacy of financial outcomes because sustainability impact is instrumental to those ends. How will this extra dose of impact be delivered? Largely via strategies that emphasise active ownership and industry and public policy engagement, implying a considerable shift in resourcing.

The measurement shift will be witnessed by success being judged more broadly, rather than an obsessional focus on outperforming the benchmark. So, progress in this area will be presenting a balanced scorecard of hard and soft measures, inputs and outputs, data looking backwards as well as forwards and covering both financial performance and sustainability.

Stepping up

Stepping up will require significant change and will be hard because we have to give up some of the hiding places from where we have operated. This is a big ask and will require industry leadership from those organisations which have the culture and capabilities to put universal ownership theory into practice and start moving ESG into the real-world impact era. The beauty of the theory is that quite small numbers of organisations can create the trickle-down conditions for larger scale change.

At a time when all industries seem to be facing their ‘Tesla moment’, reimagining ESG may turn out to be our industry’s defining moment that mobilises us to do our best work ever.

Roger Urwin is co-founder of the Thinking Ahead Institute.

Private equity performance fees are a growing source of consternation among Dutch pension funds where some have been stung for billions in fees despite beneficiary payments lagging roaring inflation and Europe’s cost of living crisis.

“Private equity fees are a difficult topic,” admits Harold Clijsen, chief executive of PGB Pensioendiensten, pension provider for Pensioenfonds PGB (PGB), the Netherlands €34.8 billion ($35.2 billion) industry-wide pension fund.

PGB targets a 7.5 per cent allocation to private assets of which only 2.5 per cent is in private equity, focused on European and US small and mid-cap buyouts.

That relatively small allocation means PGB’s current total fee spend across the whole portfolio is only 43 basis points, well under its maximum permitted budget of 55 basis points that must include all transaction and performance fees, and which shapes a highly selective budget allocation.

But other funds are suffering a much bigger hit. Civil service pension fund ABP, one of the biggest pension funds in the world, paid €2.8 billion ($2.84 billion) in costs to private equity funds last year yet has only recently increased beneficiary payments for the first time since 2008.

Elsewhere, the €277.5 billion ($281.3 billion) healthcare scheme PFZW paid €1.26 billion ($1.28 billion) in performance fees to its private equity managers in 2121, equivalent to two thirds of total asset management costs thanks to private equity’s 2-20 model comprising a fixed 2 per cent management fee and a 20 per cent performance fee.

Clijsen is supportive of fixed fees (especially for smaller private equity mangers) arguing they are an important element to successfully running investee companies.

But he questions performance fees particularly given limited partners’ ability to drive them down when so many investors are chasing illiquid allocations.

“The problem is the performance fee which kicks in hard,” he says. “But we don’t have much pricing power because all the money in the world is looking for profitable investments.”

For now, he’s still convinced private equity is worth the cost because of the returns.

“In the end you have to consider net return after fees and last year’s performance showed private equity does add value to the portfolio.”

Still, strategy at PGB is shaped around lowering the fee spend wherever possible including prioritising re-ups in funds PGB is already invested in to cut out the advisor fee, as well as co-investments beside fund managers and with other pension funds to lower the fees attached to advice and monitoring.

PGB’s growing scale also works in its favour. Back in 2005 PGB only invested on behalf of one industry fund. Now it represents 4,000 employers across 16 different industries and assets under management have grown to €34 billion from €11 billion.

“We are large enough to be an interesting client,” says Clijsen. “Our partners know we are there for the long run and this makes us attractive to do business with. We also tend to invest in follow-up funds but that said, when a large part of the team or key personnel leaves the company, that could trigger a change of mandate.”

Clijsen rules out developing an internal private equity team even though PGB runs its matching portfolio inhouse and he believes inhouse management is the most effective solution to high private equity fees. All the return-seeking allocation is outsourced, and PGB would struggle to compete for private equity talent; investing in European and US private equity also requires a team on the ground, he reasons.

Return seeking allocation

Away from private equity, other corners of the return-seeking allocation are also attracting his attention. He is concerned about the impact of stagflation crimping growth in the listed equity allocation and impacting beneficiary pay-outs.

“We need returns from equity and other assets in order to grow capital and achieve indexation. When inflation is high, people expect to get compensated because of the increased cost of living. But increasing compensation is difficult in a recession or zero growth environment. We were able to increase pensions with 3 per cent this year.”

