In April 2021, Neuberger Berman published a paper on the “Transition to Net-Zero Investing,” which leverages the framework developed by the Institutional Investors Group on Climate Change (“IIGCC”), one of the Founding Partner investor networks of the Net Zero Asset Managers Initiative (“NZAMI”). The framework outlines a climate integrated Strategic Asset Allocation (“SAA”) as a key step in the net-zero journey for investment portfolios. In May 2022, Neuberger Berman published a paper on “Integrating Climate Risk into Strategic Asset Allocation,” which acknowledges the systemic nature of climate risks to inform a “top-down” approach to incorporating climate considerations at the asset allocation level.
“Integrating Climate Risk into Strategic Asset Allocation” details our proprietary approach to SAA that seeks to optimize on client-specific fundamental objectives such as expected returns, duration and volatility, while integrating climate-related considerations, which can be tailored to client needs. However, data limitations precluded the inclusion of private markets into our initial climate-integrated SAA analysis as the potential effect of climate change was estimated using a Climate Value-at-Risk (“Climate VaR”) metric available for public equities and fixed income.
In this paper, we aim to lay the groundwork for future iterations of climate-integrated SAA by exploring the additional factors an investor may consider evaluating to refine their existing climate impact methodology in the public markets for private markets application. This paper walks through our process to adapt climate impact on capital market assumptions for private markets and outlines our preliminary understanding of how private market climate costs may compare to those for public equities.
Summary of Climate Strategic Asset Allocation (“SAA”) Framework to Date
Neuberger Berman’s estimates of climate impact on public equity expected returns are based upon Climate VaR1 which is defined as the present value of future climate cost divided by the equity market value at the company and security level. We use a proprietary methodology to convert this present value metric into an effect on return expectations at the security level. We then aggregate these security-level return reductions using the index’s security weights to create an asset class-level climate return reduction to use as an input into the SAA process.
SAA generally aims to construct an optimal portfolio with an asset class mix that offers the highest expected return for a defined level of risk or the lowest risk for a given level of expected return along the efficient frontier. An ex post Climate VaR adjustment to an SAA optimization lowers the efficient frontier: for a given unit of volatility, estimated return is lower relative to the optimization that does not take climate-related costs (and gains) into account. That said, Climate VaR is widely dispersed across different asset classes and sectors—some investments, such as those in the energy and utilities sectors, have greater Climate VaR values and appear considerably more at risk than others, suggesting potential opportunities to enhance efficient frontiers by integrating Climate VaR ex ante into the SAA optimization process
An SAA optimization that fully integrates Climate VaR ex ante can raise the efficient frontier relative to the optimization that receives an ex post Climate VaR adjustment to its estimated returns. Based on our analysis, including low carbon indices into the SAA optimization that fully integrates Climate VaR ex ante can reduce a portfolio’s financed carbon emissions without impairing its estimated risk-adjusted return. Investors can integrate additional climate metrics, such as carbon intensity2 or carbon footprint3 as constraints in the optimization process in an intentional manner; the variation in financed emissions between asset classes makes it possible to set those constraints within a wide range, and helps to minimize impairment of estimated risk-adjusted return.
| EXHIBIT 1: EFFICIENT FRONTIERS: WITH AND WITHOUT ESTIMATED CLIMATE COSTS | EXHIBIT 2: EFFICIENT FRONTIERS: WITH AND WITHOUT CLIMATE-ADJUSTED OPTIMIZATION |
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Source: Neuberger Berman, Bloomberg, JP Morgan, MSCI. Data as of December 31, 2021. Indices used: Bloomberg Barclays Indices for U.S. Treasuries, U.S. Corporate bonds, U.S. Large-Cap Equities and Small-Cap Equities; MSCI Indices for EAFE and Emerging Markets Equities; JPM EMBI for Emerging Markets Sovereign Debt; JPM CEMBI for Emerging Markets Corporate Bonds. Past performance is no guarantee of future results. Please note that estimated returns data is based on NB’s capital markets assumptions and are provided for information purposes only. There is no guarantee that estimated returns will be realized or achieved nor that an investment strategy will be successful and may be significantly different than shown here. Investors should keep in mind that the securities markets are volatile and unpredictable. There are no guarantees that historical performance of an investment, portfolio or asset class will have a direct correlation with its future performance. Net returns will be lower.
