Suyi Kim, global head of private equity at CPP Investments manages quite possibly the largest private equity allocation in the world. At C$146 billion, equivalent to a quarter of the entire C$575 billion pension fund for some 21 million Canadians and forecast to grow bigger every year, Kim leads a program that is also heading into unchartered territory.

In conversation with Top1000funds almost exactly two years since her promotion to the top job, she is mindful of how the portfolio’s size could impact its ability to continue to generate the pension fund’s strongest return of 15.5 per cent on a 5-year basis.

“We are a battleship not a speedboat compared to other programs,” she says.

Kim believes the primary source of the portfolio’s success derives from the quality of the private equity team; its synergy, level of communication and mission-driven culture.

“This is what is going to allow us to outperform the market,” she says.

Yet at 190 people and counting and spread across global divisions that now include an office in Mumbai, ensuring smooth communication is, she says, intellectually challenging.

“The larger the team, the harder the task of maintaining the culture that allows us to outperform and my continual focus is making sure we are working well as a team.”

For example, a key element of team functionality is that different divisions (the portfolio is divided in four departments) work together so that insights gained by one team feed into decision making in another. It provides a level of analysis that goes much deeper than just persistency of returns, she says. “We’d never just re-up with a manager without cross referencing with our other strategies to inform how the manager will perform.”

Partnerships pay

CPP Investments’ GPs are also part of the extended team and the fund’s long-term partnerships have been integral to the portfolio’s success. Back in 2007 when Kim began what would turn into a 16-year stint heading up the fund’s Asian private equity business (she was the firm’s first hire outside Toronto when the portfolio was just C$4.4 billion) partnering with expert GPs was the main strategy.

“If you are not the best investor in the market you need to work with the best, and when we first started out, we were nowhere near the best,” she recalls.

Manager relationships, across the funds and secondaries and direct investments divisions are, she insists, much more art than science and manifest in an understanding of how the other side is going to work. The relationship is based on transparency and trust in the other’s ability to deliver.

Size and scale have helped build GP relationships, but again, it is easy to see how size can become an obstacle. One of the challenges today is making sure the fund’s processes keep up with partner GPs yet this is sometimes slowed down because investment decisions go through various stages of approval.

“For a large-scale deal, we have to go to the global investment committee and even to the board in some cases,” she says. “Our job is due diligence, and for deals that require a level of speed that makes the due diligence difficult, well, we won’t do the deal. I like to be able to sleep at night.”

focus on Quality in a challenging Market

Kim is also preparing for tougher returns in the asset class ahead. Higher interest rates signpost a higher cost of doing business that will impact portfolio companies’ performance and multiples. But she doesn’t believe this will feed through into valuations until 2025-2026.

“When we look at the investment case, higher interest rates will have an impact on the multiple but so far market multiples still haven’t changed that much,” she says.

Unless interest rates start to come down soon (and she doesn’t think that is particularly likely) leverage will remain high and the free cash flow will be lower along with the return to investors. She says private equity players that went through the GFC have “learnt their lessons and built in more of a cushion” but she is concerned that an expectation gap continues to persist between buyers and sellers.

“I have to remind our senior managers and board that returns will be more challenging going forward.  Yes, private equity is the best performing asset from an absolute return perspective, but you must also look at it from a risk adjusted basis, and private equity is the most risk-taking allocation in the fund.”

She notices investors have been putting more money out than they have been getting back. It’s why she believes more exits must happen before investors put more money out the door and is the reason behind a spike in LP secondaries activity and GP’s restructuring their portfolios. For now her focus is on investing – and exiting – high quality companies only.

She reflects that if assets on the ground are performing and compounding at the expected rate, there is no rush to sell in the current market. Being a long-term investor means there is no pressure to constantly deploy so instead she is  continually re-underwriting deals to make sure they are still profitable. “If we are holding a business that still makes sense, I will always choose to hold onto rather than exit and recycle the capital to other deals.”

She says her teams have grown more selective because of the challenges around forecasting the operating case for businesses and notes that the fund’s deployment on the direct side has slowed. On the funds side, because commitments are drawn down over the years trying to time the market isn’t an issue. Instead, her focus is on making steady commitments and ensuring the portfolio doesn’t have vintage concentration. “We use our secondaries to adjust the portfolio here.”