One approach designed to cushion the portfolio from falls in equity include an equity hedging strategy using options to protect the downside.

“When equity is more expensive in relation to yields and momentum turns negative, we do hedge some equity risk. When equity drops, this adds a little on the return side; the idea is to protect capital and therefore the coverage ratio,” he explains.

Elsewhere in the liquid allocation, PGB is prioritising passive market weight and equal-weight strategies in combination with more quant-driven strategies like factor investing in order to gain additional return.

“We want a consistent approach to liquid markets on one hand and on the other we want to cut costs. At this moment, we are looking for more cost cutting through developing our own strategies for selecting equities.”

Funded status

The fund’s assets are split 60/40 between the return and matching portfolio respectively. Although rising interest rates and inflation are concerning in the return seeking allocation, they have buoyed the matching portfolio where PGB’s coverage ratio is currently 120 per cent.

The internal team also run a dynamic risk hedging strategy whereby when interest-rate risk is low, the fund calculates a lower risk budget and reduces its interest rate hedge; when rates move higher it increases the hedge.

At the start of the year around 45 per cent of the liabilities’ interest rate risk was hedged, but this has now risen to around 65 per cent on the prospect of further hikes but where decision making also balances the threat of recession – and lower rates.

“There is still an upside in interest rates because if inflation doesn’t come down, rates will rise further,” he says.

After eight years as PGB’s CIO, Clijsen became chief executive in 2020 turning his hand to new tasks like conversing with corporates looking to move their pension management to PGB and gauging the impact of local developments on the total organisation. One element he finds interesting is the impact of legislation on pension fund management, particularly new rules set to encourage beneficiary engagement, encouraging DC investors to take more control of the investment process.

“Beneficiaries now have choices on risk appetite; how they think about ESG and which investments we should make for them,” he says. PGB already runs extensive questionnaires, group-interviews on risk budgets and ESG-polices and has introduced a digital tool which helps participants set their own risk budget.

It’s a shift that he predicts will force Dutch pension funds to adopt more transparency around their investment process, holding consequences for trustees and boards unable to adapt that could result in PGB accruing more assets under its stewardship over time.

“I expect more consolidation in the sector. We are prepared to take on more pension plans for employers who want to outsource to a professional, social, pension fund,” he concludes.

The twinned and conjoined crises of Ukraine and inflation might have dominated the year of your average fund CEO or CIO, and after years of endless growth and prosperity doubtless some have revelled at the challenges. It is also a welcome change from the more amorphous issue of net zero (without an overshoot) which has been at or near the top of board agendas for months, and in other cases years.

For the climate enthusiastic C-suites with a combined material and moral compass on their portfolios, they will not have forgotten those net zero commitments. For those who have aligned out of obligation, NGO pressure or peer pressure those commitments may already be deprioritised, if not forgotten.

But roll forward towards the end of 2023 and Europe will have somehow scraped through its feared gas constrained winter at a cost yet unknown and inflation will be at its most painful. However, with the interest rate medicine starting to bite, glimmers of light may be seen on the other side of multiple country recessions, if not a global one.

In the climate world the global emissions Stocktake under the Paris process will be the backdrop for COP28 in the UAE  and it will be unwelcome news, even accounting for the drop in emissions which economic slowdowns bring.

It is then a two-year roller-coaster ride towards COP30 and the 2025 Paris Ratchet where the world expects the net zero momentum to peak in a flurry of new bold commitments to limit the worst of climate damages. Net zero pledges will be nearly five years old at both the investor and company levels and civil society will be hoping to have the champagne on ice, ready to declare victory.

Except the victory won’t happen.

The theory of change surrounding the net zero alignment initiatives has always been that mass collaboration at all levels of the investment chain will create unstoppable momentum that no policymaker can resist, as a private -sector led transition leaves them able to simply follow the wave of change. That they will almost reactively put in place policies to merely assist rather than radically transform the pace of transition being driven by company engagement and portfolio allocations.

The International Energy Agency (IEA) has long produced climate scenarios showing what numbers are needed to achieve certain climate outcomes and more recently, pushed hard by civil society pressure has even added a narrative and tone supporting the transition, but has always stopped short of forecasting the future.