Neuberger Berman’s Climate Commitments
As a firm, Neuberger Berman is a supporter of the Task Force on Climate related Financial Disclosures (TCFD), a signatory to the Net Zero Asset Managers Initiative (“NZAMI”), and a member of the Institutional Investors Group on Climate Change (“IIGCC”).
Neuberger Berman Private Equity has engaged with clients and private equity managers on climate topics. Generally, Neuberger Berman Private Equity seeks to focus engagement on initiatives that provide education or pragmatic tools for the private equity industry
- Neuberger Berman Private Equity continues to formalize the collection of carbon footprint information. Neuberger Berman Private Equity has developed a methodology for estimating carbon footprint information for private equity investments and seeks to increase the use of actual greenhouse gas footprint metrics as they become more available.
- In 2021, Neuberger Berman Private Equity joined the Carbon Disclosure Project’s (“CDP”) private equity technical working group to encourage greater carbon disclosure in the private equity industry, and in 2022, became a member of the Initiative Climat International (“iCI”) net-zero working group, which is a global community of private equity firms and investors seeking to understand and manage risks associated with climate change.
- In 2021, Neuberger Berman Private Equity also promoted education through co-hosting a webinar with IIGCC to help educate private equity managers on how to implement net-zero objectives in private equity investing.
- In 2022, Neuberger Berman Private Equity became a signatory to the ESG Data Convergence Project, an industry collaboration representing over 100 LPs and GPs4 which seeks to standardize ESG metrics and provide a mechanism for comparative reporting for the private market industry. Neuberger Berman Private Equity has begun requesting the standard set of ESG metrics, which includes carbon emissions-related data, from co-investments and primary fund investments.
Estimating Climate Cost Considerations into Private Markets
Public Market Proxy
Due to data limitations related to climate impact on private market investments, we elect to estimate climate costs using a public market proxy. Similar to a physics model that starts with a base assumption and then has modifications applied to it, we begin by using climate cost estimates for public equities and then add adjustments to account for differences between public and private securities. As our base assumption for climate costs, we use estimated climate costs from the MSCI All Country World Index (ACWI)5 as it offers a more comprehensive dataset compared to small and microcap equities, which may otherwise be a better proxy for private markets companies.
EXHIBIT 3: PUBLIC EQUITY (ACWI): ALLOCATION, CLIMATE VaR AND RETURN REDUCTION
* 2.0°C scenario.
** Return reduction from the 2.7°C scenario (current policy) to the 2.0°C scenario.
Public Equity Climate Cost Methodology6
To estimate climate costs for public equities, we first generate a base case equity value projection based on our standard capital market assumptions7.This base case assumes that equity prices today are reflective of climate transition costs and physical risks based on current climate policy (reflecting a 2.7°C scenario). Specifically, we derive a series of annual climate costs with a time horizon based on the geography of the security and spread these climate costs over the life of the security assuming climate costs increase by 3% each year. We assume the present value of the security’s cash flows after considering the 2.7°C climate costs is equal to the current market price
Using similar methods, we can then estimate the climate-adjusted return by subtracting the corresponding climate costs from different target scenarios; the return reduction is equal to the difference between the return reduction from the target temperature scenario and the temperature scenario under the current climate policy (2.7°C).
As an example, for a U.S. large cap stock with the following characteristics:
- $100 market value
- 5.88% estimated return in base case8
- Climate VaR: 20% (2.0°C scenario) and 5% (2.7°C scenario)
We assume the current climate policy scenario (2.7°C) is priced in and is reflected in the 5.88% expected return. Under the more punitive 2.0°C scenario, costs increase by 0.81% and expected return falls to 5.07%
EXHIBIT 4: ILLUSTRATIVE MARKET VALUE DEVELOPMENT (REFLECTS DIVIDEND RE-INVESTMENT)
Source: Neuberger Berman. For illustrative and discussion purposes only.
Using our public equity climate cost methodology, we can then apply modifications to the MSCI ACWI data in an effort to approximate climate costs for private market companies. Specifically, we walk through four factors and their differences between private companies and their public counterparts: (1) sector allocation, (2) corporate leverage, (3) weighted average cost of capital (WACC) and (4) control versus non-control ownership.
(1) Sector Allocation
The first factor we analyzed is the sector allocation discrepancy between private market companies and their public counterparts. To estimate this effect, we compare the sector breakdown of the MSCI ACWI Index versus the sector breakdown of the past five years of buyout and venture capital deal value from Preqin.
