Friday Letter Expect the unexpected

Two fresh reports suggest private equity may be well positioned to capitalise on an uncertain future.

Part of the skill of successful private equity investing lies in the art and science of forecasting. Your investment thesis and its 100-day plan for the deal are based on assumptions of how the business will perform, if leveraged appropriately and well run. Of course you will focus on the things within your control, but consideration should also be given to external forces.  These you may be helpless to influence, but you can and must plan for them.

KPMG’s sustainability team want you to think about 10 global “megaforces”, outlined in a report entitled “Expect the unexpected”, which they believe will fundamentally alter the business landscape over the next 20 years. Towering above them all is climate change – the one global “megaforce” that directly impacts all others it says. Predictions of annual output losses from climate change range between 1 percent per year, if strong and early action is taken, to at least 5 percent a year if policymakers fail to act.

Fossil fuel markets are likely to become more volatile and unpredictable because of higher global energy demand, while material resource scarcity is predicted to increase dramatically, as developing countries continue to industrialise rapidly. It is predicted that by 2030, the global demand for freshwater will exceed supply by 40 percent.

Population growth, to 8.4 billion by 2032, will place intense pressures on ecosystems and the supply of natural resources such as food, water, energy and materials. All the time the global middle class is predicted to grow and to want more, just when we have less to share.

The report adds urbanisation, food security, and ecosystem decline, notably from deforestation, to the brew of complex, interrelated impulses that make the future impossible to predict. Are we teetering on the brink of catastrophe? No one knows. The challenge is to prepare for a number of possible scenarios and to see the opportunities in them.

Here private equity is singularly well placed. A recent study by investment consultancy Mercer’s private equity fund of funds group, suggests that across all the various investment strategies, private equity managers are doing a better job on ESG than anyone else.

There are a number of reasons. The first is the industry’s high level of active ownership and engagement with company management. Then there’s the increased interest in this area from potential corporate suitors; in other words, if you know that a big public company with ESG obligations is a possible buyer of one of your assets, there’s a strong incentive to prepare the company for sale accordingly.

Finally, the growing emphasis on risk management within private equity – to include environmental and social risk – also apparently tends to result in them scoring highly.

As of April this year 1,000 institutional investors managing assets worth $30 trillion globally have signed up to the UN PRI’s principles of responsible investment.  They believe managing environmental, social and governance risks can have a material impact on long-term shareholders by improving returns.

Identifying the risks is critical. Even then the battle will be hard won. Heraclitus in the 5th Century BC first pointed out the difficulties of expecting the unexpected. Still the lesson has persisted through the ages to be no less relevant today. Oscar Wilde memorably paraphrased the sentiment in his play An Ideal Husband: “To expect the unexpected shows a thoroughly modern intellect.” Private equity: truly an asset class for our times, he might have added.

Come and meet some of the investors that believe private equity can deliver superior returns through responsible investment at the PEI Responsible Investment Forum, co-hosted with the UN’s PRI.