For the first 10 years of Bridgewater’s existence it didn’t manage money. The fund manager, now regarded as the world’s biggest hedge fund, was built on its research, content and advisory expertise, with Ray Dalio, Bob Prince and the team working one-on-one with corporate executives and policy makers to help solve problems. And now, as asset owners increasingly look to managers for “partnerships” rather than transactional relationships, Bridgewater’s advisory capabilities are coming to the fore. In this environment there are many problems to be solved.

“The key thing right now is that the problem set has changed,” says Kyle Delaney, the firm’s president and chief commercial officer (pictured middle). “Most people are starting to recognise the next 10-20 years are going to be very different from the last. This has required a re-thinking of everything relative to what people know and have experienced and is bringing into question things like how to be diversified, which is the most critical and essential thing we have in large part taken for granted in the last decade.”

Bridgewater is talking to clients at the foundational level about what their goals are and what needs to be done to achieve them because many investors are dealing with increased complexity and an environment they have never had to deal with in their investment careers.  Brian Lawlor, co-head of Americas in the client service department (pictured right), says the current environment has caused investors to re-think their investment beliefs and how they allocate risk in their portfolio.

“The focus for now is on advice, understanding their problems and helping clients work through those. We are sharing what we have done and our approach to problem solving,” Lawlor says.

Bridgewater’s research is focused on understanding how the world works and the impact on markets. An enormous amount of information is needed for that and having access to data is more important than ever.

Bridgewater: The technology provider

Established in 1975 by Dalio in a two-bedroom New York City apartment, the firm’s history was embedded in currency and interest rate advisory.

Risk management advice was at the foundation and remains an important tool both internally and now for clients as well. Problem solving internally at Bridgewater has centred around a robust risk management tool which is now available to clients to stress test their portfolios across different dimensions.

“Clients are recognising what is coming down the pipe in the investment environment but they have had a hard time modelling how those environments might impact their portfolio. Because we’ve gone back hundreds of years, and we’ve looked at all different kinds of episodes of inflation and conditions like stagflation, this helps them think through what they can do today to get ahead of that as efficiently as they possibly can,” Delaney says.

It’s an increasing part of the relationship with clients, Lawlor says, and Bridgewater is working on custom technology solutions for clients to allow them access to better insights into the macro environment where inflation, drawdowns, cybersecurity, and liquidity top the list of concerns for clients.

“We’re also thinking about other tools we can make available for our strategic partners,” Lawlor says, which is likely to include technology solutions for data integration.

Throughout the firm’s history problem solving for clients – originally around currency and risk management – has led to product not the other way around.

It’s one of the reasons the firm limits the number of clients it works with, growth is measured in mind share and an ability to help clients solve problems. Product may or may not come out of that.

“As we have gone through drawdowns the feedback we have had from clients is they value the partnership and the impact we can have across the entirety of the portfolio. That makes them feel like they want to work with us,” Delaney says. “We had a drawdown in the first quarter of 2020, which was quite painful, but the research we did at the time on Covid-19, inflation and low interest rates kept us even more relevant to the C-suite.”

Bob Prince, the co-chief investment officer (pictured left) who could also be described as co-chief problem solver, says one of the indicators of a successful relationship with clients is if “the top of the organisation brings their most important problems to you”.

Stagflation and what to do about it

Prince believes one of the most important problems for markets and for clients to understand at the moment is the prospect of stagflation and the implications for portfolios.

For a long time Bridgewater’s line has been that current inflation is not transitory but is a monetary inflation, something not seen in a long time.

“We’re not talking just about money supply, we’re talking about total credit and total spending and looking in a different way at how an economy works,” Prince says.

He says the current difference between the upward pressure on inflation and the downward pressure on growth relative to what is discounted in markets is the widest it has been in the past century.

The root cause of the expected stagflation, he says, is the excessive level of credit and money growth and until that is drained nothing will be fixed.

“We have to nurse our way out of this. Central bankers would probably not shrink the balance sheet as fast as this year and would need to work to raise the interest rate a little faster. The net of that would be a better blend of financial and real economy performance.”

In terms of investors’ allocations in such a market, Bridgewater recommends starting by looking at the environmental biases of assets to growth and inflation.

Investors should favour assets that benefit from inflation, like inflation-linked bonds. Equities, he says, perform badly in stagflationary environments and investors need to recognise that.

