Research conducted by The Carlyle Group suggests that focusing on socially-optimal strategies, such as payroll growth, responsible governance and diversity and inclusion leads to above-market returns.
Research conducted by The Carlyle Group suggests that focusing on socially-optimal strategies, such as payroll growth, responsible governance and diversity and inclusion leads to above-market returns.
Rather than look at impact investing as somehow being an investment discipline that stymies financial returns (and vice-versa with traditional funds prioritising superior returns to the cost of society), The Carlyle Group’s view is that expressly focusing on societal goals is a key impellent to generating long-term value creation.
In its 2020 Impact Review, The Carlyle Group found that among all US investments completed since 2013, every 10 per cent increase in payrolls has correlated with a 21.4 per cent increase in cumulative returns.
“The point we were trying to raise in the paper is that the origins of impact investing don’t really reflect the contemporary market,” explains Jason Thomas, Managing Director and Head of Global Research at The Carlyle Group.
“It is one where every efficiency is now fully priced. It is rare that you look at a deal where the potential gains from investing in a new product, or streamlining operations – or any other levers one might use – are not priced in. As such, we need to think about new ways of value creation.”
In Thomas’s view, the notion of a bifurcated world, where there are some implicit costs to impact investing, is a fallacy. “Instead of the impact somehow degrading the return profile of the fund,” says Thomas, “many of these impact areas are actually a way to increase value because not only are you increasing the fundamentals of the business (ie revenue growth), but you are also repositioning the asset as something that is much more attractive to a potential buyer.”
Total improvement orientation
As markets have become more efficient, so private market investors have needed to find new lenses through which to seek out and add value in a rapidly changing world.
The Carlyle Group uses what it refers to as a “total improvement orientation” to improve social and environment outcomes in all prospective businesses it looks at; as opposed to impact investors who limit their scope only to those businesses with strong ESG credentials already in place.
Given the nature of private equity, there are three main aspects of investing: 1) Control (what can you do with the asset as an active investor?); 2) Time – what is the exit strategy for the investment? – and 3) Financial incentives – what are the convex incentives to sell at the highest possible valuation?
“When you put those three things together, it naturally leads to an investment model that is going to prioritise impact on the dimensions that were highlighted in the paper we wrote – such as payroll growth and diversity of management teams – because those are the ways to create incremental returns, which are becoming much harder to come by,” opines Thomas.
Investors who take an active approach to opening new markets for sales growth, or new strategies for product innovation, can help businesses grow their top-line revenues and expand their headcount. More job creation means more positive societal impact and a demonstration of value creation traditional investors might otherwise overlook.
The value of diversity
The 2020 Impact Review stresses the importance of diverse teams; something that the firm is committed to both internally and with respect to its portfolio companies. As Co-CEO Kewsong Lee is quoted as saying in the 2020 Impact Review, “Teams with diverse perspectives, knowledge bases, interests and cultural identities are key to our edge”.
A good example of how The Carlyle Group thinks about diversity is evident in one of its investments in Carlyle Fund VII called HireVue, a video conferencing technology that provides a sophisticated tool for companies to improve their hiring practices by finding the most qualified and diverse candidates. A number of Carlyle’s portfolio companies are now using HireVue to improve the way they build diverse teams.
“What is interesting is this is helping remove unconscious bias in the hiring process,” says Megan Starr, Principal and Global Head of Impact at The Carlyle Group. “Firms are not looking at candidates based on age, race etc. It ends up producing a more diverse pool of candidates.
“Companies have the imperative to build diverse teams but they don’t always have the tools to know how to do it. If they can use technology that is cheaper, more effective and far more impactful at creating diversity, that’s a great growth market.”
The Carlyle Group’s research shows that diversity leads to better decision-making, better outcomes, and ultimately higher earnings growth.
“What’s interesting is we have very granular financial data across our portfolio, including a lot of underlying performance data, and if we are able to collect good ESG data it can lead to an understanding of where there are real correlations between financial performance and ESG factors,” says Starr.
