February 4, 2020
Gone are the days when lip service to ESG is enough to assuage investors, says StepStone’s global head of responsible investing Suzanne Tavill.
After years of talk, the private investment world is taking action on ESG and responsible investment. The key to successful strategies, says Suzanne Tavill, is for GPs to ensure ESG efforts are investment-led with clear lines of accountability. Meanwhile, she says LPs must continue advocating for greater emphasis on measurement and reporting, particularly in the application of the United Nation’s Sustainable Development Goals, or SDGs. The concern is that without impactful measurement and reporting, SDGs could prove to be a “check-the-box” activity, rather than effective indicators of progress.
Q: What is the essence of StepStone’s approach to responsible investing?
At its core is our belief that ESG is an investment strategy. What I mean is, ESG considerations need to be deeply embedded in investment due diligence so that it influences how an asset is priced. We believe strongly that if these factors are not comprehensively considered, then assets will be mispriced. We acknowledge that many ESG issues are externalities which need to be internalized in asset pricing. GPs that fail to actively embrace these issues are not effectively performing their fiduciary responsibilities. When we look at the market, we are seeing greater divergence between those investors who are considering these issues in due diligence and those who are not. This is creating an ESG arbitrage in the pricing of assets. Our approach is to position our clients to be on the right side of this arbitrage.
Q: Can you give some examples where ESG arbitrage is possible today?
An obvious example is that better-managed businesses with respect to ESG can access lower-cost debt. So, the ability to measure and report on key metrics for debt providers is delivering real value. Another example is the increasing divergence in the pricing of property portfolios that are thoughtfully curated with respect to location (high versus low-lying flood zone prone areas) versus those portfolios that are not. We believe that the pricing spread will continue to grow, and that some investors are underestimating the risk of their assets becoming stranded. This underestimation is tied to the belief that ESG issues will only be relevant in the future and fueled by a lack of foresight for inevitable policy responses. It is our belief that these policy responses will be material and are in the forecast period for investments.
Q: In your experience, how are GPs approaching ESG today and what approaches are effective?
I think GPs fall into two broad categories: Those that recognise that ESG is an investment function with a clear line of accountability to senior investment principals, and those that do not see ESG as relevant to their investment business. We recognize that within this first group, GPs will be at varied points in their journey of integration. We want to support and engage heavily with such GPs by suggesting approaches, tools and specialist consultants. Often, with the second group there’s confusion between ESG and philanthropy. They will give examples of their philanthropy efforts, but that is not ESG as we’re speaking about it, which is something that is integral to the investment process. Within this second group are also GPs that view ESG solely through a risk lens. Often this is reflected in reporting lines that only include compliance or operations departments, and not the investment team. Along geographic lines, Europe continues to lead. The US relatively has been a laggard, but in 2019, we started to see more GPs raising their game. I think 2020 is going to be a critical year for that jurisdiction.
Q: And from the LP side? How are LPs driving the progress when it comes to responsible investing?
LPs are critical in driving change at GPs. Their advocacy on these issues raises the priority level of ESG considerations for GPs. Particularly as GPs come back to market for new fundraising, we are seeing LPs becoming more vocal in terms of restrictions, exclusions and reporting requirements. On the latter point of reporting, I believe this is an area where LPs should continue to push hard; if GPs have to report on something, then hopefully this means that they will be taking action in their underlying portfolio assets. This should also drive GPs to implement more comprehensive measurement systems for their portfolio companies that blend financial and ESG related metrics. These efforts are going to become even more critical as LPs begin to further integrate SDGs into their portfolios. But for LPs to be able to invest, measure and report on SDGs effectively, they will need the GPs to invest in better systems to enable these efforts.
Q: So, LPs are pushing and GPs are responding. But how effective are restrictions and exclusions as a strategy for achieving sustainable development and responsible investing goals?
In our view, the risks and merits of each investment must be carefully considered. Any investment decision comes with complexity and trade-offs, and consequently, we are cautious around applying absolute screens or restrictions and exclusions. We are also cognisant that when you exclude capital to an asset or sector, you are removing the opportunity to engage and advocate for change. With respect to our due diligence process, there are some opportunities that fail to progress through our process. For example, we looked at a co-investment into a company that produced firearms for hunting and another that provided specific services to inmates in prison, and ultimately decided that there were a number of ESG concerns that we were unable to mitigate. On the other hand, we have been able to progress investments into certain industrials businesses that on first look presented a range of ESG concerns. The difference was these investments presented opportunities to reposition businesses and drive value through active ESG management (the ESG arbitrage we were discussing earlier).
