Founding Partner James Brooks on using sustainability strategies to revolutionise private equity decision-making and create value

Financial markets are changing rapidly as two mega trends, sustainable investing and big data, converge to drive a dramatic shift in capital allocation. This disruption is compounded by future markets becoming more volatile, uncertain, complex, and ambiguous.

Today, no investment firm can consider itself sheltered from this upheaval. Disruption has two sides: the potential threat, but also the opportunity to create new models. Successful innovation in private equity investing requires a firm to embrace and exploit emerging trends faster than the rest of their market.

Studies have proven that there is no trade-off between investing sustainably and generating returns in public markets¹, and that ESG-focused hedge funds have generated higher returns with lower volatility than their non-ESG counterparts². These principles also apply to the private equity market; however, over the last decade average returns from private equity have converged with public equities. A small handful of top quartile funds have retained an advantage based on a proven, repeatable investment strategy³.

Applied correctly, sustainable investing concepts could be the answer to creating strategic advantages, taking companies from good to great and having a system-wide impact across a portfolio. As a result, private equity firms implementing these concepts will find repeatable advantages, create scarcity value, and retain their allure to asset allocators. What Mark Carney describes in relation to climate change as the “tragedy of the horizon” and the need to “bring the future to the present”⁴ can be applied to all investment decisions and create repeatable higher return, lower risk portfolios.

To apply this new approach, the private equity decision-making process needs to be enhanced. Its historical reliance on monochromatic financial risk and return metrics, blending ‘risk’ into scenarios built on subjective interpretations, needs to evolve dramatically. A couple of recent market trends are combining to provide a framework for revolutionising how decisions are made:

• Faster and more accurate analysis: AI and modelling technology is allowing simpler disaggregation of risk baskets and the identification of patterns. They also allow decision-makers to spot asymmetry between targets across wide, dispersed data sets more easily than ever before
• A stronger framework: Modern sustainability frameworks can be used as a tool to deepen company understanding. As a different lens to overlay on traditional models, they provide clearer compartmentalisation of risk, as well as incentivise the collection of new comparable data across multiple dimensions

When harnessed together, these two trends can increase insight availability, accuracy, and speed of decision making ahead of the competition.

The right application of these strategies requires a differentiated operating model. Investment teams must dedicate the time required to learn about emerging ESG concepts, adopt more sophisticated models for risk management, and re-engineer their decision-making processes.

Like all forms of disruption, incumbents may continue to operate as normal before reaching their ‘Kodak’ moment after new leaders emerge. Big Data capability is a key enabler of future private equity investing, and sustainable investing frameworks will be the rubric for success – how long will it be before it is the new standard?

Sources:

[1] JP Morgan, Sigert, 2021 “Doing good and doing well: ESG trade-offs in investing” (https://am.jpmorgan.com/gb/en/asset-management/adv/insights/portfolio-insights/ltcma/doing-good-and-doing-well-esg-trade-offs-in-investing/)

[2] Wolinsky, Forbes, “How do ESG Hedge Funds Stack Up Against their non-ESG Counterparts?” (https://www.forbes.com/sites/jacobwolinsky/2021/09/24/how-do-esg-hedge-funds-stack-up-against-their-non-esg-counterparts/?sh=5f22569b28b2)

[3] MacArthur, Bain, 2020, “Public vs. Private Equity Returns: Is PE Losing Its Advantage?” (https://www.bain.com/insights/public-vs-private-markets-global-private-equity-report-2020/)

[4] Mark Carney interview, GreenBiz online magazine, February 2021 (https://www.greenbiz.com/article/mark-carney-how-we-get-finance-act-climate#)