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.

 

 

Last month, Allyson Tucker, chief executive officer of the $192 billion Washington State Board of Investment, was invited to Illinois by long-standing private equity partner KKR to mark the sale of one of its portfolio companies. After seven years, KKR was selling its stake in C.H.I. Overhead Doors, a garage door business, for $3 billion.

Countless numbers of companies have passed in and out of WSIB’s $44.9 billion private equity portfolio since it began investing in the asset class in the 1980s, but C.H.I was different. The company’s 800 employees had all been made owners in the business when KKR bought it back in 2015, and Tucker was in town to celebrate their windfall.

At exit, in addition to around $9,000 in dividends earned since 2015, C.H.I employees received, on average, $175,000 on their equity stake with the most tenured employees earning substantially more. In stark contrast, only a select few portfolio company executives cash in with a traditional private equity model.

“It was emotional,” recalls Tucker who became chief executive in January, an internal hire after 12 years on the investment team, most recently as CIO.

“The financial impact for these frontline workers was truly transformational. They received dividends, multiples of their annual salary and they get to remain in the company.”

Alongside the financial gains, she heard how broad-based employee ownership had given C.H.I staff a much greater stake in company decisions, workplace dignity and transformed health and safety at the company.

Pete Stavros, KKR’s co-head of the Americas, has been pioneering broad based employee ownership in private equity for a while and C.H.I employees weren’t the first to benefit from the inclusive stock ownership model. But after seeing its impact for herself, Tucker now wants WSIB’s other 40-plus private equity partners to consider the same model.

“We are encouraging our partners to explore bringing ownership all the way through to the front line. It really is a win-win if it’s executed properly: more profitable firms that give access to one of the greatest wealth generation mechanisms we have in the US.”

That encouragement starts by steering WSIB GPs towards Ownership Works, a not-for-profit set up by Stavros earlier this year that provides a toolkit for GPs, LPs, and banks on the process.

“Nineteen GPs have already signed up; each one has committed to transitioning three portfolio companies every year or two and we are targeting $20 billion of wealth for lower income workers over the next decade. We are really trying to create a movement,” she says, explaining that the structure keeps control in the hands of GPs: there is no regulatory control vested with employees and it is not an employee stock ownership plan.

Influence

WSIB adding its weight to the cause won’t go unnoticed in the industry given the pension fund’s outsized and celebrated portfolio, part of a huge 48 per cent target allocation to private markets. And as more pension funds like WSIB  increase their allocations to private equity, reducing public equity exposure where companies are more subject to governance oversight and shareholder pressure, the ability of LP investors to influence ESG is keenly watched.

All the while manager selection will come under more scrutiny as pressure on private equity returns grows and studies like Harvard Business School’s George Serafeim and others show that ESG integration can lead to outperformance.

Tucker, for one, is keenly aware that rising interest rates are starting to have an impact on leverage levels in the asset class, creating a differentiator.

“Rising interest rates will make things much more challenging for private equity,” she says. “Our priority is to make sure our managers are evolving in a way that allows them to respond. On average, it is very difficult for private equity managers to outperform markets on a leverage-adjusted basis, but through manager selection, you can create that alpha.”

Environmental

Tucker is not just focused on how broad employee ownership models could transform private equity’s integration of the S in ESG. She also wants private equity managers to do much more to integrate the E given private equity’s poor track record when it comes to tackling climate change.

For her, all those red flags represent potential currents of value creation and an opportunity to differentiate.

“I would say there is a lot of opportunity for private equity partners to outperform in climate. Those red flags might be what we consider the advantages,” she says.

WSIB’s investment in three TPG Rise funds and one climate fund run by the private equity group which invests in companies driving social and environmental impact alongside returns, encapsulates that opportunity.

“It’s the first institutional scale private equity fund with private equity returns also targeting social impact of its kind,” she says.

Still, the allocation also underscores WSIB’s inherent caution regarding these kinds of investments. The initial allocation to the three TPG Rise funds falls under its innovation fund program that tests out ideas not covered by the main investment program.

“We might not have made the leap to the social impact side if we’d been limited to our main investment programs,” she says. “It’s still early days, private equity takes a long time to prove successful, and we are only five years into these TPG programs.”

She adds: “It may take us more time to move forward on climate integration than some of our peers, but we will be well served in the long-run; we are going for full integration, but it takes time.”

WSIB’s total exposure to fossil fuels stood at $5.3 billion or 3.3 per cent of the 17  commingled retirement fund assets at the end of last year. During 2022, that exposure figure has risen because of the jump in oil and energy prices.