“In stagflationary environments equities have been the worst-performing assets, in line with their vulnerability to both falling growth and rising interest rates,” he says.

Solving problems requires innovation

At the last tightening in 2017 Prince recalls a CIO describing their concerns and the vulnerabilities they had in the environment.

Bridgewater took on a project to help the client understand the environmental biases of their portfolio, it turns out they had a bias to do badly if there was a rise in inflation.

“If you have a vulnerability you are worried about in [the] near term you can either fix it permanently by shifting your allocation or you can make some moves tactically based on a view of where we are in the cycle,” Prince says. “I suggested some things but they came back and said they couldn’t do them well enough so I said maybe we could help them with that.”

This was a risk for Bridgewater as it meant taking a particular position for a certain environment, where traditionally its portfolios are unbiased and designed to do well in all markets.

“We took on the mandate but we could only do this type of thing where we have a great relationship. The portfolio was set up only to perform in down times so most of the time it would underperform. We spent six months with them building out a risk management plan and accurate expectations.

At the moment the manager is working with a client to re-orient an asset allocation that had a heavy equities bias and shift that towards using equities as an absolute return, more consistent, resilient allocation. That approach has now also been incorporated into the firm’s approach.

“We have had a lot of innovations over the years we just always thought primarily in terms of our best alpha and our best beta so when we come up with new insights and ways to make money we’ve chosen to add them to our alpha strategy rather than become a product shop,” Delaney says.

The transition to renewable energy will be “volatile and complicated” like other major transitions in history, and spikes in demand and pricing for coal, oil and gas are likely over the near term, according to an expert in global resources strategy from NinetyOne.

While the European move towards low-carbon and renewables has been accelerating in recent years, in hindsight inadequate time was spent on security of supply of existing non-renewable energy sources, according to Tom Nelson, portfolio manager of the global natural resources strategy of Ninety One, the global investment manager established in South Africa in 1991.

Speaking in a podcast conversation with Julia Newbould, managing editor at Conexus Financial, Nelson predicted Europe’s energy crisis would drive up pricing and demand for non-renewable energy sources around the world, and argued oil and gas companies with clear transition plans were likely to do “exceptionally well” in coming years.

The Russia-Ukraine conflict, in jeopardising Europe’s foundational supply of natural gas, had seen the rare collision of two historical events, Nelson said.

“It’s a very, very unusual coming together of these two events: an energy supply shock and an energy transition,” Nelson said. “We’ve seen energy supply shocks before, we’ve seen two energy transitions, we’ve never seen two collide.”

We are now living through the “third energy transition,” with the first being the shift during the 19th century from burning wood and biomass towards coal, and the second being the industrial revolution and the move towards oil and gas, Nelson said. The third is the move away from fossil fuels and hydrocarbons towards low-carbon and renewable energy sources.

These transitions are historically extremely volatile, with new supply sources and demand trends causing large price swings, and “we should expect volatile pricing through the transition,” Nelson said.

Energy transitions “tend to take a little bit longer than people expect,” typically between 30 and 50 years, although this transition may be expedited by the urgency of climate change, Nelson said. They also tend to be “more a case of an energy supply diversification, rather than an overnight revolution where the incumbent effectively gets jettisoned.”

“So we didn’t stop burning wood and biomass when we found coal,” Nelson said. “Neither, sadly, did we stop burning coal when we discovered oil and gas. And I think what we’re perhaps beginning to learn in real time is that the advent of the arrival of low-carbon and renewable energy sources will not mean that we simply stop burning oil, gas and coal overnight.”

As consensus forecasts are established on the displacement of old energy sources with new sources, central market players stop investing in new supply of old sources, making the system more vulnerable to supply shocks and disruptions, he said.

“That is one of the reasons why the recent price action, since the invasion of Ukraine, has been as pronounced and as dramatic as it has been,” Nelson said. “We simply don’t have the spare capacity, or the the buffer, if you like, to fall back on. The system was fairly stretched going into it.”

The Russia-Ukraine conflict and the clear urgency to move to reliable and dependable energy sources will likely accelerate the transition over the long term, but there will be adverse impacts in the shorter term, Nelson said, noting “you can’t take away 35-or-so percent of Europe’s natural gas and not create, in other parts of the energy matrix…heightened levels of demand for other things.”