In fact, the number of deals across the entire private equity portfolio has slowed significantly in the last two years. “We have submitted bids, but we often come in far below the winning bid and in retrospect we are happy that we’ve missed these investments.”

Complexity in China

Kim lived in Toronto before she moved to Hong Kong, and because her partner is Canadian she describes her return to the city as a homecoming, even though she is Korean.

But it is her unique experience of private equity in China, where souring geopolitics, complex regulation, the increasing cost of doing business not to mention the inability to forecast exits means other Canadian funds like C$400bn ($295 billion) Caisse de dépôt et placement du Québec (CDPQ) and OTPP have pulled back on direct investing in private assets that the conversation now turns.

CPP Investments, she says, is intent on building a globally diversified portfolio of which Asia Pacific and China remains a vital pillar. Around 9 per cent of the private equity portfolio is invested in China while the total fund currently has around C$52 billion invested in the country. In private equity, a strategy focused on investing in companies that tap consumer spending has famously paid off . “Private equity Asia is one of the best performers in terms of relative performance of the whole book.”

Still, things are starting to change. Strategy in Asia is more bottom up whereby the team apply a risk return framework and then bring investments to the committee to discuss. She notes the market is becoming difficult to navigate and describes an increasingly cautious approach.

The biggest challenge is predicting a company’s operating capability. Drawing up financial models requires the team put together a fan of outcomes but predicting those outcomes has been problematic ever since the pandemic.

“Unlike in public markets, in private markets investors really need to go and see and touch and feel what they are investing in. Not being able to do this in China over the last three years due to the pandemic leads to difficulties predicting the operating case and where returns are going to come through. I can’t see the market going back to how it was in 2019.”

Yet it is precisely this ability of her team to research and dig down into an asset that she is convinced is the winning ingredient. It is also the characteristic that she believes makes it a more honest asset class than public equity.

“Public market investors have a level playing field and they can share all the information that is out there, but in private equity it’s all about how much work you put in, and how that helps you make a better decision,” she concludes.

Hanna Hiidenpalo, Finnish fund Elo’s CIO and deputy CEO discusses progress around internal management and the fund’s sustainability program which includes a target of carbon-neutral energy use in direct real estate by 2027. In terms of the portfolio she says Finnish equities have impacted returns but tactical allocation changes are being made around the edges.

How do you see the current investment climate? Where is the opportunity and what are the challenges?

There are many things affecting the current investment climate from monetary policy, inflation and the economic outlook in different geographical areas to the impact of artificial intelligence and geopolitics.

Overall, I would say that our investment market returns this year were better than expected thanks to good economic development in the first half of the year. However, stock market returns differed strongly, especially in late spring, both geographically and by sector. Interest income was positive at the beginning of the year, despite central banks hiking interest rates. Overall short-term interest rates rose along with the policy interest rates, but the longer interest rates stayed the same or even fell slightly.

Despite positive developments in the global equity market, it was different in the Finnish stock market and the return remained slightly negative in the first half of this year. One reason is the fact that the Finnish market is very concentrated and geared to cyclical companies, so the weak performance of the largest companies decreased the return of the entire market.

Also, the uncertain economic outlook and the rise in interest rates affected the real estate market. The number of transactions has been low and construction has decreased, and yield requirements have risen. Despite only slightly positive returns, the occupancy rate of properties owned by Elo has remained at a good level.

There are always opportunities in the market. Currently the rapid and strong rise in short interest rates has clearly weakened the interest-sensitive areas of the economy. The main risk of the investment market is that inflation will not slow down sufficiently, and the interest rate will remain high. But during this summer, the US economy has surprised with its strength, and the outlook for the rest of the year has improved. In Europe, the situation has weakened due to the weak industrial cycle, but the bond market offers opportunities and portfolio diversification.

Our current asset allocation has remained largely unchanged this year: fixed income investments are almost 30 per cent; equity, including private equity, are almost 50 per cent. Real estate is slightly above 10 per cent and other alternative investments, mainly the hedge fund allocation is around 10 per cent. Within different asset classes, we make more tactical allocation changes, for example around active geographical changes.

How have you developed inhouse expertise at ELO in recent years?

Our equities team has developed the investment process using data in decision-making. The team invests mainly with cash equities. Strategies range from enhanced index tracking to multi-factor strategies. The team is process-oriented and uses systematic approaches to investing. The results have been encouraging. It is likely that we will expand this approach to other asset classes as well in the future – for example, applying it to some areas in fixed income and credit might be interesting.