Outlook

Tucker sees much uncertainty ahead from the end of QE to inflation; shifting geopolitics and climate change. But she believes WSIB’s strong tolerance for market volatility and ability to respond rather than be reactive will stand it in good stead. Reducing the public equity allocation in favour of private real estate, private credit and allocations to tangible assets has built in diversification and inflationary protection and she isn’t planning any major tactical changes, although the fund is holding a little more cash than normal.

She can rely on WSIB’s governance and single mission; lessons learnt from the past and a swathe of new talent and fresh ideas as a new team in key leadership roles take the reins.

“We do get through things right; we do come out on the other side. We do make it through,” she concludes.

 

 

 

 

 

 

 

Today’s challenging climate has led diversified investors like GIC, Singapore’s sovereign wealth fund, to explore different approaches to portfolio construction to build resilience. Grace Qiu and Ding Li, both senior vice presidents in total portfolio policy and allocation at GIC discussed their new research conducted in collaboration with various asset managers, at the Fiduciary Investors Symposium.

Before diving into the papers, Li described how three key components go into portfolio construction: risk, return and diversification. He said all assets are likely to have lower returns in the current market, creating a challenge for investors seeking to meet their targets. This makes diversification even more important, particularly given the increasing correlation between equities and bonds. He added that traditional portfolios are most likely to suffer in a stagflation regime.

Delegates also learnt more about GIC’s approach to diversification across different asset classes and geographies.

GIC’s investment framework is based on two layers comprising the policy portfolio, which targets long-term inflation-adjusted returns and the active portfolio, which consists of skills-based active strategies. The latter is run by internal and external managers, and aims to add value while mitigating systemic risk. Active strategies are funded by the policy portfolio, explained Qiu (pictured).

Liquidity

Qiu noted that investing in private markets supports diversification and bolsters returns but holds real liquidity risk.

Working with PGIM, GIC has published a paper, ‘Building a Better Portfolio, Balancing Performance and Liquidity’, on how to measure portfolio liquidity.

The framework has played a part in shaping GIC’s exposure to private markets via a balance sheet simulation based on the investor’s short- and long-term liquidity profile. This simulation allowed GIC to factor liquidity demands into its portfolio risk management.

Li explained that as investors hunt inflation-resilient returns and diversification, and allocations to private markets continue to grow liquidity has become a priority. He elaborated on the importance of finding a comfortable level of liquidity risk and warned that cashflows are not always constant in private markets.

Elsewhere, Li noted that maintaining strategic targets in private markets is also a challenge, requiring a commitment to keep deploying capital to top-tier managers.

Li suggested that investors capture the different components that will impact liquidity through an analysis of top-down asset allocation and capital market assumptions, and of bottom-up needs from GPs and portfolio managers. This would inform how capital should be deployed and the accompanying commitment levels. From this position, investors will be able to quantify their liquidity needs, reducing the risk of failing to meet capital calls and liquidity demands, and the ensuing reputational risk.

Diversification in emerging markets

In another paper, GIC worked with PIMCO to explore the construction of a regionally-balanced emerging markets portfolio. It found that investors should allocate broadly to emerging markets across different geographies and risk factors.

“Don’t leave these choices to index providers; design your portfolio in a granular and deliberate fashion,” said Qiu. Leaving emerging market allocations to index providers risks an imbalanced allocation in terms of risk and region, with indices often dominated by Asian public equity.

“Diversification is the only free lunch in finance,” she reminded delegates.

Qiu also noted that investing in emerging markets is an important source of return despite the higher degree of uncertainty associated with it. It typically has a lag or tail, and often goes through boom-and-bust cycles, she explained. Rather than espousing one strategy over another, Qiu said the key is to construct a multi-asset allocation beyond public equity, adding that investors should “allocate in a granular manner.”

She also suggested that skilled, high-conviction investors can add value through a dynamic overlay over their long-term strategic asset allocation to emerging markets.

Referencing a third paper, co-authored with Blackrock, Li discussed how GIC factors in uncertain macro scenarios into its portfolio construction processes.

The idea is based on constructing a portfolio with a more balanced outcome, and compared to an alternative approach, focusing on better handling downside outcomes where diversification is also key. Examples include investing in US equity to balance Chinese equity exposure, and increasing investments in real estate to counter stagflation.

Qiu also highlighted GIC’s ongoing work with MSCI to explore how macro risk will impact asset returns over the long term. The paper provides a framework that is consistent across asset classes, and will be published in the latter half of this year.

