In this column, over the next few weeks, we'll be increasingly speaking to the limited partner ("LP") community: Pension funds, endowments, corporates and others who are the major source of funding for venture capital firms. The upcoming "NextWave Greentech Investing" conference by Greentech Media has already brought in a lot of participants from the LP community (you haven't signed up yet? why not!) and is aimed at encouraging a broader conversation across LPs as to when and how to get back into the sector and the megatrends it's taking advantage of. So we've been spending a lot of time recently getting the LP perspective on where the sector is right now.
As such, I had the opportunity to spend a couple of days with LPs and other fiduciaries last week, to specifically discuss energy investing topics as part of the east coast RFK Compass conference. Which, by the way, is a terrific event, they've done a great job of bringing together thoughtful LPs and creating a safe space for open conversation.
One thing that struck me about these LPs at this conference was the extent to which many of them are feeling negative pressures to divest investments in fossil fuels, but not feeling the positive opportunities inherent in the same trends.
To take a step back: The Divestiture movement is an emerging effort to get university endowments and pension funds and other LPs to eliminate their investments in fossil fuels, directly and indirectly. It's especially strongly felt at university endowments, but I've seen it asked of large government employee pension funds as well. It's analogous to previous efforts to divest from investments tied to apartheid South Africa and to tobacco.
The push-back on the Divestiture request is of course a) to point out that there's an exceptionally large amount of pension fund capital tied up in SOME way into fossil fuels, so this is a much bigger ask than one might imagine; b) it's unclear where the investor should draw the line (is responsible production of natural gas really a net-negative for the environment, if it's cannibalizing dirtier fuels? many think not); and c) to suggest that objections can be more powerful inside the shareholder meeting than outside.
My intent is not to get into that debate here.
But what struck me is that all of this is really predicated on a couple of negative assumptions: That divestiture is about returns tradeoffs. And that divestiture is about categorical shifts.
First of all, let's talk returns tradeoffs. The portfolio theory of being an LP suggests that any limitations on the LP in terms of where they can invest result in lower returns. And this makes sense in theory. If you could choose from among the entire universe of investment opportunities, then any impingement upon those available choices results necessarily in lower returns. Why? Because there will be some superior returns among the boxed-out segments or asset categories. If your goal is to produce superior risk adjusted returns and someone tells you you're not allowed to invest in a quarter of the available managers because of some restriction or another, you'll be shunted into a smaller opportunity set and therefore risk lower returns.
It's a solid theory. But in reality, which pension fund managers thoroughly evaluate all available investment options available to them? In my mind, the theory breaks down on this assumption. Since you can't possibly cover the entire universe of investment opportunities equally thoroughly, then there's a more important filter in terms of where you're looking. This supercedes any selection bias forced by a sectoral screen, and opens up the possibility of positive effects from changed priorities. But importantly, sectoral screens also aren't the only solution, which brings us to our second point.
Which is: Divestiture pressures don't have to result in categorical shifts. They don't have to result in outright rejection of all fossil fuel dependent industries, but instead they can help unlock other sources of value by identifying inefficiencies and more strategic value differentiation even within industries.
There's been a lot of research done to suggest that, within any given market category, the environmental leaders outperform the laggards. I saw it at my old shop way back when I started my career, and I continue to see it in additional research today. I believe this applies in the investment universe as well as down at the individual portfolio company level (where most of this research has been done).
One participant in last week's conference declared, "Over the long run, externalities will be priced in." And this, I believe, is true. But let's not be sanguine about this fact. "Over the long run, we're all dead" would be the appropriate rejoinder to this sentiment. Just because eventually externalities such as the societal damage of coal, etc., may end up being priced into the market, doesn't mean alternatives are necessarily a good bet today. It's unclear how or when even "inevitable" shifts will happen, and I sympathize with LPs who now have to take a perspective on timing this long-term dynamic. So I'm not here to argue that it makes sense for all LPs to assume, for instance, a particular carbon price when evaluating investment opportunities.
But that said, LPs are affected not only by returns expectations, but by risks. And across investment categories, climate change and other related factors now represent an external risk that at some unpredictable point might become internalized in the portfolios of managers that these LPs back. Thus, LPs should hold managers accountable for how they're assessing and dealing with this risk. Even for LPs who cannot or choose not to divest from fossil fuels for whatever defensible reasons, the divestiture movement could serve as a wakeup call to view their manager selection through a sustainability lens.
When I was starting my career, working with Fortune 500 companies helping them identify profitable and sustainable business opportunities, we developed a perspective that there are actually four different ways that such a perspective could unlock shareholder value. Only the first of which was "right to operate", i.e., worries about being denied ability to operate thanks to public reaction or regulatory crackdown or other negative pressures. Yet, this is where the Divestment movement is mired right now, from the LP perspective.
What we showed was that positive screens -- "how can you take advantage of rethinking your operations, business or market" -- also yielded strong shareholder results. Sometimes very significantly so, by unlocking business model innovation. And that requiring the thought experiment ("how can we take advantage of sustainability trends, instead of just reacting to them") was the way to uncover such improvements.
As far as I can tell, few LPs are viewing the Divestiture movement -- much less broader sustainability pressures -- in this way. It's still a reactive exercise, and still viewed as a negative screen.
We'll talk more about other implications in future columns, but the one big implication of this for LPs is this: Even if you're not going to deny yourself entire categories because of Divestment and sustainability pressures, you should still look to favor some managers over others within any categories and sectors, on the basis of evidence they've soberly assessed these pressures themselves. Managers who've got a thoughtful perspective on climate change and likely regulatory impacts, etc., have at least thought it through. Even if they then invest against these factors (for instance, I've seen some thoughtful energy project firms recently invest in both solar project finance AND coal-fired powergen production) it's an educated judgement call they've made. They're considering the risks and the tradeoffs. And that ultimately reduces LP risks.
So while the Divestment debate rages on, it should be a prompt to LPs to apply climate risk-mitigation strategies across their entire portfolio, in a more discerning fashion. Within even seemingly extraneous categories (real assets, real estate, etc), using this lens can help differentiate between long-term thoughtful managers and riskier-than-advertised firms. And certainly in direct-hit categories like venture capital and especially energy project finance, it can be an invaluable screen for seeing which managers are viewing long-term trends appropriately and who's ignoring them. That's true even if the answer is to back a manager who's heavy into fossil fuel projects; just knowing they've asked the right questions is a risk-mitigating move.
I don't see a lot of LPs viewing their world this way right now. It's all about categories, not differentiating managers within categories. And thus Divestiture is seen as a threat to returns rather than an opportunity to boost returns. We'll talk in the next column about cleantech as an alternative category in which to put capital with equivalent returns. But for today, just note that even without shifting any asset allocations or category allocations, simply reacting to Divestiture pressure by using it as a lens by which to view managers and their risk-mitigation strategies, can yield dividends for portfolio managers.
And sign up for NextWave today!