Elo is 10 years old. All operations – including investment operations – are based on the company’s strategy and values: openness, activeness, and commitment.  On top of these elements, we have also built a functional investment organization that works actively and professionally in the global market in various asset classes.

During the last decade we have continuously developed our own in-house investment operations and capabilities, especially in the areas of direct investments, equities trading and responsibility. At the same time, we have built an interesting workplace for new talent. Currently the entire investment process employs more than 100 people in different positions.

On the leadership side Elo has also developed its capabilities. The company has created an ongoing program to support the implementation of our strategy where we strengthen and deepen the skills we require.

How have you integrated sustainability in recent years?

We look at sustainability with a wide perspective. At the beginning of this year, we updated our principles of responsible investment and climate policy which have both been approved by our board.

Recently the focus has been more on climate. We have been working on our new climate targets and roadmap. Elo is committed to a Paris-aligned portfolio that we will achieve via setting interim targets, which we have set for 2025 and 2030. The carbon-neutral portfolio will come via decarbonization and reducing the share of fossil fuel investments but also increasing investments in sustainable solutions and engaging with companies and other stakeholders both individually and in collaboration.

We are integrating sustainability into our real estate investments by managing climate risks like decisions on new investments, and the efficient use and development of existing buildings. Elo has a new sustainability program for direct real estate where we are aiming for carbon-neutral energy use by 2027.

Engagement and collaboration are our key ways when it comes to implementing responsible investment. We have increased proxy voting and been more active on collaborative engagement, especially on environmental and human rights topics. Besides climate, we are currently working on biodiversity, and we will publish a roadmap later this year. Human rights are also another focus area for the future.

In a nod to headwinds including climate change, evolving demographics, and the future economic outlook the $85.5 billion United Nations Joint Staff Pension Fund, UNJSPF, will use a slightly lower real rate of return on investments to inform its upcoming actuarial valuation. The 2023 ALM study will consider various scenarios for the future, including those incorporating climate risk.

The 2023 ALM study will consider various scenarios for the future, including those incorporating climate risk. Under a baseline scenario based on moderate growth and a suitable asset allocation, the current contribution rate will “remain adequate.” However, another scenario estimated the impact of a financial crisis arising from a failure to transition to net zero and the board heard how in this scenario, the fund will face a much more challenging outlook.

“It is important that the fund continues to monitor the impact of climate risk over the long term. The ALM study provides crucial insight for the fund’s office of investment management in developing its future strategic asset allocation, with an emphasis on continued risk management to ensure long-term sustainability of the fund,” states the fund.

A recent board session also referenced UNJSPF’s recently-published 2022 annual report which reflects on the impact of last year’s equity and bond market volatility. “Both stock and bond markets yielded double-digit negative returns, leading to the poorest performance of a 60/40 portfolio on record,” it states. Last year the fund’s market value plummeted 14.7 per cent, shedding more than $13 billion during the year.

Last year tumultuous returns followed robust returns between 2019 and 2021 that had swelled the UNJSPF portfolio by 30 per cent to a record high to over $91.5 billion by the end of 2021.  In its latest annual report the fund states all asset classes outperformed their benchmark over the one and three-year periods and said the fund “compares favourably” with other pension funds in terms of cost and return of the assets.

The board agreed that a 6 per cent nominal rate of return composed of a 3.4 per cent real rate of return on investments and a 2.6 per cent inflation rate should be used for the actuarial valuation at the end of this year in a change from recent actuarial valuations that used an assumption of 3.5 per cent. The valuation will determine the long-term solvency of the fund based on a wide set of assumptions that include, for example, future growth of participants, investment returns and various demographic assumptions.

Alongside outlining its assumptions for the next actuarial valuation, the board session (the pension fund’s 75th since it was established in 1949) included a discussion of its asset-liability management study (ALM), funding policy, and performance.

Market outlook for the rest of the year

Looking ahead to expected performance in international and emerging equity markets through the rest of 2023 the fund’s outlook is mixed “as relatively attractive valuations are counterbalanced by weaker earnings growth and their sensitivity to a potential US recession.”

