This session examined research from the Woodwell Climate Research Centre that assesses the socioeconomic risks associated with climate change and shows how societies and economies will cross critical thresholds and face new vulnerabilities over less time than the duration of a typical mortgage. It highlighted the role the private sector can play and the importance of integrating the insights of climate science into decision making the same way financial and cyber risks are.


Speakers
Chris Goolgasian, director, climate research and portfolio manager, Wellington Management (United States)
Zach Zobel, scientist, Woodwell Climate Research Center (United States)


Chair
Fiona Reynolds, chief executive, Conexus Financial (Australia)

ESG presents a strong opportunity for businesses to differentiate themselves, but there are a number of common mistakes businesses make along the way, according to widely respected business author and Harvard Business School professor George Serafeim.

Speaking with Fiona Reynolds, chief executive of Conexus Financial, at the Sustainability in Practice forum held at Harvard University, Serafeim said ESG is an opportunity to understand how good management and good governance can make a difference in all sectors of the economy.

Companies that tap into “animating forces” such as a strong feeling of purpose among staff will be better positioned to differentiate themselves and potentially lead the industries of the future.

Serafeim is the Charles M Williams Professor of Business Administration, and faculty co-chair of the Impact Weighted Accounts Project at Harvard Business School. He is the author of ‘Purpose+Profit: How Business Can Life Up the World.’

“I don’t adopt the exclusionary perspective, where you withdraw from things, but rather the question is one of how do you deploy skills and capabilities to improve things inside companies, and as a result drive change inside organisations,” Serafeim said.

Serafeim said there are four fundamental aspects of driving change inside organisations: measurement, analysis, strategy and communication.

Unfortunately many companies have “made the fundamental mistake of starting from the fourth step and allowing for reporting to drive strategy, rather than the other way around.” Under pressure to become transparent, being reactive to this pressure can lead to the wrong business decisions, he said.

Management teams need to step back and look at how climate change, water related issues, safety-related issues, workforce inclusion concerns and other issues are affecting their businesses. These issues are not equally important for all companies, and the adaptive capacity of different management teams differs dramatically as well.

A typical mistake companies make is they “are trying to make the measurement perfect,” this takes too long and they get stuck at this point. An 80/20 approach, instead, would involve the company saying “that’s good enough, we kind of understand where we are,” and then pressing forward.

Next the company needs to engage the management team into analysis of the findings, and a typical mistake at this point is management teams move quickly from measurement to strategy without properly analysing.

“Not every metric actually matters from an analysis perspective,” Serafeim said, and different businesses have different levels of sensitivity to the same information, with some able to be more adaptive. Some sectors and regulatory regimes may allow large values to be passed down the value chain.

When it comes to developing strategy, this sometimes becomes confused with operational effectiveness, he said. “Strategy is not about that,” Serafeim said. “Strategy is about what makes you unique and allows you to have a unique competitive positioning. A lot of the ESG issues that we have found in our research are actually operational effectiveness issues.”

These operational effectiveness issues are quickly codified as best practice and “get imitated pretty fast” leaving behind the question: “How are you differentiated?”

Then on the communication front, another mistake a lot of companies make is doing a lot of communication about efforts and intentions, rather than about outcomes of those efforts and intentions.

“I think there is a trap there which is in the ESG space, a lot of what is getting measured is actually effort rather than outcomes,” Serafeim said. “What creates value at the end of the day is the outcomes that you’re achieving, not how much you’re spending. In fact what you would want to have is the highest ratio of outcomes to effort, right?”

There will be a tremendous business opportunity over time for differentiation in various markets, he said, pointing to Norwegian waste management company Norsk Gjenvinning which went through a difficult transformation to ultimately emerge as an industry leader with best-in-class practices that attracted top talent and high-reputation brands.

“Transformation can happen in many organisations, and the fuel of that is purpose, that actually you’re doing something that people feel very strongly about,” Serafeim said. These “animating forces” inside organisations are different to things that are “a simple process to imitate.”

