GLOBAL INSIGHTS FROM IMPACT INVESTING TO INVESTING FOR IMPACT

By Jason M. Thomas and Megan Starr

The dual purpose of "impact investing" has always seemed to imply that positive social and environmental outcomes necessarily come at the expense of financial performance. In this paper, we document that it is precisely the societal goals of the impact investor – diversity and inclusion, environmental sustainability, responsible governance – that increasingly generate the above-market returns sought by the market as a whole. As traditional financial efficiencies have become more fully integrated and priced in to assets, environmental and social factors provide a lens to identify untapped value in all types of companies by driving sales, reducing costs and boosting productivity through improved governance, inclusion and diversity initiatives, workplace in human capital, and investments in energy sustainability.

1 FROM IMPACT INVESTING TO INVESTING FOR IMPACT By Jason M. Thomas and Megan Starr

The phrase “impact investing” was coined in 2007 to describe actually impede improvements in performance. a new form of financial intermediation that combines social By presuming that social benefits detract from returns, and environmental mission-orientation with traditional asset traditional investors ignore the ways an impact orientation management.1 From the outset, the dual purpose of the can add (market) value. And by assuming that genuine strategy seemed to suggest that positive social and environ- impact requires some degree of financial sacrifice,4 impact mental outcomes necessarily come at the expense of finan- investors can fail to appreciate how socially-optimal strat- cial performance. Researchers focused on impact’s “cost” in egies manifest themselves in company income statements terms of foregone returns,2 often implying that traditional and valuations. strategies must involve some degree of social or environ- mental degradation. As initially conceived, impact investing Improved Governance & Longer-Term Orientation seemed predicated on a “damned if you do, damned if you Relative to listed equities, private markets are illiquid, don’t” mindset that treats genuine impact as irreconcilable involve more concentrated ownership stakes, and offer with (risk-adjusted) return maximization. investors a much greater degree of control over the under- lying portfolio companies. These features naturally cultivate a longer-term orientation and a much broader assessment N.B. impact investing traditionally refers to private of risks and opportunities. Investors exchange liquidity for investments made into companies or assets with the intention to generate social and environmental influence, a trade-off that could only make sense if the impact alongside a financial return. ESG integration returns to more active governance compensate for the strategies are applicable across both public and private costs of being “locked in” to the investment. Since these markets, and typically refer to the incorporation of returns typically take years to manifest themselves, private environmental, social, and governance factors into a holding periods tend to be much longer than those of the traditional investment analysis across a wide range of typical stock market investor,5 and require a willingness to companies. Most institutional investors focus on where hold the asset for five or more years. ESG factors add material value through differentiated insights (however other types of investors use these As interest rates have declined and entry multiples have tools to express market views or personal priorities). risen, it is no longer possible to generate historic rates of return without investing for impact – to use the term in a very broad sense. With no tailwinds from falling finance As markets have evolved, this stark dichotomization between costs, recovering economies, or rising valuations, private social and financial returns has become progressively harder markets investors can only meet return targets by consis- to defend.3 The same companies often receive financing tently building better businesses. And while better busi- from both traditional asset managers and dedicated impact nesses tend to be stronger financial performers, company funds. The same pools of capital often commingle funds financials provide much too narrow a vantage point to from highly-motivated environmental, social and gover- assess the strength or sustainability of a business. A much nance (ESG) investors with those of investors focused solely broader lens is required, which examines every component on earning the highest possible (risk-adjusted) return. of the business through a total improvement orientation More consequentially, as we describe in greater detail that adopts aspects of the intent, actions, and theory of below, it is precisely the societal goals of the impact change once thought to be the exclusive province of investor – diversity and inclusion, environmental sustain- “impact” funds.6 ability, responsible governance – that increasingly generate Impact investors seek to produce beneficial social outcomes the above-market returns sought by the market as a whole. that would not occur but for their investment in an enter- As traditional financial efficiencies have become more fully prise.7 While “impact” funds in their purest definition are integrated and priced in to assets, environmental and social limited to investing in companies whose sole, or “core,” factors provide a lens to identify untapped value in all types business directly addresses a defined set of environmental or of companies by providing means to drive sales, reduce costs, social challenges, a total improvement orientation assesses enhance productivity, or expand valuation multiples. the potential actions to improve social and environmental The assumed trade-off between social benefits and finan- outcomes at all prospective businesses. Hence while cial returns may not just be outmoded; such thinking could 4 Brest P. and K. Born (2013), “When Can Impact Investing Create Real Impact,” Stanford Social Innovation Review. 5 Morningstar estimates that the average turnover ratio for managed domestic stock funds is 63%, as of 1 Höchstädter, A. and B. Scheck. (2015), “What’s in a Name: An Analysis of Impact Investing Understandings Feb. 28, 2019. by Academics and Practitioners,” Journal of Business Ethics. 6 Jackson, E. (2013), “Interrogating the Theory of Change: Evaluating Impact Investing Where it Matters 2 Barber, B. et al. (2019), “Impact Investing,” NBER Working Paper No. 26582. Most,” Journal of Sustainable Finance & Investment. 3 Chowdhry, B. et al. (2019), “Investing for Impact,” Review of Financial Studies. 7 Brest and Born (2013). 2 impact investing channels capital to a narrowly defined of the $1.7 trillion increase in private markets assets under subset of potential investment opportunities, private management (AUM) as delistings have waned in significance markets’ particular characteristics – concentration, control, (Figure 1). With virtually no fat to cut, returns on these invest- and a longer time horizon – provide both the opportunities ments depend on investors’ ability to catalyze growth, which and financial incentives for investors to generate beneficial typically results in substantial increases in employment.12 outcomes across a much broader universe of businesses. FIGURE 1 From Cost Containment to Top-Line Growth Changing Nature of Private Investment Types, In the early years, private markets resembled a “barbell” 1990-201813 with capital focused on early-stage venture and late-stage public-to-private delistings. Most of these late-stage invest- Deal Type by Share of Investments ments targeted public companies that had squandered 1990-2004 2005-2018 resources on dubious investments that seemed to priori- 60% tize size and maximize the resources under management’s 50% control (often referred to as “empire building”).8 Private governance more closely scrutinized the cost structures, 40% product lines, and organizational hierarchies that evaded 30% detection under the ownership of a broadly diffused mass 9 of public shareholders free to sell their stake at any time. 20% While delivering significant increases in productivity, such All Deals of Share scrutiny also often resulted in payroll reductions and it is, 10% perhaps, these experiences more than any other that have 0% contributed to the sense that financial returns and social Public-to-Private Private Carveout PIPE, Add-On, 10 (Primary & Other returns do not coincide in traditional private investing. Secondary)