Half the pension fund is invested in public equities, most of which is managed internally by four teams covering North America, Europe, Asia Pacific, and Global Emerging Markets. Small cap equities and select markets outside this benchmark are managed through specialized external managers and funds. The internal teams follow a disciplined investment process, centred on equity screening, fundamental analysis, and frequent dialogue with corporate management teams of the companies the fund invests in or is interested in adding to its portfolio.

The fund has a more bullish outlook for fixed income ahead. “Long-term expectations for fixed income returns have also increased, following a decade of historically low interest rates and quantitative easing policies,” state the annual report. “Bonds now appear to offer a reasonable yield and serve as a hedge against a potential recession.”

Fixed income is managed internally in five portfolios comprising US treasuries, US securitized, corporates, government related and global emerging markets. The benchmark for the core portfolio is the Bloomberg MSCI US Aggregate ESG Custom Index while the benchmark for emerging markets is the Bloomberg EM Local Currency Government, 10 per cent Country Capped. Eighty per cent of corporate and government related portfolios are managed externally.

In a recent change of strategy, UNJSPF introduced a new benchmark for fixed income that incorporates a corporate bond component, broadening the pension fund’s asset mix. UNJSPF uses external managers in the allocation as it continues to develop and strengthen in-house capabilities. Over time it expects that the internal fixed income team will progressively assume a larger management of the portfolio as resources and capabilities are added.

UNJSPF’s private markets portfolio includes private equity, real assets, and real estate. Private equity, infrastructure, timber, and agriculture are managed via externally managed funds and co-investments. UNJSP, which began allocating to private equity in June 2010, currently invests with over 100 high quality externally managed funds diversified by vintage year, sub strategy, sector, and geography. A small portion of the private equity programme is invested in co-investment alongside high performing private equity managers.

The real asset portfolio is invested through externally managed funds where selection is based on moderate leverage, strong cash flow and a demonstrated record of realizations.

Similarly in the real estate portfolio (which dates from 1971) the fund invests through around 100 externally managed funds and co-investments. The allocation is 50 per cent core “open ended” funds and 50 per cent non-core “closed end” funds. The Fund’s core funds are diversified by geography and property type, and its non-core funds are diversified by vintage year, geography, property type and risk profile.

MN, the €175 billion ($190 billion) Dutch fiduciary manager for pension funds and insurers including the large metal schemes PME and PMT, as well as the pension fund for the Netherland’s merchant navy, is preparing to invest in private corporate debt.

The fixed income portfolio currently accounts for around 60-70 per cent of MN’s total assets under management. It already comprises allocations to sovereign debt (the lion’s share since client funds’ matching portfolios are typically bigger than their return seeking allocations) Dutch mortgages, high yield bonds, bank loans, infrastructure credit and emerging market debt and will shortly include a new mandate to corporate debt, explains Markus Schaen, a senior manager at MN in the fixed income team.

MN’s pension fund clients’ demand for the new allocation – which will comprise three or four new managers over time – derives from a combination of factors and has been two to three years in the making. On one hand, it is a natural extension of a Dutch focused, pre-existing allocation to private corporate debt. This allocation dates from the GFC when Dutch companies were hunting for finance, recalls Schaen.

On the other it is born out of a deliberate ambition to have more diversification in fixed income as their allocation to the asset class has grown.

“Our clients have got more comfortable with illiquid investment,” he says. “They started with infrastructure debt which has also allowed them to incorporate impact into their investments. In the private corporate debt strategy, they want access to companies that they can’t easily find in the public bond portfolio; are too small to come out with a bond or do not have an official rating. They also want to help companies that are struggling to access finance because banks are concentrating on bigger corporates and want to invest structurally in the local economy.”

Alongside the illiquidity premium and impact potential, Schaen traces demand for the allocation to the fact it has a low correlation with other markets and comes with lower transaction costs because it involves long-term, 10 to 15-year investments.

The new allocation will comprise investment grade corporate debt via private placements and bank co-financing and high yield debt via senior loans. Client funds aren’t particularly looking for direct lending exposure, despite the higher returns.

“Our clients have set moderate risk/return targets for private corporate debt and want to have very low probabilities of defaults in their portfolios.”

He is mindful of a few key challenges ahead.

Sourcing is an important factor to watch and means it may take time to build up the allocation. More so in today’s competitive environment which is impacting the spreads available for investors, creating tighter pricing and seeing covenants and documentation spring up.