Looking ahead at impact reporting, there are lessons in looking at accounting statements and reporting standards which were a contested idea 100 years ago, Serafeim said. Companies baulked at the idea of revealing their assets, sales and accounts receivable, but now it is impossible for investors to imagine being without those things.

Measuring impact is similarly in its early stages now, Serafeim said, with “something that will look like a minimum viable product” to appear soon, and then ongoing improvements that could take 100 years.

Infrastructure investments face many and complex challenges including sustainability. This session looked at specific case studies of ESG in legacy infrastructure as well as the investor priorities with regards to green energy infrastructure.

Speakers
John Ma, partner and head of North America infrastructure, Igneo Infrastructure Partners (United States)
Max Messervy, head of sustainability, Americas, Mercer (United States)

Chair
Fiona Reynolds, chief executive, Conexus Financial (Australia)

The Public School and Education Employee Retirement Systems of Missouri (PSRS/PEERS) is increasing its private equity co-investment programme and boosting its direct lending to private companies in the hunt for cost-saving opportunities in private markets.

“Combined, we expect these programmes to save over $1 billion in fees over the next ten years,” says Craig Husting, CIO of PSRS/PEERS. “Private equity co-investment and private credit direct lending have become major portfolios for us, and we believe they have already and will continue to offer significant value.

We like the no fees no carry aspect of the co-investment and credit direct lending strategies, and right now we are seeing great deal flow. The performance is as good if not better than performance in our broader private markets portfolios.”

The strategy is the latest seam within Missouri’s bold push into private markets where the fund now targets a 40 per cent allocation (up from 35 per cent) split between private equity (21 per cent) real estate (11 per cent) and private credit.

Long-term, Husting expects approximately half of the private credit allocation to be in the direct-lending programme. Private equity co-investment currently represents approximately 15 per cent of the private equity portfolio but this is also set to grow.  “Long-term, we expect this to grow to approximately 25 per cent of the total private equity portfolio,” he says.

Indeed, private markets now play an essential role in Missouri’s ability to hit a high 7.3 per cent target return. “We expect our private markets program to strongly supplement the long-term investment returns of our System.”

The five-year annualized return for the period ending June 30, 2022 was 8.63 per cent or 8.44 per cent net of all fees and expenses. This exceeded 80 per cent of peer group funds as defined by the Wilshire TUCS universe of public pension plans with assets in excess of $1 billion while Missouri also took less risk than approximately two-thirds of comparable public funds.

Team spirit

Off the back of the co investment and direct lending programme, the in-house private markets team has now grown to ten people. “It’s a much more labour-intensive process than picking GPs,” says Husting who describes how the in-house team conduct deep dive analysis of the deal flow where being able to turn down investments is just as important as seizing opportunities. Missouri’s back-office team have also grown, responsible for monitoring co-investment cash flows coming in and out of the portfolio as well as tracking valuations on a quarterly basis. “Co-investment/direct lending as part of private markets has been a major growth area for our team,” he says.

Private credit

PSRS/PEERS first began investing in private credit direct lending in 2019 in opportunities developed through private equity relationships. “As our GPs purchased companies and financed debt on those companies, we were able to get a slice of the debt,” he says, adding the benefits of the allocation come via shorter duration investments and less risk that private equity. “In private equity, we look for returns in the high teens compared to high single digits in private credit.  We primarily invest in first line debt within our direct lending program with no leverage.”  Moreover, it remains a less crowded investment space since banks exited in the wake of the GFC and fewer public pension funds compete for assets.

Risks

The decision to increase the allocation to private markets was preceded by a detailed liquidity study. This involved stress testing the portfolio based on a number of market scenarios to ensure the pension fund could meet its benefit payments and capital calls in all environments. “The results of the study supported an increase in private markets,” says Husting. “The Board, staff and our external consultant were fully aligned in the decision.”

Board buy-in has been a particularly vital part of the process, nurtured by education around private investments, transparency and the gradual building of confidence. Given the amount of money ploughing into private markets he admits concerns about demand pushing prices up. But counters that opportunities in private markets are also growing compared to ten years ago.