That mantle fell in 2018 to a non-profit consortium called the Inevitable Policy Response (IPR) formally commissioned by the Principles for Responsible Investment that gently landed its first transition forecast in early 2019.

Set against a backdrop of a potential Trump second term and Asian intransigence, some funds, particularly US investors, thought IPR forecasts of acceleration optimistic. It became eerily accurate as a series of perceived low probability events, such as EU border taxes announcements, combined with high probability technological and private sector momentum saw a record number of country net zero commitments.

The IPR update in 2021 was released immediately prior to the giddy days of COP26 in Glasgow where the GFANZ initiative, chaired by former Bank of England governor Mark Carney rolled out its impressive list of supporting net zero private actors from the asset owner, asset manager, service provider and company communities

The IPR 2021 update and its subsequent quarterly updates have only cemented end points of its initial 2019 forecast – that net zero is somewhere between very unlikely and impossible. This sacrilegious language will be most unwelcome news to the net zero aligners who must already be preparing to defend it to civil society when the blindly obvious becomes….inevitable.

It is not that net zero itself is unlikely, it just that net zero without an emissions overshoot is now virtually impossible.

In the fine print of all those net zero commitments lies the caveats that “governments must play their role” for private sector actors to succeed. Some aligners are already changing business models or portfolios regardless of the policy settings – who knows the implications for those brave actors once the required net zero policy settings fail to materialise.

Even for those taking unilateral action, it is the type of action taken that is part of the problem. While the divestment community continues to claim victory, or at least masthead momentum, the reality is that divestment is leading only to a privatisation of high emitting assets and the capital released is not going directly into new incremental clean solutions but spread elsewhere.

Funds and companies can thus claim they are meeting their targets, but this new type of financial engineering will and is resulting in zero climate impact without investment in assets that can potentially reduce demand for fossil fuels. The supply side theories of change are failing and failing badly.

The key question for all stakeholders is to now ask themselves:

  • How will this all unravel? “
  • When will it all unravel?
  • How can we maintain our reputations when it does unravel and
  • Will civil society buy our defence when we point to the net zero fine print?

For funds and companies to come out of this remotely unscathed and without a chaotic war of words and blame games there now needs to be a new focus.

The Clean Capital, NETS & Asia Trifecta

Firstly, all net zero aligners need to focus on clean solution capital – large scale renewable energy investment and breaking down of the CIO arguments around illiquidity barriers.

Secondly, Negative Emissions Technologies (NETS) needs to move from a dirty word to a formalised discussion leading to huge collaborative investment between investors and governments.

Finally, Asia needs to become the predominant investment theme. The IPR forecasts that OECD countries will likely meet their 2050 net zero targets but this will be done with no impact on climate whatsoever at the current rate, due to the residual emissions left in Asian countries and supply chains.

Engagement at the sovereign and sovereign debt levels about how to switch this momentum is urgent to minimise the inevitable overshoot. We will now enter unchartered waters from a physical climate point of view. The battles to prevent overshoot are effectively lost and damages are already high. The war is not yet lost, but without an injection of realism into the net zero debate, the pain of recognition and adjustment will be greater.

Once the C-suites return from their summer breaks, they would do well to address these questions.

While the Ukraine and this economic crisis will pass and possibly several more cycles after them, the climate war is omnipresent as far as we can see into the future.

Only a dose of realism can save us now.

 

Julian Poulter is head of investor relations at Inevitable Policy Response (IPR) and a partner at Energy Transition Advisors (ETA).

The Inevitable Policy Response (IPR) is a climate transition forecasting consortium commissioned by the Principles for Responsible Investment in 2018 that aims to prepare institutional investors for the portfolio risks and opportunities associated with an acceleration of policy responses to climate change.

When Mark Anson, CIO and chief executive of the $28 billion Commonfund, headed up US pension fund CalPERS between 2001 and 2005 he got embroiled in a research project exploring why beta levels in private equity were so low compared to public equity. Analysing the low levels over one period (betas, he recalls, of 0.4 -0.5 compared to the public stock market) triggered much head scratching: private equity is still equity and surely its illiquidity should make it even more risky? Only by playing the models in an excel spreadsheet did he realise the delay between movements in public markets washing into private markets in a statistically significant lag that can go back over a series of quarters.