Qiu and Li concluded that investors should not rely on a single toolbox for diversification, and highlighted the importance of geographic diversification given today’s geopolitical tensions. In addition, to address the risk of stagflation, investors should consider portfolios comprising inflation-linked bonds, gold, and commodities, as well as private real assets.

Randall Kroszner, Federal Reserve governor from 2006 to 2009, praises the Fed for acting decisively to bring inflation under control, but predicts a lot of pain ahead for global markets.

It will be “very difficult” for the United States to avoid “at least a mild recession” as monetary policy is tightened to avoid runaway inflation, according to former Federal Reserve governor Randall Kroszner.

Kroszner said there were only two times in his 35-year professional career that he hadn’t been optimistic about the future, speaking at Conexus Financial’s Fiduciary Investors Symposium held between May 23-25 at the Chicago Booth School of Business. One was when he was at the Fed staring ahead at the Global Financial Crisis, and the other time is now.

He pointed to the impact of the war in Ukraine and rising sanctions, along with the aftermath of the pandemic and ongoing supply disruptions and lockdowns in China. While it was the right decision for the Fed to decisively tighten monetary policy, the combined impact on markets would be painful, he said.

“I think it’s going to be very difficult to do it without at least a mild recession,” Kroszner said. But while he admitted “there’s a chance for a lot more negative stuff” and there is a lot of uncertainty, he is not anticipating a deep or prolonged recession with persistent inflation–the so-called “stagflation” scenario–despite inflation being at its highest point in 40 years.

“Inflation expectations certainly have moved up, and in the short run they’ve moved up very significantly, but in the intermediate to longer run they’re basically at the upper edge of the range that they’ve been in over the last decade,” Kroszner said. “So not wildly out of sync with where they have been.”

Kroszner is the Deputy Dean for Executive Programs at the University of Chicago Booth School of Business and Norman R. Robins Professor of Economics. He was Governor of the Federal Reserve System from 2006 to 2009, and represented the Federal Reserve Board on the Financial Stability Forum–now the Financial Stability Board–as well as on the Basel Committee on Banking Supervision.

Speaking with American historian, academic and author Stephen Kotkin, Kroszner praised the Fed for moving quickly in “50 basis point chunks.” By raising interest rates decisively, the Fed is ensuring it doesn’t lose its credibility and that inflation expectations don’t get out of control, he said, despite acknowledging there is evidence it would have been better for them to raise interest rates earlier.

While tightening monetary policy will be painful for markets, “it would be much more painful in the long run if they didn’t move quickly,” he said, noting it is politically more palatable to raise interest rates at a time when unemployment is low. While the Fed was created to act independently of political pressures, it still needs to take into account the environment in which it is operating, he said.

“Traditionally the Fed was there to take the punch bowl away when the party really gets going, only that hasn’t happened for 30 years,” Kroszner said. “For 30 years, the Fed has been like a good neighbour. The Fed is there to provide support if there’s a global financial crisis, there’s a panic. And so you’ve got two generations of policy makers, of market participants, of citizens, who don’t think of the Fed as having that responsibility. 

“And actually, I think it makes it a bit tougher for the Fed to be able to pull the punch bowl away, than for [Former Federal Reserve chair Paul Volcker] to do it, but they have the opportunity to do it now. They should be moving quickly,” Kroszner said. “I think it’s going to be very difficult to avoid a significant slowdown and even potentially a recession. 

Kroszner said the Fed learned hard lessons from its Great Depression mistake of being passive despite falling GDP and soaring unemployment, which resulted in a collapse in the money supply as people were trying to hold cash and banks were holding their reserves.

Staring ahead at the Global Financial Crisis alongside then Federal Reserve chair Ben Bernanke in the late 2000s, Kroszner said he and Bernanke were determined not to repeat the same mistake, and so undertook a variety of large-scale asset purchases now known as quantitative easing, “to make sure that the financial intermediation system continued to work, to make sure that we didn’t have crushing decline in the money supply, and deflation.”

They also ensured a “good exit strategy” such as withholding interest on reserves as a whole, to avoid hyperinflation as the Fed’s large balance sheet turned into excess money supply.

Kroszner said he felt these decisions were vindicated in the following decade as the worst predictions of hyperinflation didn’t play out. And he was heartened the Fed “ran the same playbook” when the pandemic set in, suggesting the programs he and Bernanke had put in place were “worthwhile to revive” rather than seen in retrospect as flawed policies.