Diversification within the portfolios is also essential. In private equity PSRS/PEERS won’t allocate small dollars to small funds and large dollars to large funds. Instead, each manager, from buyout to growth or venture, has the same bite size, typically around $60 million. Although it would be easier to give large allocations to bigger teams, he says some of the small private equity firms can produce as good if not better returns over the long term. “Our priority is the best manager,” he says.

PSRS/PEERS has been with the majority of its managers (94 in private equity) for ten years in a selection process that is based around GP funding cycles – in public markets manager selection can take up to 18 months. It’s a longevity that is also mirrored in PSRS/PEERS’ own investment team. Husting has been CIO for 23 years and six of the investment team have been in their roles for 15 years, anchored by PSRS/PEERS strong mission and culture, and incentivised by the  opportunity to invest boldly with limited  constraints. “We have the ability to invest in  relatively innovative structures which keeps the team energised. ”

Hedge funds

Alongside direct lending and private equity co-investment, Husting also voices his enthusiasm in the current investment climate for Missouri’s hedge fund allocation. It sits in the 60 per cent allocation to liquid public markets and is currently overweight at 9 per cent of total AUM compared to a target allocation of 6 per cent. In today’s volatile market of rising inflation and interest rates he has no plans to pare back.

In the year ending June 30th PSRS/PEERS hedge fund allocation returned zero while Treasury bonds declined 9 per cent and global equity declined almost 16 per cent. Husting was happy with the result. “We were pleased that our hedge fund portfolio protected on the downside in a difficult market, ”he says. “As market volatility continues to increase, we think it’s a good environment for hedge funds to offer value.”

PSRS/PEERS has an in-house staff that selects and monitors external managers in a stand-alone program with no fund-of-fund managers. This comprises around 16 managers in 21 assignments targeting a a beta of approximately .35. A second hedge fund portfolio, established in 2006, is an alpha overlay on the S&P 500 comprising 11 mandates with 9 managers.

 

Reliable data that gives visibility into the demands and challenges of different asset classes is a growing focus among large pension funds, who are exploring a range of execution strategies as part of their net-zero ambitions.

Private sector investment strategies can find synergy with asset owners’ broader push towards net zero emissions targets, with funds directing capital towards a range of technologies and solutions that will help drive the transition.

American multi-national holding company Franklin Templeton has been advocating publicly for standardised and reliable climate information disclosures for investors.

In thinking about private equity, Franklin Templeton can use its investments to examine emerging data projects that may help to overcome some of the methodology and data challenges it faces, according to Piers Hugh Smith, the holding company’s global stewardship manager.

“One of the big opportunities that we have in the structure of private equity investment is being able to overcome these barriers around information asymmetry,” Hugh Smith said, speaking at Conexus Financial’s Sustainability in Practice forum at Harvard University in a panel discussion about the different sustainability demands and challenges of different asset classes.

“This allows us to better understand what’s fundamentally going on with the climate risk scenario of our underlying assets and also we can drive solutions towards public markets through these investments.”

Hugh Smith said thinking through transitioning assets “really takes us beyond ESG as one idea.” He added: ” We need to think about managing the three holistic forms of capital: our economic capital, our social capital, and our natural capital. This is really the mechanism through which we can seek to drive a transition in the real economy.”

This means driving change in underlying companies–particularly in private markets– and takes precedence over “having the most sustainable measurement of our investment products.”

The governance rights and structure of control in private markets can be more effective in driving change than in public markets, Hugh Smith said.

“And so, in this structure, we can have this ability to really allocate towards solutions and drive transition in a much more direct way than we can in some of our public strategies through traditional engagement and voting.”

Also on the panel was Hyewon Kong, vice president and head of responsible investment at Investment Management Corporation of Ontario, or IMCO.

IMCO is “a toddler” on its journey to net zero, Kong said, having been created five years ago; he only joined two years ago. Relying on external managers, the fund is working with its GPs and portfolio companies to set expectations on carbon reduction.

IMCO expects all of its companies to have a long-term net zero target, Kong said, which means “we expect our companies to think about this net zero target and set the climate action plan to deliver that net zero goal.”

