Thematic private equity investment

How do you incorporate ESG into the due diligence of potential co-investments?

We believe that collecting data is only useful when you do something with it. We assess GPs’ ESG maturity and practices, benchmark them and actively give feedback – for example, by engaging with managers that are lagging, and sharing our expectations with the aim to raise the bar for the industry overall. To help us get better data, we joined private equity’s ESG Data Convergence initiative as a steering committee member. This data has in turn proved useful for focusing our efforts and prioritising our engagements with managers.

In terms of what we are looking for in a co-investment, it needs to fit with one of our five pillars: greenhouse gas emissions reduction; sustainable consumer goods and agriculture; pollution control; the circular economy; and technologies that support the other four pillars. Each time an investment fits into one or more of these segments, we look for the top line to be growing and for the environmental KPIs to be moving in the right direction as well.

The measurement of a company’s environmental contribution is also critical, but it can be challenging, particularly for small firms. In those situations, we try and connect with the management team of the underlying asset to better understand their environmental life cycle and footprint. This will ultimately create value because when it is time to raise a new round of capital or exit, being able to show that data opens up the number of potential investors, and can have a positive impact on valuation as well.

Can you tell us about the Planetary Boundaries framework?

The Planetary Boundaries is an open framework developed by the Stockholm Resilience Centre. Pictet has spent a lot of resources developing a proprietary model based on this framework that allows us to take a holistic approach to assessing investment opportunities. It allows us to map investments against hundreds of different business segments, allowing us to estimate the footprint of the company’s economic activities based on the nine Planetary Boundaries.

This model has been used in the listed side of our business for several years already, and we are now implementing it on the private equity side as well. It is slightly more challenging to map companies against business segments where the business model is more disruptive and the technologies more nascent. It requires some adjustment, and so takes more time.

By running the Planetary Boundaries model, we can quickly assess if it’s an investment we want to pursue or not: if the company’s economic activities have, on average, too great a negative impact, we will not proceed. However, the most interesting part of the model is that it shows us the footprint a company’s economic activities can have on each of the nine boundaries, therefore creating an engagement opportunity.

For example, if a company is making a significant beneficial contribution by reducing greenhouse gas emissions, but is also having a negative impact on biodiversity, it creates an opportunity for us to engage with the GP - or even the management team itself - to better understand the causes and see how that issue could be addressed.

How would you describe the scale of the sustainability opportunity?

We receive at least three to four co-investment opportunities per week. Of course, there are many situations where it’s too early stage or the GP doesn’t have the right track record, for example, but that gives you a sense of the scale of the deal flow out there. This is helped by the fact that there are a growing number of firms focused exclusively on the environment, and we are primary fund investors with many of them.

At the same time, the majority of big established venture, growth and buyout firms are now investing a substantial proportion of their capital in environmental themes as well.

Why is the environment such a compelling investment theme for you? Which sub-sectors do you consider to be the most interesting?

We believe you can generate outsized returns by investing in firms that address pressing environmental challenges; we see established businesses in buyout situations that are generating between 20 and 30 percent growth, along with healthy margins. We also believe there is less risk of tech or regulatory disruption when investing behind environmental themes because you are already investing in the economy of tomorrow.

A good example of an environmental investment theme that corresponds with financial performance would be recycling, which has become an increasing priority given high inflation. We are invested in a business that recycles harmful gases emitted from air conditioning systems. This company has a significant, positive environmental profile and also has high margins and strong growth.

However compelling a sector may be, it is important to buy in at an attractive valuation. When we looked at investments in battery production for electric vehicles, for example, we realised valuations were already too high. So we started to explore other elements of the value chain instead, ultimately investing in a company specialising in the magnets that are critical to electric vehicle production. That means we will still benefit from the upside of electric vehicle take-up, but we were able to buy into that trend at a more attractive multiple.

Another example would be cement; the construction sector is responsible for 6-8 percent of global greenhouse gas emissions. While there have been multiple technologies developed to produce carbon-neutral cement, none of them are commercially viable. We are eager to find an investable opportunity in this area. Equally, we would love to find an opening around cultivated meat, but again, the economics don’t yet stack up.

What does it take to be a successful co-investor in the environmental space?

Co-investment is all about having an established network, and the expertise to make good and quick decisions. Pictet has always had a partnership ethos. We are close to the GPs that we back, we know the partners, we know the assets and we are reliable.

We also understand that a quick ‘no’ can be as important as a quick ‘yes’. Nearly everyone who joins our team comes from a direct background, which means we have the willingness and ability to do deep dives on deals and hold conversations with management about ways to create value. We are flexible on ticket size and we deliver on what we promise. We have been doing this for 30 years. We are an experienced and efficient co-investment machine.

This article appeared as a keynote interview in Private Equity International's March Issue on co-investing.