Our thinking Quick reads Private markets: sustainability for institutional portfolios
 
Credit and private debt
May 2021
9 min read

Private markets: sustainability for institutional portfolios

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With the global COVID-19 pandemic in its second year now and with the immense uncertainty that institutional investors still face, investment strategy reviews should be high on the agenda (if not already completed!). With the extreme market volatility experienced in the last year and sharpened focus on ESG, investors have been given a wake-up call to reassess their strategic asset allocations: rethinking or enhancing the role of portfolio diversifiers and the role that ESG and sustainability strategies should have within their portfolio.

Whilst formal investment strategy reviews are typically only carried out every three or five years by institutional investors, the combination of the COVID-19 pandemic and the sharpened focus on ESG & sustainability has provided a natural opportunity for investment decision-makers to conduct interim reviews of their portfolios to ensure they are more robust and as resilient as possible to future exogenous shocks, while also effecting positive change in the world.

Indeed, last year’s proverbial ‘black swan’ has served as a stark reminder to investors that extreme, unexpected and unprecedented events do happen and can have a major impact on the global economy (and along with it highly correlated asset classes). This has underlined the need to embed integrated, multi-asset investment models, which may represent a move away from historical and outdated approaches. Additionally, the shift of sustainable investing to the mainstream, underpinned by regulatory changes such as the EU taxonomy, the EU Sustainable Finance Disclosure Regulation (SFDR) and climate-related financial disclosures (TCFD), has prompted many institutional investors to revisit their approaches, and to give greater consideration to what ESG goals they want to pursue when making strategic asset allocation decisions.

Against the economic backdrop of low risk-free rates and stretched equity valuations, investors are being challenged when seeking out opportunities in the traditional asset space that will continue to deliver attractive risk-adjusted returns. We think that the arguments for institutional investors to increase exposure to alternatives, more specifically to private market strategies, when setting strategic asset allocations are now stronger than ever, not only in terms of portfolio optimisation but also to meet their ESG and sustainability requirements and goals.

Private market allocations can help meet ESG targets

Regardless of the asset class in the private markets space, those that are integrating their investment approach with a strengthened ESG mindset are helping to futureproof themselves against significant uncertainties.

Looking across the asset class spectrum, listed equity investors have long been the first movers in the ESG and sustainability space, with access to sustainability data allowing them to identify and act on risk within their portfolios. The momentum within the fixed income space has grown substantially in recent years as the recognition of ESG risk alongside credit risk has grown, though there are still diversification challenges for investors in the green bonds markets with issue numbers currently limited and concentrated in a handful of sectors, not to mention the lack of coverage in high yield bonds.

For private market investors, while access to ESG data to ascertain risk and opportunity may be harder to obtain in the first instance, the potential for a number of alternative assets to improve their sustainability credentials – or indeed boast a sustainable purpose in the first place – is very high relative to traditional asset classes. As such, asset class allocation and ESG considerations should be seen hand in hand when considering an investment strategy.

Besides the obvious diversification benefits and yield opportunities that private markets can offer, some inherently align with establishing an approach to responsible investment and their high relevance to sustainability is two-fold: firstly, the ability to identify and manage material underlying ESG risks and opportunities can protect and enhance the financial performance of underlying assets; and secondly, the purpose and the ESG performance of the asset itself can be used as a main driver to pursue real-world sustainability outcomes.

In the case of private equity, ESG risks and opportunities can be wide-ranging depending on the sectors involved. It is important for a pragmatic approach to be implemented that seeks out where the potential impact on value is material and how this can be acted upon effectively. The natural focus on ownership and engagement helps to navigate company operations away from potential operational disruption, breaches of compliance and liabilities resulting from ESG risks towards improved management controls, demand for goods and services and strengthened competitive position. For example, imagine you take a majority stake in a strong, well-managed food and beverage company, whose revenues are partly linked to palm oil and by extension activities relating to deforestation. As a private equity investor, your seat on the board could be the key to effecting positive change and shifting this source of revenue to a more sustainable alternative, which has the potential to increase demand for the company’s goods as consumers increasingly factor sustainability into their purchasing decisions and consumption patterns.