The fund also expects these companies to lift their game on disclosure, and set short-term, mid-term and long-term science-based targets.

A due diligence questionnaire for every asset class when selecting GPs addresses ESG risk and opportunity, and explores what would be a realistic and acceptable timeline towards setting a net zero target.

“We started developing our ESG dashboard, including climate dashboard, so that we can now understand for every GP that we are selecting and hiring and we can actually start monitoring them,” Kong said.

The fund is now in the process of setting targets for the 2030s for every asset class. “Our performance or review will be affected if we don’t deliver our ESG objectives, which are part of our corporate objectives.”

A footprinting exercise using PCAF methodology covers about 75 per cent of the portfolio, but there are currently significant problems with data quality, she said. Establishing the fund’s carbon footprint on private assets is “still very much qualitative, it’s very difficult to do a quantitative look,” Kong said.

“We are not talking about reported and verified information, it’s all economic activity based estimates. So we have to start somewhere.”

The fund then looks at a “conservative scenario” involving key actions it can take with each asset class to move on a decarbonisation pathway. With some assets like private equity, infrastructure and real estate, the fund has more control. Others like private credit offer less control and greater limitation of options.

“But every asset class still has to contribute to our top of house target,” Kong said. “So right now we are negotiating this with every team and just trying to understand what are the key action points.”

The board of the OPTrust pension fund has approved a net zero strategy, but this is operationally focussed,” said Alison Loat, managing director, sustainable investing and innovation at OPTrust.

“We are not going to be leading with targets,” Loat said. “The overall strategy is more operationally-oriented and really focused on how we build this out across the organisation.”

The concept of resilience features in the fund’s defining purpose behind its net zero declaration, which is “about the tools to manage the risks that we know are coming, both physical and transition to ensure that our portfolio is resilient over the long-term,” Loat said.

The fund is putting particular focus on how it carries out due diligence on assets. “We’re asking much deeper questions around climate,” Loat said. “We have much more specific, for lack of a better word, checklists that we’re workshopping with all of the teams.”

Work has also been done on public markets and proxies, and how to effectively respond when companies don’t meet their plans or put forward “loosey-goosey plans,” she concluded.

UK pension funds with large LDI exposures including schemes like the BT Pension Fund and the Pension Protection Fund have just had one of the most torrid weeks in the history of the strategy.

What happened?

Last week the UK government sent its own gilt market into a tailspin when new Chancellor Kwasi Kwarteng announced a series of unfunded tax cuts spooking the government bond market. The decision, now reversed, triggered a sell off in government debt forcing yields sharply higher, leaving schemes that hedge their liabilities via LDI strategies to scramble for margin and some funds unable to get cash fast enough to meet increasingly urgent collateral demands.

LDI is best described as a fancy name for a structured set of derivatives exposed to the price of gilts. The idea is that pension funds buy these derivatives to protect them against yields going down as this leads their liabilities to go up – when their liabilities are going up, they also have an asset that is posting them collateral. When yields fall, LDI funds receive margin but in the reverse scenario when yields rise like last week, pension funds must post more collateral in line with calls from their investment banks.

“Collateral calls are designed like a traffic light system,” describes James Brundrett, senior investment consultant and partner at Mercer which has been flagging the risk of low collateral levels in an environment of rising rates for a while. “Trustees are initially given a two-week warning; then another warning signal flashes to post margin. If collateral isn’t set aside, the hedges are reduced, and exposure gets taken away. Over the last week, the increase in yields was so quick, that traffic light system was shot through.” Patrick Bloomfield, partner actuary and pensions specialist at Hymans Robertson and chair of the Association of Consulting Actuaries adds: “The speed and extremity of rate rises exhausted schemes store of collateral.”

In  a vicious circle, pension funds frantically sold government bonds to post margin, exacerbating the problem. Elsewhere, they scrambled to sell equities and corporate bonds in a process complicated by the fact settlement periods are two to three days. Some started to look for other sources of collateral including loans from sponsors to bridge the gap.