She explains that research conducted over the past three years “demonstrably showed that Carlyle portfolio companies with at least two diverse board directors have experienced 12 per cent faster annualised earnings growth, versus companies without diverse boards.
“We have a goal of having at least two diverse board directors in place within two years of ownership in our portfolio companies.”
Sustainable growth = long-term value
As mentioned in The Carlyle Group’s 2020 Impact Review, management teams that integrate ESG factors with rigour and nuance build businesses that create more sustainable long-term value. By way of example, Starr refers to one specific portfolio company called Jeanologia, a Spanish denim manufacturing company that uses eco-efficient technologies. A key aspect of its business model is to reduce as much as possible the amount of water and chemicals used in the finishing process.
“Jeanologia is an interesting example of how we track material, bespoke ESG factors across certain portfolio companies,” Starr explains.
“On the cost reduction front, the technology Jeanologia uses means it is able to use 85 per cent less water and chemicals, creating a more efficient business model. Consumers increasingly value sustainability traits so if you are able to quantify that, it is increasingly becoming a differentiator in the market.”
Using ESG targets to lower debt interest
Another benefit Starr refers to is that Carlyle linked ESG data to Jeanologia’s financing, when it completed an ESG-linked term loan last December.
“In short, if Jeanologia is able to hit its annual water savings, the cost of financing the debt becomes slightly cheaper and if it misses the target by 15 per cent or more, the cost of financing increases. It is an interesting way to view the convergence of financial incentives and, in this particular case, environmental performance,” she says.
This concept of linking ESG performance metrics to financing could present some interesting opportunities going forward as companies look to access capital on more favourable terms, particular in the debt markets. And as such, offer another value-creation lever for PE investors to pull.
In Jeanlogia’s case, it is able to generate wider margins because of a much more efficient process, while also using a financing arrangement that includes explicit ESG targets to reduce its debt interest, thereby benefiting both the top- and bottom-line.
Multiple expansion opportunities in Oil & Gas
In recent years, climate change risk has risen to prominence and as a result, within the energy sector, significant disparities in multiples have emerged. By investing for impact, and applying its total improvement orientation, The Carlyle Group sees clear opportunities to re-orient traditional fossil fuel businesses in a way that brings down overall carbon emissions.
“When you look at a pure fossil fuel business, these are some of the cheapest companies available in the market, selling for 5X trailing EBITDA,” states Thomas.
“Conversely, when you look at pure play renewable energy businesses, these are often some of the most expensive assets to own.”
However, as Thomas notes, most businesses are a combination of these two extremes; a number of fossil fuel businesses may have 25 to 30 per cent of their total revenues coming from renewables and renewable businesses may still have some residual revenue coming from oil and gas.
“When you dig into these businesses and look at where the revenues are coming from, what you find is a continuum and that continuum is non-linear, where each percentage of a company’s total revenues and total earnings from renewables leads to a non-linear increase in market value and the multiple given back to investors (MOIC).
“What that implies is that those companies that take cash flows from oil and gas and effectively re-invest them into renewable energy assets can dramatically increase – and in some cases double – their exit multiple.
“An oil and gas company that goes from 30 per cent renewable to 70 per cent renewable as a share of total revenue over a three- to five-year holding can see its market multiple go from 10X to 11X EBITDA,” explains Thomas.
The financial incentives to improve companies in legacy industries like energy, as the global economy sets about reducing climate change-related risks, seem evident. While pure impact investors would ordinarily screen oil and gas companies, it is precisely by recognising the financial and societal benefits to transforming these companies that supports the premise of ‘investing for impact’.
“As we see deeper societal issues develop, changing attitudes and perspectives are very quickly reflected in asset prices – so a model where you have to sell an asset in five years’ time, means you have to account for those changing attitudes in order to get a favourable value at exit. If businesses don’t evolve, you’re going to be faced with a significant financial discount at the end of it,” concludes Thomas.