Kotkin asked if the US “just got lucky” in the 2008-09 running of the playbook.

Kroszner said there were differences this time that explained the different inflation outcome. There was a much larger amount of monetary stimulus, a much larger amount of fiscal stimulus, and there were very different shocks to the economy owing to lockdowns.

“We were seeing this incredible contraction and expansion of the economy, which the economy is just not used to doing,” Kroszner said. “It’s just not structured to have these lockdowns and then rebirths, immediate rebirths. And so you have the supply constraints, you have a lot of disruptions that make it difficult for the economy to come back.

“And with so much more stimulus, you are then led to this situation where you have much higher inflation now. Even though the types of responses were similar–strong monetary responses to a crisis–the economy is recovering much more strongly [this time], I mean the unemployment rate is under four per cent.”

This explains the different inflation outcomes of the two crises, he said, but the key lesson from both crises remains the same: “Act boldly and act quickly, which I think the Fed did in both cases.”

The investment industry has always struggled to fend off short-term pressures that prevent it from being genuinely long-term, to the benefit of end beneficiaries. This despite much evidence to support the existence of a significant long-term investment premium – up to 1.5% per annum according to TAI research. A premium of this size can only exist if it is hard to capture. I assert that it is hard to capture for behavioural reasons, which are exacerbated by traditional performance reporting. As a consequence, many investment mandates being terminated for the wrong reasons and at the wrong time.

To rectify this and to promote a longer-term outlook, TAI has collaborated with members (particularly Baillie Gifford, MFS, S&P Dow Jones Indices and WTW) to devise a methodology and framework that allows portfolio evaluation to be based not only on market-value returns, but also on changes in fundamental attributes over time. This new attribution and monitoring framework – called Fundamental Return Attribution (FRA) – separates a portfolio’s returns into three main components:

  • Returns arising from changes in market sentiment (multiple return)
  • The growth of the portfolio’s fundamental characteristics (growth return)
  • The change in these fundamental characteristics due to changes in the portfolio’s holdings (activity return).

In our view, decomposing returns into these three components enables a deeper understanding and assessment of how an investment strategy generates returns. Compared to more traditional attribution methods (that focus on explaining returns by reference to the performance of different groupings of securities), this approach considers how the decisions of the asset manager within their investment process generate the portfolio’s returns.

The approach separates out returns arising from changes in short-term market sentiment (essentially noise and, arguably, mean-reverting around zero impact over the long term), enabling a longer-term outlook by asset owners and asset managers when evaluating recent performance or setting future return expectations.

 The FRA methodology – which is described in more detail in our research paper – should allow all institutional investors to think differently about investment performance and how it is reported. And in turn should improve the quality of conversations between asset managers and asset owners about the long-term return drivers of an investment strategy, particularly during periods of underperformance. This may prove quite helpful in the predicted forthcoming period of significant turbulence. In addition, it should also help broaden the conversation to include how the quality of underlying decision-making can produce sustainable long-term returns.

This FRA framework can be applied to all asset classes but, as with any single measurement methodology, it may be more applicable to some mandates than others. Currently, it has been applied to portfolios using company fundamentals, but there is potential to apply it to other characteristics that investors increasingly wish to monitor or manage in their portfolio.

Some of our members are already making use of this methodology to assess equity managers and expect to widen that to other asset classes.

They have found it to be particularly helpful in understanding what has been driving performance when there has been a divergence in fundamentals and stock price performance in the wider market.

In future, we think this methodology will also be able to support investors who seek to align their portfolios to ESG objectives but are struggling to identify if a portfolio’s decarbonisation is, for instance, due to underlying companies reducing emissions or the divestment of high-emission companies. We believe this framework, and an enhanced version of the tool, could provide much needed clarity into how ESG objectives are being managed and achieved.

A significant part of the Institute’s mission is to influence change in the industry and we believe this framework can achieve this if widely adopted. To that end, we are open-sourcing on Github.com the underlying computer code as a way of making it easy for investment organisations to apply this framework to their own portfolios and to develop more meaningful reporting tools.

The genesis of this research was to find a monitoring tool that gave the asset owner sufficient confidence to retain a currently-underperforming-but-high-quality asset manager. That would counteract the behavioural forces pushing for termination and would, further, allow the capture of that long-term return premium. Our hope is that FRA will turn out to be a very valuable contribution to the investment industry and the end beneficiaries we serve.

Tim Hodgson is co-head of the Thinking Ahead Group, an independent research team at WTW and executive to the Thinking Ahead Institute (TAI).