“It’s something we’ve noticed particularly in renewables,” he explains. “It’s getting to a point where the return is not a good reflection of the risk, and investors are not being adequately compensated.”

He is also aware that changing the composition of the allocation down the line will be difficult – yet MN’s clients’ appetite for ESG exclusions that will force a change in portfolio composition seems to be rising.

“Various sectors are now getting excluded. For example, one of our clients has sold off all their fossil fuel investments,” he says, referencing PME’s 2021 decision to divest all fossil fuels. “Compared to liquid strategies, it will take more time and it is more costly to sell off a sector in an illiquid asset class.”

portfolio impacts of esg

He also points out that ESG exclusions will make the portfolio more concentrated, with a lower number of positions thereby increasing risk.

It leads him to reflect on how ESG is becoming increasingly important across the fixed income allocation. For example, MN recently incorporated MSCI ESG ratings into its custom benchmarks for several strategies so that companies with lower ratings than its threshold won’t make the benchmark. And he notices some investors are poised to go one step further.

In the past, ESG integration was primarily focused on exclusion of sectors and companies, and engagement. Today, he believes the market is evolving whereby more investors only want to invest in “the best” companies. He believes this cohort are increasingly looking at how to build portfolios from ground zero, adding the most sustainable and transition-proof companies one at a time as opposed to starting with an index and benchmark, and knocking out polluters via an exclusion policy.

“More investors are starting to think about hand picking the companies they want to invest in.”

This approach may bring hands-on control for the Netherlands’ ESG-conscious pension funds, but he reminds it also comes with the risks inherent with investing in a small universe and that with every exclusion the remaining eligible positions in the benchmark will get bigger.

In another observation he notes that client funds’ focus on ESG often results in a disconnect with external managers. Another part of his role includes monitoring European and US external managers (he works with around 30 external fixed income managers on behalf of  client funds) who he says sometimes fail to grasp that for some pension funds, ESG integration and impact is more important than out-performance.

“Of course, client funds are looking for decent returns, but sometimes this is not the most important thing, especially if they have ESG considerations. A growing number of funds are comfortable with passive, benchmark-like returns if it is accompanied with ESG integration.”

They don’t want any negative headlines around their investments, and they want transparency around how their asset managers are paid, he continues. “We sometimes see a disconnect between traditional asset managers who continue to strive for financial return only, yet this isn’t what many client funds actually want.”

Schaen, who typically meets with external managers twice a year, concludes with a nod to his pet manager peeve that can also create a disconnet: personnel changes in the management team without any warning.

“It still surprises me. Some organizations are straightforward and inform us if there is a change in personnel, but others don’t mention it and we find out ourselves. We understand people move on, but not telling us is worse.” As well as being put on watch, these managers can also expect key questions to follow around how they will ensure the rest of their team don’t leave, and inquiries into their culture and team.

Does he think succession planning is a problem in the asset management industry? “I would say only a few of our managers are very good at succession planning,” he concludes.

 

Faced with Thames Water’s financial difficulties, and the potentially very negative consequences for investors with shares in the holding company controlling this business, many stakeholders seemed surprised by the size of the loss in value recognised at the end of 2022, while transactions carried out in recent years were based on high and even rising valuations.

However, careful consideration of trends in both Thames Water’s cost of capital and volatility, calculated using an appropriate risk model, would have made it possible to anticipate the operator’s financial difficulties.

Indeed, Thames Water’s volatility and value-at-risk have always been high in relation to various infraMetrics benchmarks, including its closest peers, namely other regulated utilities companies. However, the risks have doubled over the past 10 years, as shown in Table 1. Meanwhile, logically, this risk was reflected in the value of the cost of capital and therefore in the discount rate of future cash flows. As a result, its true fair market value has fallen sharply over the past 10 years.

Thus, over the period 2013-2017, under Macquarie’s ownership, the price-to-sales ratio of Thames Water dropped by 58 per cent and EV/EBITDA went down by over 25 per cent, while all the other benchmarks improved in value. In other words, the loss that was booked in December 2022 did not happen overnight.

Clearly, the failure to recognise this loss in value in investors’ financial statements at the right time raises the question of how to value this type of asset, and in particular the methodologies used to calculate the fair market value which, in the case of infrastructure, are based on discount rates that take no account of the reality of the risk factors to which the investments are exposed, nor of the market dynamics of the premiums associated with these risks.

