Sustainable private equity combines the investment merits of an attractive asset class with a promising investment theme, says Andrew Musters, who is spearheading the sustainable private equity fund of funds initiative of Rabobank and Robeco.
Over the past decades, alternative investments have become more and more established as valuable additions to the investment portfolios of many institutional investors. An important category of alternative investments is private equity, which is concerned with the provision of equity capital to private (ie, non-public) companies.
Looking at the market for private equity, the US is leading, with Europe in second place. From 1981 through 30 September 2003, over US$1,400bn was raised by private-equity funds worldwide (Source: Venture Economics). Investor participation, especially amongst institutions such as pension funds and insurance companies, grew strongly until the global economic slowdown in 2000. Since then, investors have been allocating capital to private equity more sparingly. For 2003, funds raised were more in line with the long-term market average than the allocations around the turn of the century.
In a traditional risk and return framework, the main reason for investing in private equity is its performance, which can be characterized as providing attractive returns, relatively low risk and relatively low correlation with other asset classes. As a result of these characteristics, adding private equity to an investment portfolio can offer significant benefits.
Since the establishment of the World Commission on Environment and Development by the United Nations, sustainable development has become more and more interpreted and accepted as an overarching concept to ensure the continuity of our planet. Sustainable development is defined as development that meets the needs of the present without compromising the ability of future generations to meet their own needs. As an economic imperative, sustainable development has inspired new legislation geared to incorporating social and environmental costs, both at the supranational level as well as in national jurisdictions around the globe. This irreversible trend is gradually changing the economics in important supply chains and has made social and environmental criteria important factors in business decisions. As a result, sustainability is also rapidly gaining ground in the financial-services industry. A concrete example of this is the emergence of sustainable investing, which is an investment process that, in addition to pure financial criteria, takes social and environmental aspects into account.
Looking at the market for sustainable investing in public equity, one can see that it has grown substantially over the past decade. In the United States, professionally managed assets in sustainable or socially responsible investment portfolios rose from US$1.19trn in 1997 to US$2.16trn in 2003 (Source: Social Investment Forum). In Europe too, the institutional market for sustainable investing has become of significant size with E336bn of assets under management (Source: Eurosif). For the future, continued growth of assets invested in a sustainable manner can be expected around the world, partly as a result of new legislation that may force pension funds to publish to what extent social and environmental criteria are factors in their investment decisions.
Sustainability can enhance the profitability of companies. This is supported by a vast body of academic research that indicates that there is a positive or at least non-negative relationship between sustainable investing and financial performance. A similar conclusion can be drawn when a commonly used quoted sustainable investing index, the FTSE 4Good Global 100 Stock Index, is compared to the MSCI World Index over a longer period.
Rationale for sustainable private equity
Until recently, sustainable investing has primarily focused on investment in public equity and, to a limited extent, bonds. A well-diversified institutional investment portfolio however also includes other asset classes, such as private equity. From this basis, it is a natural progression for socially and environmentally conscious investors to expand their investment portfolios with sustainable private equity investments.
Private equity is, more than other asset classes such as public equity, focused on companies with innovative technologies and new business concepts. In the context of sustainability, innovation towards less energy and material intensive production and consumption alternatives is more and more becoming an economic necessity and a matter of corporate survival. Although there is no one single path to sustainability, technological advances in areas such as nanotechnology, biotechnology, energy technology, material technology, and information and communication technology all point to the possibility to meet the needs of a growing world population in a satisfactory way without sacrificing natural or social capital. The vast majority of fast-growing companies with exciting new sustainable technologies are too small to be listed on stock exchanges. Therefore, the only way to invest in these appealing companies that can offer highly attractive investment returns and at the same time contribute to sustainability is through investing in private equity.
Sustainable private-equity market
Sustainability is gaining momentum in the private-equity industry. This can be seen by the increasing number of dedicated sustainable private-equity funds coming to the market. These funds can be classified based on the distinction between the People (social) and the Planet (environmental) aspects of sustainable investing. Within the environmental sustainable private-equity field, funds are typically focused on new forms of energy, new food, agriculture and nutrition technologies and new ways of utilizing resources, including water. Within the social sustainable private-equity field, the focus usually is on developing regions and the use of the talents of minorities in commercial business. At present, the most attractive investment opportunities in the universe of dedicated sustainable private-equity funds are found in the environmental field.
Sustainability is also becoming increasingly important within the mainstream private-equity sphere. This is exemplified by mainstream private-equity funds starting to explicitly include the environmental industry as a target investment sector. Moreover, the number of mainstream private-equity funds contemplating incorporating sustainability in their investment decisions is growing. This increased focus on sustainable investing presents attractive investment opportunities for private-equity investors, as socially responsible private-equity practitioners are often well positioned to capture benefits deriving from changes in the business environment due to social developments and environmental legislation.
Selecting top quartile sustainable private-equity funds is not an easy task, given the broad range of skills required in the fund-selection process. That is, in order to fully understand the dynamics of the sustainable private-equity market, knowledge and experience in the fields of private equity, sustainability and various technologies (eg, energy, environmental and nutritional) is of importance. Moreover, given the dedicated focus of many sustainable private-equity funds, investing in a single fund may result in a relatively high risk profile for investors. However, these challenges can be overcome by investing in a well-diversified sustainable private-equity fund of funds that is managed by an institution experienced in and capable of integrating private equity and sustainability. In this way, investors can invest responsibly and profitably in companies that are ahead of the wave and that have successfully incorporated the new rules and market opportunities into their business strategies, thereby decreasing their risks and maximising their upward potential.
For further information, please contact Andrew Musters of Robeco Alternative Investments.
Tel: + 31 10 224 7240