Today lagged beta is a well-known phenomenon. But speaking in a recent webinar hosted by the Journal of Portfolio Management, Anson stressed the enduring importance of measuring lagged betas in portfolio construction: it may seem like private equity doesn’t suffer the vicissitudes of the public equity market, but both are linked much more closely than estimated by current metrics. And only when investors understand the amount of systemic or beta risk that will wash into their private portfolios, can they budget how much beta risk to allocate to private equity compared to public equity.

Anson said that private equity investors should include two to three lagged betas in addition to the current period beta to estimate the full amount of systematic risk embedded in a buyout/growth equity portfolio. For venture capital, the lagged betas can extend back three to four quarters, and for real estate—the least liquid asset class—the lagged betas can extend up to five quarters.

Accumulating all the systemic risk associated with private asset classes also reveals the true correlation of the illiquid asset classes with the public markets. When lagged betas are included, the correlation of private equity with public equity increases substantially, critical for risk budgeting.

Alpha

Measuring lagged beta also reveals the true amount of alpha. “You cannot measure alpha until you account for all the beta associated with an active investment,” said Anson, noting how lagged beta used to be claimed as alpha but now investors are smarter, realising there is not as much alpha.

Accurately measuring beta is also important because it safeguards against over allocating and the risk of a liquidity crunch. In the GFC, funds over allocated to private equity, underestimating the amount of systemic risk embedded in their portfolios and inadvertently increased their risk profile.

He added that the amount of volatility in public markets is also embedded in private markets, only private markets amortise that volatility over time. Because portfolios are marked on a quarter by quarter basis they can absorb the volatility. Volatility does exist and is impactful in alternatives, but it’s not as transparent as it is in public markets. “Volatility is still there and still needs to be accounted for,” he said.

Continuing, Anson explained that because private equity managers only mark to market their portfolios on a quarterly basis, they have significant discretion as to how they “price” their underlying portfolio companies – the resulting volatility of private capital portfolios is typically understated. If lagged betas are used to accurately measure the correlation coefficients between illiquid and liquid asset classes, and also to better estimate the actual volatility of private equity and venture capital, then investors will have an economic constraint that limits the amount allocated to these illiquid asset classes.

Small is beautiful

Research by Commonfund estimates private equity investors can achieve a long-term liquidity premium of 3.5 per cent over and above public equity markets.

“We believe in it, track it and measure our performance to check if we’ve earnt it or not,” said Anson.

His one caveat? Achieving that premium depends on investing with top-notch managers.

Only first or second quartile managers will outperform public markets. He also noted that large private equity managers (those with PE funds greater than $5 billion) often don’t fully capture the liquidity premium and do not produce any independent alpha. However, smaller PE funds, and specifically, small PE funds that are sector specialists, fully capture the liquidity premium plus another 2 per cent of alpha.

Due Diligence

Private equity investment requires giving control and discretion to GPs. Still, every sophisticated investor goes through a due diligence process, marking the portfolio.

Elsewhere LP advisory committees bring input, advice and sometimes criticism to GPs on how they are marking portfolios and reporting flows . CommonFund ranks PE managers according to their Distributed to Paid In capital (DPI) levels that takes into account the capital flowing out of the fund. Investors may have a high IRR or high multiple on invested capital (MOIC), but have no realised gains, warned Anson. “How much money are you getting out of your managers?” he asked.

Venture capital

Anson also reflected on changes in the VC market.  Firstly, start-up companies are staying private longer. In the old model, an entrepreneur funded with seed capital and then a second and third round of financing (Series A and B) before going public. Today, start-up companies might have a Series C through G round of financing before going public.

Second is the rise in unicorns. Today, venture capital managers spend more time looking for a unicorn—a start-up company that achieves an IPO value of $1 billion or more. A single unicorn can carry the whole performance for a venture capital fund. This is also why venture managers will back a start-up company through several rounds of financing—to capitalize on that unicorn status. The third change has been the entrance of Non-Traditional Investors (NTIs). In the past, the venture capital industry was a small, tightly knit community of select venture capital managers that had access to the best ideas and entrepreneurs.

In a catch-22 companies staying private for longer is stretching the time between investors putting money in and getting their cash out. This in turn is increasing dependence on unicorns.