“So we’re likely to see more coal burned in Europe in the very short term. We’re likely to see Europe become a very strong bidder, and probably the first port of call for global cargoes of liquefied natural gas.”

If gas supply that would have gone to Asia gets diverted to Europe, Asia is likely to also burn more coal in the short term, he said.

Oil and gas companies that demonstrate clear, coherent transition plans, and even potentially become “solutions providers and, if you like, diversified energy companies of the future,” will do “exceptionally well,” he said, pointing to European oil and gas majors like BP, Shell, TotalEnergies and Equinor.

“The ability of us, as investors in these companies, to buy those stocks today on five, six, seven times earnings against a backdrop where a lot of people are not comfortable to own these names–that as active investors we can buy these companies, we can engage with the management teams, we can help them to drive this transition–we think that’s a tremendous opportunity,” Nelson said.

Longer term, demand for metals like lithium, copper, nickel and zinc will see structural tailwinds, driven by electrification and the energy system moving towards more metals-reliant energy sources such as wind and solar, he said.

At CalPERS’ latest performance, compensation and talent management meeting, committee members continued to discuss changes to the $500 billion pension fund’s compensation program to make it more competitive in attracting and retaining staff.  CalPERS’ efforts to modernise the process reflects a sector wide struggle as other institutional investors including the Teacher Retirement System of Texas and the $83.4 billion Alaska Permanent Fund Corp struggle to fill a swathe of investment positions.

Returning to the board with their latest revisions, compensation consultant Global Governance Advisors’ Peter Landers and Bradley Kelly offered more detail on how to evolve the pension fund’s compensation, building on an April presentation when Kelly warned that complacency is the kiss of death for any organisation, especially public pensions, in today’s tight recruitment market.

Among the measures are plans to widen the peer group of funds that CalPERS compares its compensation levels against to include larger private sector firms, and introduce salary packages that have more incentives attached including an annual incentive plan that focuses on total fund results.

Regular review

The determination and assessment of compensation at CalPERS can lag peer funds. Although reviews may not always lead to salary adjustments, they need to be more frequent and regular. In a worse-case example, committee members heard how the compensation for CalPERS’ chief actuary position wasn’t adjusted over a 14-year period.

“Avoid major delays; our recommendation is you set a regular scheduled assessment roughly every two years to make sure you stay aligned with the market,” said Kelly, a partner at GGA.

The committee also reflected on the importance of CalPERS aligning pay, and benchmarking its compensation, with investors with a similar half trillion dollar assets under management.

“Your fund is growing; you want to make sure you are constantly benchmarking against similar-sized organisations,” said Kelly, later adding that alignment helps ensure CalPERS hires people best positioned to understand the size and complexity of the portfolio.  The board also discussed the importance of ensuring the benchmarking process compares CalPERS to other public pension funds and public state agencies, not just the private sector in a blended peer group.

Internal vs external

The committee also heard how, in some cases, internal candidates had been discouraged from applying for positions because of a perception that external candidates are more highly valued. GGA recommended putting in place a fair, transparent and objective assessment that treats external and internal candidates the same.

Moreover, there is a perception that external candidates are hired at the upper end of pay bands while internal hires, coming into new positions from within the fund, tend to sit at lower compensation bands.

Competitive

Although CalPERS cannot compete with private sector compensation, the pension fund can retain talent by offering a compelling quality of life and purpose in a value-add package. For example, the board heard how New York State Common Retirement Fund has successfully hired a senior investment professional from BlackRock.

“People in the private sector look at these pension funds as an opportunity,” said Kelly.

Board member Theresa Taylor added: “For some, it’s all about the experience of wanting to work in a pension fund for the mission.”

Incentives

CalPERS is planning to introduce an annual incentive plan that focuses on total fund results for incentive eligible positions. For now, suggestions that incentives incorporate returns of the asset class in which an investment executive works are on hold.

Discussions on the importance of rewarding talent and meritocracy at CalPERS captured some of the challenges in its pay structure. For sure, people shouldn’t be rewarded just because; the organisation needs to ensure everyone gives their all every day and are not keeping their seat warm for guaranteed incentives.

Yet higher levels of pay based on merit opens the potential for large pay differences and disparities between executives and rank and file workers that could lead to attrition among these essential employees.

Last year CalPERS approved a plan to pay its new chief investment officer, Nicole Musicco, annual and long-term incentives as much as 100 per cent to 150 per cent of an annual base salary ($707,500) based on investment performance.

