Toward a New Economy: The New Investors
Towards a New Economy: Investors forging a road less traveled
We live in an economic world that most would call capitalism: a word we all use, but definitions vary. Generally starting with “An economic 'system' …”. The definitions go on to define aspects of the ownership of capital. What is left out is the question: "What are the goals of a capitalist system?" As the goals of a capitalist economy have changed, so have the investor strategies that fuel markets. Currently, the system has tended toward 'maximizing shareholder profit' rather than on creating companies that have long term value for shareholders through:
- Transparent and accountable governance,
- A stable employee base that makes enough money to purchase the output of the economy,
- Policies that strengthen local communities, and a
- Means of production that produces goods at the least cost to the environment.
Investors, who do use these metrics as a basis for their decisions, use terms such as 'mission investing' ,' triple bottom line', 'ESG' and 'impact' investing. However, such terms can miss the point because they imply that investors are searching for social good, not for metrics that provide returns above market rate. Yet as far back as 2009, Sarah Stranahan, speaking at a Sustainable Investing conference in New York, spoke about the Needmor Foundation, which has used a mission investing strategy.
"Why are we trying to prove that we [mission investors] are as good as the dominant markets? The dominant markets have failed dismally. Needmor did 4.5% better [than a comparable foundation without a mission strategy]. So what? We still lost 25% of our endowment. We failed in our fiduciary duty and disappointed our grantees and our staff because we had faith in the dominant markets."
As foundations and funds were reassessing their strategic goals in 2009, Dave Chen in San Francisco was working on a plan to implement.
Equilibrium Capital: The New Metrics
Mr. Chen gathered together a few like-minded people, then started a company called Equilibrium Capital — Eq-Cap.com — where he is Chairman and Head of Product Development. In recent remarks in San Francisco at Equilibrium’s 5th Annual Summit, he compared the early days to trail-blazing through dense tropical forests. He was speaking to over 70 participants from major public and corporate pension funds, sovereign wealth funds, insurance companies, US state and federal agencies, family offices, and others. While Equilibrium now has nearly $1.5 billion gathered onto its platform, , the combined investment power in the room was easily over $1 trillion, all of whom are at least thinking about what a new capitalism might look like, and many of whom have already invested.
“These [environmental] asset classes aren’t new – they’re 10,000 years old – land, water sheds, buildings, farms, transportation routes, water supply systems. There’s property in Oxford University’s endowments that have been continuously owned for close to 1,000 years. What’s new, by comparison with currently prevailing investment methods for institutional capital, is the understanding that sustainable approaches translate to asset productivity and asset value resilience in long investment hold periods. That subtly affects how one shapes the investment opportunity in these old basic asset types.”
His analogy was apt, because he was talking about a new way of understanding building investments in critical assets – water, energy, agriculture and food, real estate, and transportation—that involve long term plans to develop, finance and manage in an increasingly complex technological, financial and policy environment. In 2007, when the US economy was breaking from the overheated mortgage market, Mr. Chen and his team began combining their deep financial and market experience with new in-depth sector research. By building relationships, they expanded their core knowledge base with insights from technology and policy experts. These are important steps, as new investment approaches, even to ancient asset classes, are generally viewed with skepticism by the major institutional investors that can ‘move the needle’. Two of the challenges include how investors get their money out of long term investments, and how markets define the terms that manage risks for new asset classes.
Liquidity, the degree to which a security can be quickly bought or sold without affecting the asset's price, is critical for investors who may need to access their invested cash. As Bill Campbell, Equilibrium’s Head of Structuring and Sustainability, explained: “Assets are often going to be adding value, perhaps dramatically, for a development period, and then entering a longer period of stability. The former are ‘value added’ funds and the latter, ‘core funds’. Either way buyers have to be able to get in, and out. If they are going to be tying up their capital for up to longer periods without liquidity, they expect to get paid for it, and there’s a place for that in their portfolios.”
He went on to describe the characteristics of each.
- Value Added Funds: Are used to develop and build buildings, windfarms or other assets that will then produce long term returns upon completion.
- Expect higher returns than core funds due to development risks that do not recur in the stability period.
- Typically are designed around a particular market window. The project is kicked off in the first year or three, and completed and sold within the fund’s life, which may be 10 years, for example.
- Provide liquidity at the sale of the project, often into a core fund. However, some such funds allow investors to sell some of their share earlier and some later than the formal end date, providing some flexibility.
- Core Funds:
- Reap returns from the cash flows coming off a fully leased building or utility scale solar installation for example.
