Investing in environmentally-driven businesses over the past fifteen years has been a roller coaster. Once known as “Cleantech” investing, it has been both a buzzword and later, a synonym associated with broken promises of great returns. Mostly funded by venture capital firms, in 2005 many senior executives forecasted “Green Technologies” as set to be “bigger than the internet.” Expectations were definitely not met.
According to MIT research, around US$25 billion of A-round investments were ploughed into Cleantech between 2006 and 2011. Almost half of that capital was burnt away. Investment cases around new technology development proved to be too high risk and too long term to generate targeted returns. Since then, investors have increasingly shied away from the topic, assuming returns in the space would lag behind the market average. Most funds have been unable to raise new capital for the same strategy.
This has changed in recent years due both to changing consumer attitudes and a more international approach to sustainability. The introduction of the UN Sustainable Development Goals in 2015 clarified to investors what only a handful of them had previously understood: sustainability encompasses a much wider range of topics than just energy and climate change. It is about rebalancing economic development with its drawbacks, such as global social inequality and negative environmental impact. In parallel, raising consumer awareness has put pressure on large asset managers to focus on sustainability-driven investments, thus including in their mandate not only financial returns but also sustainability objectives. A brand new investment case for asset managers emerged.
Industry juggernauts, such as TPG, KKR or Bain, raised large dedicated vehicles for sustainability, joining specialized firms. Almost all claim to target uncompromised top-tier financial returns and uncontroverted positive impact on society and/or the environment. While proving returns will be a standard test for the industry, the ability to achieve and demonstrate actual environmental or social impact will be a hard first-of-its-kind test for the whole industry.
So far only a handful of private equity investors have achieved a positive return track record in private equity investment coupled with measurable impact metrics. Several traditional impact investors have achieved impact but failed to deliver compelling returns.
In the next ten years several things have to happen to make sure this powerful trend continues to thrive. First, industry practitioners will need to clarify the definition of impact in order to allow for meaningful comparison across funds. It is really unclear today how investing in safe water access in Africa is comparable in sustainability terms to providing growth capital to a consumer finance platform serving e-commerce in Asia. Second, a clear definition of targets in terms of sustainability objectives has to be defined. If not, the financial returns objectives, clear and prevailing in most executive incentive schemes, will eat out any other considerations. For thematic investors who do not commit explicitly to specific objectives that would be fine, but otherwise customers’ requests to achieve specific impact in addition to financial returns are likely to be betrayed.
It will take at least a decade to fully see how far the industry has progressed with this mission. All these new investment vehicles have to deploy capital, as well as report on both financial and impact metrics, and investors will need to review, assess and compare performance on both sides.
Investors are encouraged to focus their attention on managers’ initial statements around their impact objectives and the relative impact reporting along the way. Check for consistency of message: if managers commit to quantitative targets, they should report against them and explain why and how these targets were achieved or missed. If the targets are not met, or revised downward while economic performance is high, then give the correlation between financial and impact returns a second detailed review. Very few investment cases are so intimately in line with one another that no compromise is required. If a compromise is needed, it is likely the impact side of the story is at stake.
The next ten years will be critical for the industry. I am sure many new winners will emerge, but on the other hand, some investors will have to review management incentive schemes to ensure impact objectives aren’t going to be neglected along the way. As top tier investors achieve top tier returns, top tier sustainability investors will have to prove top tier sustainability and financial returns. The bar’s been set. Let’s see who reaches it.