The Sustainable Development Goals (SDGs): Driving resilient returns and performance excellence in private equity
Last year, private equity had its most successful year to date, with the largest number of new funds raised, according to Hamilton Lane’s latest report. Over the course of 2018, around $1 trillion was committed to funds, up from just $200 billion 8 years ago. Resilient returns have been a key driver of this growth. Whilst private equity has rarely found itself at the top of the class overall, it has consistently delivered good returns and investors are unlikely to lose their money entirely. This steady performance, most markedly seen in developed markets such as the United States, reflects the solid nature of the underlying assets and the environment in which these companies operate.
However, the sector faces a challenge. Drifting returns and increased volatility risk is being felt across the market. A strong factor in this is swelling asset prices. In 2018, the sector average EV/EBITDA ratio was 10.5, compared to 8.2 in 2012. These higher prices increase pressure on managers to deliver ever more effective transformations in order to justify higher purchase prices and deliver returns to investors. With market seeming to have cooled and worsening economic conditions expected over the next few years, many are nervous.
Yet private equity managers have ace card compared to their listed market managers. Once the vision has been realised and the planned transformation complete, if market conditions are not favourable, managers can then chose to wait to sell. With control of asset sale timing in their favour, negative returns can often be avoided. However, the cost of waiting is lower annualized returns due to the longer time horizon and there is an additional risk that industry conditions or the market context changes. With so many megatrends colliding at this time, preparing for the unexpected is more challenging than ever.
How can good managers address this risk? Firstly, a deeper understanding of the market, company and context. The right expertise, consisting of sector specialists, those with prior experience of a down cycle and a team that profoundly understands the operating environment of the asset, including the culture, communities and country in which it operates. With the right team on board, deep and ongoing investment in market understanding is essential and funds should invest in the right infrastructure to make this possible. Thirdly, the team must embrace what is fast becoming the most in demand skill among effective managers, the ability to manage and embrace large amounts of complexity in order to introduce deep resilience.
On all three of these counts, the sustainability lens adds value. This long-term, systemic perspective captures effects that might ordinarily be viewed as externalities, creating a richer view of the operating environment, supply chains and downstream impacts. An experienced hand would have a good sense of these and be able to judge their importance, including how this changes in a more challenging context.
Seeking to identify some of the big risk factors that could impact the market, the World Economic Forum’s Global Risks Perceptions Survey 2017–2018 identified the most likely and impactful risks. Many of these are the result of complex issues such as climate change and geopolitical dynamics, resulting in cyber attacks, food crises, extreme weather, and water shortages, for instance. Whilst these events will likely impact any business operation, it would also impact the context in which it operates, leading to ripple effects that go far beyond business as usual.
The capacity to understand the physical and financial environment, as well as, the ability to go beyond the spreadsheet by considering a wide range of individually unlikely but collectively material issues, in other words, to take a systemic view, is a key skill for top management talent today. What an analysis of this type makes clear is that investing in the resilience of an asset means taking a closer look at the context and system in which the business operates to see how sustainable it is.
The dominant framework for investors considering sustainability issues is the United Nations’ Sustainable Development Goals (SDGs). The goals create a vision and route for sustainable growth and support effective management of fiduciary duty by investors. By laying a path by which success is an inclusive aim, they provide minimum aims for society, an important perspective in any systemically-informed strategic view. By taking this wider outlook, opportunities may arise to contrast this with a more traditional approach, uncovering risks and opportunities that might otherwise be missed.
The advantages reported for considering these questions are a greater awareness of trade-offs and how to manage or mitigate negative impacts. Opportunities to add social value as well as economic value, the financial results of which are often picked up in other ways, be it employee goodwill, standing of the employer in the community, relationships with governments and NGOs or even opportunities to enter new markets. Taking such a view creates an opportunity to leverage the insight with other parties that may have an interest in outcomes, including governments, lenders, industry bodies and NGOs who are engaging with the SDGs. The insights are particularly valuable in emerging markets.
As well as informing a higher level of operational resilience of an asset, sustainability can assist funds in other ways. Investment policy decisions can be informed by the SDGs, as well as contributing to wider communication about the activities of the fund. The SDGs provide a common language and framework for communicating positive impact, for instance, job creation, contribution to society through taxation and the improvement of industry standards. Further, fund managers indicate an interest in reporting on these factors by prospective and existing investors. Tomorrow’s most successful funds may well be those that consider the SDGs.
Brigitte Small, partner at Ampersand can be reached at brigitte@amplab.co and on Twitter @SmallBrigitte