“We were in a very disorderly market, most particularly in index-linked Gilts with levels of volatility we’ve not seen in at least 35 years,” said Simon Pilcher, CEO of USS Investment Management which, unlike other funds, is still open to new members and therefore has less liability matching assets than other more mature schemes.

Only when the Bank of England stepped in with an emergency plan to fire up QE via a £65 billion bond buying programme until mid October, did the market find support.

More collateral, less leverage?

The Investment Association estimates that the amount of liabilities held by UK pension funds that have been hedged with LDI strategies is around £1.5 trillion including some of the UK’s biggest funds.  For example, following a multi-year build out, the  BT Pension Fund , which runs an internally managed £18 billion LDI portfolio mostly invested in index linked gilts, hit a hedge objective of close to 100 per cent hedged on a funding basis. Elsewhere, the Pension Protection Fund runs a sweeping inflation and interest rate hedging strategy to shelter its liabilities.

PPF CIO Barry Kenneth told Top1000Funds.com the fund has weathered last week’s storm well and LDI has worked as expected. “The PPF has been able to keep all its liabilities hedged without needing to sell assets,” he says. Moreover the fund’s strategic asset allocation has ensured “multiple sources of interest rate and inflation protection through physical assets, lowering reliance on leverage to hedge the fund.” Where leverage does exist, the PPF has been cushioned by a “conscious decision to mitigate liquidity risk by borrowing for longer terms and keeping a healthy cash buffer to meet immediate margin calls.”

Still, many schemes face an urgent reappraisal that could involve more conservative management of collateral and leverage in the days ahead. For some, putting aside larger slices of collateral may no longer be as capital efficient. They may be forced to reduce their hedging levels, warns Brundrett. “I doubt pension funds will be using the same level of leverage because the increase in yields will require more collateral than in the past. Pension funds basically have two weeks to think about what their hedges look like – maybe they were hedged 90 per cent but now, using the same amount of collateral, they will only be able to hedge 70 per cent.”

“It’s hard to know what the current hedge ratios are until pooled LDI funds have gone through a deleveraging event,” he continues. “We are going to encourage clients to think about what happens after the 14th October and the prospect of interest rates going up.”

The better funded schemes may wish to de-risk which could could trigger more demand for physical assets. This could manifest in demand for long-dated gilts particularly. Pension funds will also need to rebalance. Many are now overweight risk assets (having sold bonds to post margin) and will want to rebalance, especially as the economy heads into recession.

At USS, the prospect of higher interest rates will positively impact the funded status, reminds Pilcher. “From a funding perspective, interest rate rises are having a positive impact. But the volatility in the UK market clearly driven by recent government announcements makes it very difficult to establish a long-term view.”

Longer-term impact

Crisis in the LDI market may have longer-term implications too, particularly on how the strategy is run. The astonishing growth in the investment strategy suggests a “fire and forget” decision by many pension funds, suggests Roman Kosarenko, senior director, pensions, at $2 billion listed Canadian corporate Loblaw Companies Limited who studies leverage use in pension funds. “What many LDI believers did not realize is that passive LDI, where exposure is calibrated to match the dollar duration of liabilities over the long term no matter what, relies on an orderly interest rate regime. In the current situation, a sudden interest rate shock was outside of what the trustees where prepared for via asset-liability studies.”

Kosarenko adds  that the shock itself is not as damaging to a pension plan as the opportunity cost of liquidating assets to fund margin calls when asset prices are falling. “Accounting for these friction costs is beyond what AL studies could do,” he says. “My conclusion from this is simple: LDI should never be passive with respect to target exposure. Although the probability of an outlier event is very small, the cost of it may be disproportionally high. This cannot be managed on auto-pilot.”

For others – auto pilot or low collateral levels aside – the fault likes unquestionably with the UK government. “The risks of LDI have been overblown,” concludes Bloomfield. “The UK experienced a rate move in size of quantum and speed that is so far into the tails of distributions of outcomes. The value in gilts halved in a couple of days. If this had happened in the equity market, everyone would have understood it. Because it happened in the gilt market, people are suggesting it’s opaque and inappropriate.”