 

Table 1: Risk & Valuation Metrics for Thames Water Utilities, UK Water, Global Utilities and the infra300® market index

Date Segment Volatility* Value-at-Risk** Median Price/Sales Median EV/EBITDA
2013 Thames Water 18.9% -33.1% 3.73 10.30
Global Regulated Utilities 13.4% -11.3% 2.22 8.92
infra300 8.3% -1.2% 2.19 9.69
2017 Thames Water 38.6% -68.1% 1.77 8.13
Global Regulated Utilities 13.8% -11.1% 2.44 12.33
infra300 8.8% -3.0% 2.62 11.83
2020 Thames Water 38.0% -63.0% 1.94 8.45
Global Regulated Utilities 13.0% -8.5% 2.42 11.69
infra300 8.6% -1.7% 2.79 12.00
Q1 2023 Thames Water 37.9% -64.5% 1.54 7.69
Global Regulated Utilities 12.9% -12.7% 2.06 12.81
infra300 10.4% -7.0% 2.93 11.66
Source: infraMetrics.
*Standard deviation of monthly returns over a historical 10-year period.
**Gaussian value-at-risk at 97.5% confidence interval.

An anomaly or a poorly measured systematic risk?

Today, the Thames Water event is often presented as a special case. Indeed, a financial structure favouring debt, a dividend policy inconsistent with the economic performance of the business and furthermore constrained by the securitisation of the dividends, and the regulator’s decision to no longer take account of the project’s real cost of capital when setting tariffs, all played a particular role in the risk of this investment.

However, it would be regrettable to limit the risk of investing in unlisted infrastructure to purely idiosyncratic considerations. Thames Water is not an isolated case. Table 2 provides some significant examples of the materialisation of extreme financial risks in the infrastructure investment class. Lessons for the whole unlisted infrastructure asset class should be drawn from the Thames Water event.

 

Table 2: Impairments, Defaults and Related Volatility of Infrastructure Projects

Company Sector Country Event Detail Value Before the Event (USD) Price After the Event (USD) Drop in Price Volatility Before the Event
Company Segment infra300
Bluewaters Power Station Coal-fired power Australia Default
in 2012		 87,929,231 63,280,539 -28% 21.2% 10.9% 10.3%
Line 9 Metro Arganda Urban mass transit Spain Impairment
in 2020		 51,568,739 33,186,324 -36% 21.8% 13.1% 8.9%
A-70 Circunvalacion de Alicante Motorway Spain Default
in 2012		 25,195,207 – -100% 21.6% 9.9% 6.6%
Nottingham Express Transit Urban light rail UK Default
in 2018		 474,227,049 340,903,055 -28% 27.4% 11.2% 8.3%
Robin Hood Airport Doncaster Sheffield Airport UK Impairment
in 2013		 182,580,630 53,902,406 -70% 21.5% 13.8% 10.3%
Source: infraMetrics.
The segments used to qualify the business risk are those determined in the TICCS framework and representative of the sector and operational risk of the infrastructure investment in question.
Volatility is calculated over periods of 2 years prior to the occurrence of the event affecting the infrastructure investment under consideration.

In particular, managers and investors need to stop thinking that the volatility of this asset class can be measured with a global appraisal-based index calculated from very backward-looking and de facto smoothed valuation data. An annualised volatility of 3-4 per cent and a Sharpe Ratio of more than 3 tell you nothing about the risks in infrastructure investment. Furthermore, as can be seen in Table 1, not only is the volatility of unlisted infrastructure, as represented by the infra300 index, reasonably higher in general, but it can also vary significantly depending on the business segment (in this case, regulated utilities for Thames Water).

This link between observed volatility and default risk is not unique to Thames Water. Table 2 shows that, before they suffered a major impairment or even default, the investment projects under consideration experienced high volatility calculated on the basis of fair market value. This volatility, as with all other asset classes, was predictive of the risk of loss in value. As such, it is much higher than not only the volatility of global equity infrastructure represented by the infra300 index, but also that of the TICCS segment representing the sector and business risk to which each of the projects in question was exposed.

This reality of the risks involved in investing in unlisted infrastructure must be taken into account both when allocating to this asset class and when assessing a specific project.

Measuring risks for what they are represents the first and indispensable step towards good risk management. Moreover, this transparency lends credibility to an asset class with attractive financial characteristics, whether it be comparing its risk-adjusted performance with that of other private or public asset classes, or considering its diversification and, of course, liability management capabilities.