Private debt also carries many similar characteristics from a sustainability perspective and many of the same principles hold true. Consider the same food and beverage company seeking access to capital. Regardless of whether you are investing in the equity or debt element of the capital structure, the sustainability of the company’s business model (through its connection to future profitability and therefore ability to repay its debts) holds weight in your decision whether to lend to this company, and on what terms. Investors who focus on risk management and transparency from issuers can curate high performing portfolios with strong ESG credentials and credit risk profiles more broadly.

Infrastructure’s relationship with sustainability is often very clear. For most, those two words – infrastructure and sustainability – immediately bring to mind images of wind turbines and solar power plants which have become core to meeting the energy needs of our populations. These are long-term assets that are dependent on a social license to operate and a resilience needed to survive in a future low-carbon world. Investors who identify and select infrastructure assets through a robust ESG process not only establish a reliable source of long-term value, but also generate significant positive environmental and social impact – realising action that many stakeholders want to see.

Within real estate, the opportunity is arguably even greater. The building sector contributes an astounding 30% of global annual greenhouse gas emissions and consumes approximately 40% of the world’s energy, making it an important puzzle piece in achieving the goals of the Paris Agreement1. A structural shift towards green and sustainable buildings is not only much needed but has the potential to deliver substantial socioeconomic benefits beyond simply reducing emissions, for example by improving the quality of life for the users of buildings and creating positive impact for the surrounding community.

Regardless of the asset class in the private markets space, those that are integrating their investment approach with a strengthened ESG mindset are helping to futureproof themselves against significant uncertainties. Not only can investors maximise value growth and preservation this way, but they can also realign their purpose to be able to deliver more than just financial impact.

The Past, Present and Future of Allocations to Alternatives

It is fair to say that there are some institutional investors who have been reluctant to allocate to alternative asset classes due to the complexities of these strategies and the increased governance burden. However, there has been growing awareness among investors that alternatives are more accessible than previously thought. According to recent analysis by the Thinking Ahead Institute2, when aggregating the asset allocations of the world’s seven largest pension markets (US, UK, Australia, Canada, Japan, the Netherlands, and Switzerland), just 7% of assets were allocated to alternative asset classes in 2000, compared to 26% in 2020. We expect this trend to continue, particularly in the UK, where the Chancellor announced in his recent Spring Budget that the Government would launch a consultation to remove barriers in Defined Contribution pension regulation (such as the 0.75% default fund cap charge and liquidity constraints) that have previously discouraged these schemes from investing in alternatives. Unleashing this untapped pool of capital could potentially provide strong tailwinds for alternatives, as well as creating more exit opportunities for existing investors in secondary markets.

Investors yet to explore alternatives due to portfolio constraints (such as liquidity) should consider broadening the opportunity set to include allocations to alternatives as part of their investment strategy reviews. The main downside of alternatives, in particular private markets, is the relative illiquidity; however, even holding in traditional close-ended structures that do not allow redemptions can often be traded in the (growing) secondary markets. Also, it is worth noting that these strategies can sometimes be accessed through more liquid structures, as there are some that are listed on stock exchanges and investors can trade shares in the secondary markets (but this does result in additional equity price volatility as the trade-off) and many investment managers are increasingly offering open-ended structures, with quarterly or semi-annual liquidity. Nonetheless, the assets are inherently illiquid, regardless of the structure in which they are offered to investors and so the ability (or desire) to take on illiquidity risk should be a key consideration for investors.

Those who can capitalise on the need to create more resilient portfolios while affecting positive change in the world will be particularly appealing to the likes of institutional investors.

Conclusion

With the global COVID-19 pandemic in its second year now and with the immense uncertainty that institutional investors still face, investment strategy reviews should be high on the agenda (if not already completed!). With the extreme market volatility experienced in the last year and sharpened focus on ESG, investors have been given a wake-up call to reassess their strategic asset allocations: rethinking or enhancing the role of portfolio diversifiers and the role that ESG and sustainability strategies should have within their portfolio. Some institutional investors have done so, but others are behind the curve. Those who can capitalise on the need to create more resilient portfolios while affecting positive change in the world will be particularly appealing to the likes of institutional investors, such as local government pensions schemes and university endowments, who face increasing pressure to answer to their members and stakeholders to invest responsibly.

[1] Sustainable Real Estate Investment: Implementing the Paris Climate Agreement

[2] Thinking Ahead Institute: Global Pension Assets Study 2021

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