Q: Which responsible investment and SDG goals matter the most to LPs?
With 17 UN SDG goals to choose from, there’s something for everyone. We see two groups emerging: LPs with a more social orientation tend to focus on education, gender equity, health, and wellbeing goals; and LPs that are oriented around sustainability and environment, tend towards clean water, sanitation and circular economy goals. There are two goals that I would say resonate across most LPs. The first is climate action and the second is gender equality. Arguably, climate action has become the first among equals as climate is relevant across E, S and G dimensions. With the partnership between UN Principles for Responsible Investment and the Financial Stability Board’s Task Force on Climate-related Financial Disclosures, the climate is becoming central in terms of what LPs are expecting GPs to consider, and how they report.
Q: Can you give an example of how StepStone’s approach to responsible investing has created value for its clients?
StepStone allocates capital to and invests alongside GPs, so our key mechanism for value creation is in our due diligence and continued active engagement with GPs. We recently vetted a co-investment in the heavy industrials sector. This space is replete with ESG issues: challenging working conditions involving hot metals, extensive toxic chemical usage, noise and dust pollution, groundwater contamination risks, etc. It would be easy to walk away from industrial investments, but our approach involves considering the risks and merits of each investment. We engaged heavily with the lead GP during our due diligence, raising the set of ESG risks and opportunities we identified. The GP was able to produce solid responses across many of the issues but was also receptive to extending environmental due diligence and ensuring that there were relevant executive and board-level appointees dedicated to these issues. At the end of the collaborative process, the deal structure was improved and the risk-adjusted return enhanced. One could say, great, you’ve gone through all this trouble to do an investment in an old industrial metal business. The thing is this company manufactures critical components for aircraft that materially enhance fuel efficiency. The investment in this company directly contributes to lowered greenhouse gas emissions. The reason I highlight this example is that often when people think about making responsible investments, there’s a tendency to concentrate on the obvious green sectors, such as renewables. But I feel very strongly that if the global economy is to effectively decarbonise, it is important to recognise that capital will need to go into all sectors, including spaces like mining and industrials. Having said that, selectivity at the asset level will be critical, as not all businesses will manage to transition and unfortunately some may not even embark on the journey.
Q: Within the investment world, how has the conversation around gender equality, and diversity more broadly, evolved in the face of modern social movements including #MeToo?
I think #MeToo raised awareness of sexual harassment, but critically it was remarkable in giving a modern voice to women. As you’ve rightly noted, the issue of diversity is broader than sexual harassment and gender; but #MeToo has helped drive all these discussions into the open – and we need to work hard to maintain the momentum. Within the finance community there are several very rational-sounding arguments about why there’s not more diversity within financial and investment organisations. But we know that the people managing these organisations are can-do people. They build businesses and provide solutions for their clients, and I think those minds need to be applied with ever more urgency to driving diversity. I would hope that the equity argument is sufficient, but there’s plenty of research supporting why diversity leads to more sustainable and arguably more successful organisations, so diversity efforts can be supported on purely financial grounds.
Q: When you talk about advocacy, what are some of the challenges for you in your role as the head of responsible investment at StepStone?
I’ve heard it said that there is often a cognitive disconnect between what people know to be true in their personal lives and their mandate at work. I think this is an important observation. I know that across our hundreds of employees in 13 countries, they are deeply concerned about building a sustainable future for themselves and their families. My challenge is creating that link so that StepStone’s employees understand they are empowered in their work. As a global private markets investment firm overseeing over $280 billion of private market allocations, including $58 billion of assets under management, we can make a real difference. With our considered focus on responsible investing and a drive to support those GPs that effectively integrate ESG into their investments, we enable the decarbonizing of our economy. Just like GPs and LPs, we are on a journey. There is urgency in this journey. We all must do more and do it better. I often hear colleagues in finance speak of the difficulty of explaining to their kids what they do. Responsible investing allows us to shift from speaking about numbers to real-world outcomes. When my kids enquire about what I do, I speak about the companies and projects we have funded that are actively contributing to decarbonizing our world and making it more sustainable. They ask tough questions at home, and are disappointed with the rate of progress, particularly around climate change. I’m proud to know that they feel I’m contributing to changes necessary for their futures.