EXHIBIT 5: SECTOR ALLOCATION: PUBLIC EQUITY VS. PRIVATE EQUITY
As shown in the table above, we find that private equity allocations are typically more technology, consumer discretionary and healthcare oriented than public indices, and such industries tend to be comparatively less affected by climate costs. Furthermore, although private companies and public companies may be classified in the same sector, private companies may potentially have lower climate costs than their public counterparts. As an example, a company in the private markets categorized under Energy & Utilities is unlikely to be a traditional utility company as found in the public markets, and more likely to be a company providing services to utility companies that is more asset-light.
(2) Corporate Leverage
The second factor is the corporate leverage differential between private and public companies. Generally, the average private company is more leveraged than the average public company9. Assuming that enterprise value/EBITDA of the average private market company and the average public market company is relatively similar, the equity market value (MV)/EBITDA of the average private company is thus less than that of the average public company
Since Climate VaR is estimated as the ratio of the present value of future climate cost over the company equity market value, we expect the smaller equity MV/EBITDA of a private company will typically decrease the denominator climate VaR, and may ultimately result in more climate cost impact per unit of equity value.
(3) Weighted Average Cost of Capital
Third, we compare the Weighted Average Cost of Capital (WACC) difference between private and public companies. We can break down WACC into three components: (1) debt/equity ratio, (2) cost of equity and (3) cost of debt.
Compared to public counterparts, a private company tends to have a higher debt/equity ratio and a higher cost of equity and debt. While higher cost of equity and debt will likely increase the WACC of a private company comparatively, a higher debt/equity ratio will typically have an opposite effect (since cost of debt is lower than cost of equity).
Combining our estimates for the three components above, we believe that the WACC of a private company is higher than the WACC of a corresponding public company10. Given that future climate costs are discounted by WACC in the Climate VaR calculation, this higher WACC may result in a lower estimate for climate cost impact11.
(4) Control Ownership
Finally, private equity managers generally have control ownership of companies and accordingly have more ability to influence key strategic and operational aspects, including changes in management. Private equity-backed companies generally have experienced lower default rates compared to non-private equity-backed companies (1.4% vs. 2.2% in the past three years as of 04/2022 according to S&P LCD), partially due to the ability to support capitalization of companies, such as through add-on equity investments. The ability to work with companies in an involved manner and respond nimbly to evolving business challenges, including climate risks, may better position private equity-backed companies for the impacts of climate change compared to their public counterparts.
Summary of Private Equity Factor Adjustments
Due to the variability in idiosyncratic characteristics within both the private market and public markets, it can be challenging to be quantitatively prescriptive when applying the climate cost adjustments for the four identified factors. That said, when considering the impact from these four factors, we can speak to directional effects at this point, which we summarize in the table below.
EXHIBIT 6: SUMMARY OF PRIVATE EQUITY FACTOR ADJUSTMENTS
While it would be prudent to analyze private companies individually to capture idiosyncratic risks related to climate impact, overall, our analysis indicates that private market companies are likely to be impacted by climate costs to a different degree than public equities. Based on our analysis, we believe that qualitatively: (1) sector differences between public and private companies may decrease the climate-related return impact for private companies, (2) the lower equity MV/EBITDA of private equity companies could increase the climate-related reduction, (3) the higher WACC of private equity companies appears to decrease the climate-related reduction, and (4) the private equity control premium may result in a positive influence to reduce climate impact. While three out of the four factors imply an overall positive effect on potential private equity return compared to public equity return, we would need to further test this hypothesis quantitatively in future iterations.
Conclusion
The systemic nature of climate risk demands an expanded “top-down” approach to assessing climate risk that informs broad asset allocation decisions. These climate considerations can be reactive (such as changes to the estimated returns and volatilities due to climate and climate-policy risks) or proactive (such as making specific portfolio allocation choices to minimize those risks). Based on the data available in the public markets today, this paper has explored how private investments may be impacted by climate costs by honing in on key assumption differentials and presenting a view on directional effects.
This discussion is intended to lay the groundwork for more granular quantitative analysis to ultimately inform an updated climate-adjusted SAA inclusive of private markets. Given that private markets can represent a meaningful portion of institutional investors’ diversified portfolios, it would be sensible to explore means to overcome inherent data hurdles posed by private markets so that investors may have a comprehensive view of their strategic asset allocation adjusted for climate considerations.
