Dynamic investors are well-situated to bring their capabilities to bear on issues like decarbonisation.
Private equity’s total assets, up nearly sixfold from 2004 to 2019, are poised to grow steadily over the next four years.
Private equity has an immense amount of capital at its disposal: US$5.8tn in 2019, and rising as high as US$8.3tn by 2025, according to PwC analysis. In an evolving and dynamic world, PE firms are important providers of liquidity, debt and equity—catalysts for growth and transformation. In the US alone, 5,000 private equity firms have investments in some 35,000 businesses that collectively employ 8.8m people. PE firms also serve as intermediaries for remarkably deep pools of capital: university endowments, public employee pension funds, sovereign wealth funds. And among these stakeholders, expectations are rising rapidly that stewards of capital—be they CEOs of companies or PE firms—play a more active and constructive role on a range of environmental, social and governance (ESG) issues, especially those related to decarbonisation. Exhibit A: the declaration by US$7tn BlackRock that climate will play a central role in its investment considerations.
One way PE firms can do good is by doing what comes naturally: function as an accelerant of existing trends by providing capital in large tranches, thereby enabling companies to gain scale and bring down costs further. Last January, for example, CVC Growth Partners invested US$200m in EcoVadis, a Paris-based company that provides ratings, tools and software aimed at boosting sustainability in global supply chains.
Another approach could be more powerful. Years ago, it made sense for a PE house to buy carbon-intensive assets and mine them for value and cash flow. That’s still a viable strategy for some investments. But one need only look at the public market valuations of companies in the auto manufacturing ecosystem to realise that clean(er) business models yield a much higher value multiple than companies that are perceived to be less clean. One path to pursue now, given this reality, may be what we call “buy dirty and cheap, sell clean and expensive”: an impact turnaround. That would mean, say, acquiring a merchant power generator that relies primarily on fossil fuels at a multiple of six times earnings and transforming it into a lower-emission fleet that can yield a multiple of ten. Or investing in equipment makers that cater primarily to the legacy automotive sector and pivoting them into electric vehicle technologies. Or transforming waste management companies into circular economy players that can recycle and reuse materials instead of burning or burying them, and create renewable energy in the process.
For a private equity firm to announce that it will strive to reduce emissions in its own operations and offices is admirable. But what if PE firms were to promulgate a similar set of ambitions for their portfolio companies, regardless of geography and sector—to become net zero by, say, 2035? Keep in mind that the portfolios may include businesses as varied as retailers in Asia, mine operators in Australia, steel manufacturers in Europe and hospital systems in the US. That’s a much larger commitment, and a much more significant challenge.
As they have evolved over recent years, PE firms have already shown a capacity to apply best practices and strategies across diverse portfolio companies. Many have developed in-house expertise in logistics, HR and technology that can be leveraged to improve the performance of all investments. What if carbon reduction or elimination became the next cross-portfolio area of expertise? Blackstone has already set a goal of reducing emissions in new acquisitions by 15%.
What we’re suggesting is that ESG measures—including decarbonisation—could be embedded into the powerful and sophisticated value creation plans that PE already has. PE firms have proven, as a class, to be world beaters when it comes to creating value by taking costs out of business. With carbon increasingly becoming a cost—through direct taxation or limits, outright bans on certain products, or investor and consumer demand for reductions—it makes all the more sense for investors and owners to focus on it. And it is entirely consistent with realising a profitable return.
It’s not too far-fetched to imagine a world in which a PE fund’s carried interest could be linked to, in addition to financial returns, progress on decarbonisation. Such a change would allow firms to more naturally ally with the changing demands of investors. As noted, sovereign wealth funds, university endowments, public employee pension funds and mainstream institutional investors are steadily ratcheting up the requirements on a range of ESG topics. Critics may dismiss this trend as “woke capitalism.” But the trend is real and irreversible. Early last year, KKR raised a US$1.3bn Euro Global Social Impact Fund, which promises to invest in companies that provide solutions to environmental or social challenges.
PE funds are intermediaries that have earned the licence and built the capacity to drive change more aggressively and quickly than other investors. The focus on ESG efforts fits neatly into the system in which PE has operated successfully—aligning ownership, strategic intent, governance and incentives over a longer timeframe. Precisely because of this ability, PE has a significant and distinctive competitive advantage compared with publicly held companies in tackling issues such as climate change—and doing so profitably. In 2021 and beyond, putting PE’s muscles to work on ESG improvements such as reducing emissions will go well beyond reputation-building—although the recognition that will flow from such successful efforts will be salutary. Rather, it’s about retaining an edge in a remarkably competitive environment while contributing to societal improvement.
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