When we talked about sustainability themes 18 months ago, climate and the environment tended to dominate as the key systemic and idiosyncratic risk to all issuers and corporates in both private and public markets, says Vikram Raju, head of Impact Investing for Morgan Stanley Investment Management AIP Private Markets
So much has changed since then. Along with the pandemic we endured, growing social awareness of critical issues like diversity, equity and inclusion have come to the forefront of public consciousness.
What we see now in the markets are essentially push and pull factors driving the evolution of sustainability as part of the investment process, with the aim to optimize particular outcomes. The push factor is the growing scrutiny from regulators in the US, Europe and Asia. The pull factor comes from clients who are increasingly looking for ways to gain greater transparency and influence with their capital.
Identifying four key themes linked to UN Sustainable Development Goals
At Morgan Stanley Investment Management (MSIM), we have adapted our analysis and scrutiny to focus on four key themes linked to the UN's Sustainable Development Goals (SDG)1 that we think are material from an investment perspective.
Climate continues to be relevant, as well as pollution prevention, waste control and the circular economy. We would all agree that these themes matter, not just from the risk perspective of managing downside — particularly companies' exposure to carbon prices or fossil fuels — but also the potential opportunity to help drive the clean energy transition. So both risk and opportunity are related to those themes.
Thinking first about decent work and resilient jobs, we believe that as we move into the global economy's phase of recovery and growth, a company's ability to succeed is going to rely on having a productive, healthy and educated workforce.
At the same time, the nature of work is evolving, with recent surveys illustrating that employees have reassessed their goals and priorities over the past 18 months. So it has become even more important for firms to engage with workers to make sure that they are not only safe but also motivated, equipped and skilled in their roles. In our view, those companies that have invested in their people are best placed to benefit as the economy recovers.2
Turning to inclusive business practices, academic research has illustrated that a diverse workforce helps to avoid everyone coming from homogenous backgrounds and thinking the same way. Alternative perspectives and insights are invaluable along the investment process, from security research to client communication. That has always been true.
Also relevant for us is reflecting on movements like Black Lives Matter, which are raising our awareness that the effects of events like pandemics are falling disproportionally on the most vulnerable and marginalized elements of the population.
When we evaluate companies to invest in, we need to consider whether they have done their part to make products and services more accessible to those less privileged, and to help their brands resonate with a more diverse community. That can be powerful for fostering customer loyalty and keeping the brand profile aligned with the current state of public consciousness.
Building sustainability factors into our investment practice
We live with competing and critical challenges. Our private equity clients are looking for good long-term premium returns associated with private investing. The question whether climate investing can generate returns has been answered affirmatively.
What we now need to ask is how can we afford to avoid climate investing or climate loans if we are investing for the long term? We know the size of the problem: to cut our carbon emissions by 40 gigatons each year from now until 2050 to reach the goal of carbon neutrality. That is the bad news.
But here is the good news: Investing for climate impact is intrinsic to compelling private equity outcomes across four dimensions. First, company managements recognize that efficiently using raw materials and other inputs into the production process directly impacts the bottom line. We could say that improving EBITDA margins is private equity 101, so aligning with environmental objectives can be quite intuitive.
Second, sustainability is a growth area. Consumers are willing to pay more to eat sustainable food, wear sustainable clothes, drive sustainable vehicles and live in sustainable housing. These are all exciting markets and revenue streams for older traditional companies to pivot towards for future growth — often by acquiring newer companies focused on sustainability.
Third, building climate resilience into business models becomes imperative as frequent extreme weather events pose threats to supply chains. Infrastructure needs to last for the 8- to 10-year investment periods of the private funds we offer. Managing operational risk through secure locations and backup plans can improve cash flow predictability.
Tying together the dimensions of margins, growth and resilience, we find the answer to our question in the markets. In our experience, private companies with concrete sustainability stories tend to capture the so-called gradient when they list in the public equity markets. Or traditional companies acquire them for the same reason.
Levelling the playing field in early-stage funding
Through the lens of our clients at Morgan Stanley — that pull factor - we see a real desire to be part of the solution around the funding inequity in private markets — especially for early-stage companies. According to Crunchbase, only 2% of early-stage dollars are earmarked for founders of color and women, perpetuating the inequality that pushes into middle-market private equity and ultimately the companies that file IPOs and exit the market.
Our surveys reveal that 75% of our VCs (venture capitalists) strongly agree that an investment strategy can intentionally invest in women and founders of color, while still maximizing returns.
So investors are coming to understand that they are not required to sacrifice returns for diversity in their portfolios. Diversity really plays into the ability to fund direct investments that can actually outpace the benchmarks, even in early-stage companies.
So we do observe that push and pull where LPs (limited partners) say, "We want to see diverse founders in VC portfolios." And VCs say, "We want to find diverse founders," and then go to their sources to open their own networks to those founders.
We also hear LPs say, "We want to put more capital into emerging managers and funds of color." The objective is to tackle social issues while investing in companies that are inherently more sustainable, because they find solutions to problems affecting their communities.
Bottom line
Across the spectrum of private investing — from early-stage funding to deal sourcing to public offering — we see the role of sustainability as ever-increasing. Governmental supervision and legislation push us to factor ESG metrics into our investment analysis, while our clients pull us forward to take their preferences and objectives into account.
Relative to the public markets, private markets give investors the ability to require these outcomes and let them track the impact their money is creating. After all, this is just good private markets investing, and we are headed in that direction.
By Vikram Raju, Head of Impact Investing for Morgan Stanley Investment Management AIP Private Markets