At a time when all stakeholders, including regulators, agree on the importance of increasing the proportion of private assets in pension fund allocations, transparency on the risks of these investments is essential.

Noël Amenc is Associate Professor at EDHEC Business School (Singapore).

 

The discourse around ESG investing may be “messy” but Mercer’s global chief investment strategist, Rich Nuzum, says media and political scrutiny can help sharpen the focus of pensions and sovereigns on their objectives and duties. The comments come amid a debate about the merits of decarbonising portfolios ahead of the COP28 climate change summit in Dubai. 

The increasingly “messy” and “impolite” discourse around environmental, social and governance investing, especially in the US, may have unlikely benefits for fiduciaries, says Mercer’s global chief investment strategist, Rich Nuzum. 

Institutional investors who adopt an ESG objective or overlay have been targeted by high-profile US policymakers, including Florida Governor and Republican presidential candidate Ron De Santis, who has lashed the investing style as reflecting an “ideological agenda” and “left-wing values”. The topic has become a mainstay of conservative critics on cable news and social media platforms, while some state legislatures have sought to restrict or even ban activity by ESG-focused asset managers. The discourse has frustrated industry leaders and governance experts, who argue the politicisation of investment decision-making presents a “systemic risk”. (See The politicisation of investments at US public funds)

But while Nuzum admits the conversation has become “less polite and more pointed”, he says it is the latest incarnation of a meaningful debate being held by boards and investment committees for decades.  

“This is a contrarian view … [but] I think it’s a very constructive dialogue,” the New York-based Nuzum tells Top1000funds.com on the sidelines of last month’s Mercer Global Investment Forum in Sydney. “It is forcing fiduciaries to think deeply about what they want to do and why.” 

Nuzum says the scrutiny placed on US-domiciled pensions in particular, which are increasingly subject to a raft of federal and state restrictions on capital allocation and proxy voting processes, sharpens their focus on the extent to which environmental or social impact should form part of their investment objective, if at all. 

“You can make investments to have an impact … and you can do it for values. But let’s be clear as stakeholders – as the investment committee or board – about what we are doing and why,” he says. “The US dialogue is forcing clarity around that.” 

Beyond ESG 

However, Nuzum, who advises more than a dozen of the world’s largest asset owners, says the term ‘ESG’ can be unhelpful, suggesting fiduciaries really ask themselves whether they should be aiming for impact beyond a return on capital to members, and, if so, in which areas.  

For example, he says diversity, equity and inclusion is often a stated focus of US and South African funds, while decarbonisation is a goal for many Europeans. Endowments and funds associated with religious organisations may also have specific ethical overlays, he points out.  

For many other funds, it will not be appropriate to have impact as an explicit objective. In that case, Nuzum says, any investment in, for example, electric vehicle manufacturers or renewable energy providers should be squarely focused on risk and return, and the “sole interest to participant”, where that legal obligation applies. 

Net-zero nitpicking 

Aside from the heated political and media discourse, Nuzum has detected an active debate within the global asset owner community over the benefits, or otherwise, of net-zero goals.  

Many funds around the world have made commitments to reduce carbon emissions by either 2030 or 2050. But in the scramble to decarbonise portfolios other ESG-minded investors have asked whether removing exposures from individual portfolios is really conducive to meaningful climate action setting up a debate between asset owners Nuzum says.  

Making proactive investments in green technologies may not reduce the size of a portfolio’s carbon footprint, but it would assist with the economics of replacing carbon with other forms of energy.  

“Impact oriented investors, [especially] large sophisticated sovereign wealth funds, get really frustrated with the net-zero part of the community, because they say ‘you’re solving your portfolio, not changing the world,” Nuzum says, reflecting sentiments he has heard among his client base and broader network.  

Political pressure 

At the same time, Nuzum says asset owners must resist pressure from governments, which may wish to influence their investment decisions for political reasons.  

He gave examples including UK legislation known as the Mansion House Compact, under which large pensions agreed to increase their allocation to British private equity and start-ups.

But Nuzum says there are both political and investment risks to being pressured into backing such projects.  

“It’s easy in my experience for politicians to target [pension] funds because they’re not very sympathetic. But the moment that voters realise ‘Hey, that’s my money’, it becomes very bad politics.”