Accelerating sustainability in alternatives

Investors have increasingly prioritized environmental, social and governance (ESG) standards in recent years. Now an economic shock of historical proportions presents the first real-time test of sustainable investing. Will the crisis push governments and investors to prioritize growth over sustainability? Teresa O’Flynn, Global Head of Sustainable Investing for BlackRock Alternative Investors, explained why that is a false dichotomy in our recent webcast, Accelerating sustainability. The following is adapted from her conversation with Mark Everitt, Head of Investment Research and Strategy for BlackRock Alternative Investors. 

What was the state of play in sustainable investing before the current crisis?

We’ve seen a rise in sustainable investing in recent years driven by a few key factors:

Firstly, the increasing incidence and severity of extreme weather events are moving climate, which is just one aspect of sustainable investing, to center stage.

Secondly, we are seeing a growing number of regulatory interventions around the globe putting ESG at the center of the asset management industry.

Finally, society as a whole is placing increasing emphasis on sustainability, and we believe this represents a structural shift for investing.

The culmination of these factors led BlackRock, in January, to commit to making sustainability our new standard for investing. We did this because we believe that sustainability- and climate-integrated portfolios can provide better risk-adjusted returns to investors over the long-term.

Since then, of course, we’ve had the COVID shock, and questions about whether interest will wane in a downturn. But if anything, the reverse is true. 

Public market data backs this up - we have seen strong flows into sustainable products during this unique time. Global sustainable flows totaled US$44B across the industry in Q1—a 57% year on year increase.

What’s different about ESG investing in private markets?

Let’s start by defining what we mean by Sustainable Investing: Sustainable investing combines the best of traditional investing with ESG insights in order to generate better long-term outcomes for our clients.

There are two major elements: ESG integration, which is about risk management and investment process and applies to all investment strategies. Over and above integration, sustainable investing also includes those strategies that target specific sustainable outcomes such as renewable power.

ESG is relevant for both public and private markets but is arguably more important for private investing given the long term and illiquid nature of the asset class. It can also be harder to do in private markets.

For one thing, private markets do not have the same data set, particularly on return implications. In public markets, we have seen studies from Bank of America Merrill Lynch and others showing positive links between ESG factors and performance over the last number of years.

It also requires a much heavier lift in private markets. There are no third-party ESG ratings reports to rely on. Instead one has to do all the analysis from scratch on the way in – digging into environmental reports, working with external engineers or interviewing management.

ESG also needs to remain top of the agenda once you own the asset - a key element of private market investing is hands-on day to day asset management. ESG issues will vary considerably depending on what sector you are in (energy v healthcare v IT) and even within the same sector ESG issues can be very nuanced project to project, so this becomes an asset by asset decision.

How will the COVID 19 crisis impact sustainable investing?

This crisis has forced us as investors to question our assumptions in fundamental ways across the board, and that's true for sustainability as well. Most of the sustainable investing strategies in the market today have been developed in the 12-year period since the GFC, so this is an important test.

We have seen resilience of ESG factors in both public and private markets during this time. 

We have seen an increase in the importance of “S” issues: supply chains, employee health and safety, retention and community engagement are examples of some of the factors that have come to the fore as some of the most material issues for companies’ resilience in the current environment.

Governance issues such as the strength of a company’s risk management procedures and business continuity plans have been tested. These areas have been a key focus for investment teams across our business. In many cases, we’ve seen that a focus on these ‘S’ and ‘G’ issues has increased financial resilience during this pandemic. 

Mark Carney, the former Bank of England governor, zeroed in on this point in a piece he published in The Economist last month. His observation is that where the last crisis taught banks hard lessons about leverage, this one will change how companies balance risk and resilience. We have entered a world in which firms that operate with minimal liquidity, stretched supply chains and token contingency plans face a harsh judgement.

We think some of these lessons are already appearing. Let’s turn to public markets again for a moment. Sustainable strategies have not just held up relative to non-sustainable peers, they have also in some instances seen outperformance and accelerated flows. Per Morningstar, ESG active funds have generally outperformed non ESG counterparts over the first quarter of 2020. 70% of sustainable equity funds ranked in the top half of their Morningstar categories and 44% ranked in the top quartile.

In private markets, the best example of the resilience of ESG factors that we have seen has been in our renewable power infrastructure strategy, which benefits not only from low correlations with broader markets but also its positioning within a long-term global energy transition.

As for client interest, I’ve already mentioned the flows we’ve seen into sustainability strategies on the public side. Our client conversations indicate that this interest is equally strong on the private side, with growing recognition of the structural shift sustainable is creating and the attractive growth opportunities it’s creating.

How do you see the future?

Climate change will remain a top focus – we are spending more and more time developing our analytical capabilities around this. We view climate risk as investment risk. 

We believe that technology can be better leveraged in private markets ESG. In our Real Assets business, for example, we are working with GRESB – the leading Real Assets sustainable investing benchmark – to help define the best approach for collating, monitoring and reporting on key ESG data. In our renewables business, we have developed an innovative impact reporting methodology to better quantify and contextualize the real-world positive outcomes and enable comparison across sectors and regions. 

We also expect a growing emphasis on the ‘S’ in ESG. This is particularly relevant in private equity – which has a special duty as a change agent and an important participant in the corporate restructuring ahead. We are encouraged to see industry adoption of sustainability standards – through our private equity fund of fund business we believe we play an important role in demanding the highest standards from the GPs we work with. Through our direct private equity business, which is focused on flexible hold periods and longer time horizons, we think we’ve brought additional focus to incorporating ESG into the underwriting process in all its dimensions, from prudent use of leverage to attention to stakeholders, to cybersecurity and beyond. 

I’ll close by noting that this is not an easy agenda. There’s plenty of work ahead. And as a fiduciary, we see it as our role to help our clients carry it forward.