- Core funds are typically perpetual, providing in-and-out liquidity either through public vehicles such as REITS (Real Estate Investment Trusts) or private institutional markets. The latter is often preferred by institutional buyers because they can avoid the volatility of public markets.
Mr. Campbell added: “You can think of this as intrinsic vs. extrinsic liquidity. Intrinsic liquidity gets you money by selling the funds’ assets. Extrinsic liquidity gets you money by organizing it so you can sell your interest in the fund. Good economic theory says they should be worth pretty close to the same thing. In the real world, sometimes it makes sense to do one, sometimes the other.”
Growing New Asset Classes
By creating funds in infrastructure, Equilibrium is – at the most basic – investing in the simplicity of necessities. As Mr. Campbell said, “We invest in things that people need and will continue to pay for.”
One example of infrastructure investment is water, an essential that is too often taken for granted in modern society. We need water for our very survival as animals, but we use as much as 70% for agriculture, 19% for industry including power generation and 11% for municipalities. Ironically, as power demands grow for long distance water management, so does the water used to create the energy that fuels the pumps.
Equilibrium’s Ben Vitale, Principal on Water and Waste, remarked that the company recognizes the potential capital behind water and wastewater, while also encouraging support for local communities in their water conservation endeavors. Mr. Vitale sees wastewater treatment as a way to provide capital from resources that have already been used. This fills two important needs: one to clean, preserve and manage our fresh water, and the other to support local governments that do not have the expertise, the time or the budgets to develop and manage complex water projects.
As an example, Mr. Vitale noted that in spite of California’s significant water challenges, the state is not set up to efficiently manage water and wastewater, as existing regulations tie water rights to agriculture. Such policies create tension between farmers and municipalities, politicizing solutions that are going to require collaboration between public policy and private markets. Long neglected, cities and towns across the country are finding a need to prioritize water infrastructure as crumbling pipes, outdated facilities and EPA regulations are making existing facilities outdated, inefficient and, in some cases – as in Flint Michigan -- dangerous. Solutions are going to be expensive and essential. Mr. Vitale cited three examples of areas that Equilibrium is evaluating.
- Water Reuse
Waste water is in many ways a misnomer: it is full of organics that have a useful life if extracted. If not, they are released as pollution and the water wasted. Often the bio solids in water treatment plants are burned, releasing toxic substances that impacts local communities, especially low income neighborhoods where treatment plants are likely to be located. This is a problem that local municipalities and industries can find it hard to solve on their own.
- Anaerobic Digestion
The company is building market expertise around methane, which is the output of anaerobic digestion. This biological process employs microorganisms to break down organic materials in the absence of oxygen, producing a gas with the lowest carbon intensity of the transportation fuels. The result is renewable energy that couples waste management with a huge amount of potential, as methane can be injected back into pipelines, compressed as natural gas or used to create new lower carbon transportation fuels.
- Agricultural Waste
Agricultural waste is another win-win as communities reuse the potential energy from manure lagoons to provide a natural resource based energy for rural communities. Such processes keep pollutants out of waterways, where they become an added burden for downstream waste treatment facilities. In rural communities, which depend on agriculture as a financial base, processing waste streams with long-term solutions helps keep communities in compliance with agricultural and water regulations, while creating capital streams from the energy extracted.
The Equilibrium Strategy
Mr. Vitale and others at Equilibrium are building on huge opportunities to provide a bridge between infrastructure problems and investors. Jay Pierrepont, President of Asset Management at Equilibrium, mentioned at the San Francisco Summit that the growth in the sustainable investing world could be gauged by the growth in assets represented at Equilibrium’s forum – from less than $24 billion 5 years ago, to over $1 Trillion in 2016.
By using their expertise to bring together investment management and sector operational expertise, they seek to manage the risks and take advantages of improved performance. By following sector trends, they find hidden opportunities as market demand shifts and new innovations increase production efficiencies. Their market expertise also helps to identify and find ways to capitalize on market inefficiencies, finding mis-priced assets, mis-priced risks, and misunderstood asset classes.
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Mr. Chen said in his remarks, “Equilibrium is now out of the jungle, laying tarmac on a single-lane road, while getting ready to expand to a multi-lane highway.” He described Equilibrium's approach as "innovation at scale.” It’s a strategy that looks at the long term, evaluating opportunities based on real values, which works with massive infrastructure deficits against basic needs while helping communities build a capitalism that cares about all resources – including the people who live and work here.