Approved proposals will come to the full board at a later date.

 

 

AP2, the SEK 440 billion ($44.1 billion) Swedish buffer fund, has drawn up criteria for classifying its forestry assets as a climate investment.

“An investment in forests is not automatically beneficial to the climate and needs to live up to certain criteria in order to be classified as climate investment,” explains chief executive, Eva Halvarsson. “We have therefore drawn up 10 criteria that AP2 considers to be important from a climate perspective and that our forest investments must meet to be classified as a climate investment. By climate investments we mean investments that, in addition to a good risk-adjusted return, aim to contribute to reduced emissions of greenhouse gases and reduce the effects of climate change.”

The ten criteria to which managers must adhere include a comprehensive and externally published policy for responsible investments; that timberland assets must be managed in a sustainable manner that is verified by a third party through certification, and that all managers integrate TCFD in their reporting.

Timberland managers must also maintain or increase carbon sequestration in the forest, and actively contribute to maintaining or increasing biodiversity associated with the timberland in addition to the minimum requirements specified in the conditions of certification and local laws and regulations.

AP2 began investing in forestry back in 2010. The majority of AP2’s investments are in Australia and the US in forest assets that produce saw timber and pulpwood. The latest criteria build on policies and management systems the fund’s forestry managers already have for promoting sustainability as well as conduct analyses to determine whether the forest real estate might be appropriate for inclusion in ‘carbon projects’.

Net Zero

Halvarsson outlined how else the fund is investing in the transition.

At the end of 2020, AP2 announced plans to align its foreign equity and corporate bond portfolios (around half its total AUM) with Paris Agreement 1.5°C goals. The fund introduced the EU Paris-aligned Benchmark (PAB) framework to develop its own multi-factor indices which reduces climate risk, as well as the portfolio’s carbon footprint.

In accordance with the PAB framework, AP2 won’t invest in companies that generate more than 1 per cent of their turnover from coal, more than 10 per cent of turnover from oil and more than 50 per cent from gas. Nor will the portfolio invest in utilities that receive more than 50 per cent of their revenues from electricity produced using fossil fuels. In total, approximately 250 companies will no longer be included in the portfolio in a wave of divestments that don’t compromise the risk and return characteristics of the indices.

Earlier this year AP2 committed to additional investment in Copenhagen Infrastructure Partners, the Danish fund management company focused on renewable energy infrastructure, explains Halvarsson.

“In the first half of the year, AP2 made additional investments in Copenhagen Infrastructure Partners, one of the world’s largest developers of sustainable infrastructure. The focus of the investment is on the production of bioenergy by processing advanced waste products from agriculture and forestry, as well as food production, in different ways, in accordance with EU regulations, without affecting land use.”

Green bonds

In another example of the fund’s ongoing investment in the energy transition, recent green bond investments include NextGenerationEU, a European recovery fund which aims to build a greener, more digital and more resilient future. AP2 has also invested in bonds issued by the International Development Association, part of the World Bank, which supports projects and programmes for sustainable development.

 

Tom Nelson, head of thematic equity at Ninety One, talks to Conexus Financial managing editor Julia Newbould about the extent of the shock to energy markets through the Ukraine War and how it will impact the transition to clean energy and how portfolio managers can invest in renewables and achieve carbon zero targets in this volatile market.

 

What is the Fiduciary Investors series?

Through conversations with academics and asset owners, the Fiduciary Investors Podcast Series is a forward looking examination of the changing dynamics in the global economy, how decision making should adjust for different market pressures and how investors are positioning their portfolios for resilience.

The much-loved events, the Fiduciary Investors Symposiums, act as an advocate for fiduciary capitalism and the power of asset owners to change the nature of the investment industry, including addressing principal/agent and fee problems, stabilising financial markets, and directing capital for the betterment of society and the environment.

Like the event series, the podcast series, tackles the challenges long-term investors face in an environment of disruption,  and asks investors to think differently about how they make decisions and allocate capital.

A new HBR paper, “Private Equity Should Take the Lead in Sustainability” by Robert Eccles, Vinay Shandal, David Young and Benedicte Montgomery argues how – and why – the private equity must lead on integrating sustainability.

Private equity has grown so large that society’s most urgent challenges can’t be addressed without the industry’s active participation in the sustainability movement. Having interviewed a large sample of executives who run PE firms and the asset owners that fund them, the authors offer recommendations for how private equity can emerge as a leader in the ESG field to benefit the wider world as well as its own long-term performance.

Although the G in “environmental, social, and governance” has been important in the PE industry from the outset, the E and the S have been virtually non-existent. The industry has been content to seek returns with little concern for the long-term sustainability of portfolio companies or their wider impact on society.

Because the industry is now so large, society won’t be able to tackle climate change and other major challenges without the active participation of private equity firms and their portfolio companies. And unless those challenges are addressed, the PE industry, along with all other economic activity, will fail to thrive, the authors write.

Control to drive change

Private equity’s business model gives it clear advantages over investors in public equities when it comes to implementing a sustainability agenda. A PE firm has virtual control of its portfolio companies from an ownership and governance perspective, even when it doesn’t own 100 per cent of a company. It has one or more representatives on the board and a strong influence on who else serves. It has access to any information it wants about both financial and sustainability performance—whereas investors in public companies see only what the company reports. Finally, the firm determines executive compensation and can fire a CEO who is not delivering.

PE-owned companies operate on a longer time horizon than publicly traded companies do, further facilitating a focus on ESG. The average holding period for portfolio companies has increased from about two years in the industry’s early days to about five today, which gives a GP and its handpicked CEOs ample time to make investments without the glare of quarterly earnings calls, says the paper.

Three forces

Three forces are pushing ESG in the industry. First, ESG is becoming more important to limited partners and their beneficiaries. The largest asset owners—among them pension and sovereign wealth funds—are increasingly concerned about the system-level effects of climate change and inequality. A recent survey of LPs by INSEAD’s Global Private Equity Initiative found that 90 per cent of them factor ESG into their investment decisions and 77 per cent use it as a criterion in selecting general partners.

The second force pushing ESG in the industry derives from the belief of many LPs and GPs that it will be essential if private equity is to continue delivering its historically high returns. The third force is portfolio companies’ increasing recognition of the importance of ESG issues. The reasons are unsurprising: a changing zeitgeist reflected in the preferences of employees and customers; growing awareness of the significance of climate change; social expectations regarding diversity, equity, and inclusion; pressure from large public companies to which the portfolio companies are suppliers; awareness of the sustainability focus in publicly listed companies; opportunities to boost their own value through sustainability; and increasing regulation.

Leaders

What are the leaders in ESG doing differently? They are becoming more sophisticated in three ways: (1) integrating ESG factors in due diligence, onboarding, holding periods, and exit strategies; (2) increasing transparency in the reporting of sustainability performance; and (3) assessing and improving the ESG capabilities of portfolio companies.

Each target or portfolio company’s performance is assessed on the critical ESG issues that will affect value creation. That means moving from a short “risk and compliance” checklist in the due diligence phase (to screen out any obvious problems that could have financial consequences) to a sophisticated analysis of how well a portfolio company understands and is managing the ESG issues material to its business.

The private-equity business model puts general partners in a good position to help portfolio companies improve their ESG integration and reporting practices in a number of ways. These include identifying relevant issues and best practices for dealing with them, providing measurement and reporting tools, benchmarking against other portfolio companies, offering access to internal and external experts, and monitoring regulatory developments.

Some GPs have developed methodologies for assessing the degree of ESG sophistication in potential portfolio companies and helping them improve practice.

Firms can adopt a mechanism for simplifying and harmonizing ESG data reported by their portfolio companies to GPs and by GPs to LPs. Every general partner where we interviewed had a bespoke set of KPIs and a methodology for collecting, analyzing, and reporting data, and all agreed that some degree of standardization would be useful. Portfolio companies with multiple GPs face multiple data requests. Similarly, GPs receive wide-ranging and differing data requests from their LPs. Make net-zero commitments.

Given the size of this asset class, the PE industry needs to make the kind of commitment to “net zero by 2050” that all financial institutions under the umbrella of the Glasgow Financial Alliance for Net Zero are making.  The industry also needs to improve its track record with DEI. Today private equity is still predominantly white and male, particularly on deal teams. Evidence continues to mount that a more-diverse workforce leads to better performance. Lastly, the authors write how the PE industry needs to directly confront the fact that the tremendous wealth it has created has been unevenly distributed. LPs, GPs, and the top executives of portfolio companies have benefited to a much greater degree than other employees of those companies.