Deal Type by Value Invested “It is precisely the societal goals of the Relative to 2004 AUM Relative to 2018 AUM $1,400 impact investor – diversity and inclusion, $1,200 environmental sustainability, responsible $1,000

governance – that increasingly generate $800

the above-market returns sought by the $600

market as a whole.” USD Billions of $400

$200

While discussions about the impact of still $0 focus on these public-to-private de-listings, these invest- Public-to-Private Private Carveout PIPE, Add-On, (Primary & Other ments have declined significantly as a share of private Secondary) market activity. The success of private governance – and the evidence of gross inefficiencies it uncovered – led to both The alignment between financial and social returns is evident a sharp decline in the number of public companies – from in the data. Among all U.S. Carlyle investments completed nearly 8,000 in the late-1990s to less than 3,500 today – since 2013, every 10% increase in payrolls (excluding the and improvements in public company governance.11 As a effects of mergers) has been associated with a statistically result, the market opportunity from public-to-private cost and economically significant 21.4% increase in cumulative rationalization has declined precipitously and returns have returns (likewise, every 10% decline in payrolls corresponds come to depend on investors’ ability to underwrite – and to a -21.4% drop in returns).14 Among investments where deliver – value creation from top-line growth. employment growth exceeded 15%, average returns were nearly 60% higher than for investments where headcount Since 2004, investments in private companies – including declined, on average (Figure 2). secondary buyouts – have accounted for more than 60%

8 Jensen, M.C. (1986), “Agency Cost of Free Cash Flow, Corporate Finance, and Takeovers,” American 12 Davis, et al. (2019). Investments in private companies are associated with a 13% increase in employment, Economic Review. on average, over a two-year period. If the private company was previously owned by a private investor, the 9 Richardson, S. (2006), “Over-investment of Free Cash Flow,” Review of Accounting Studies. average employment gains are 10%, on average. 10 Davis, S. et al. (2019), “The Economic Effects of Private Equity Buyouts,” October 7, 2019. 13 Josh Lerner, Harvard Business School, Global Preqin Data, June 2019, Carlyle Analysis of Portfolio Data. 11 Business Roundtable, 1997 Statement on Corporate Governance, affirmed that CEO’s “paramount duty” is 14 This is based on a sample of 35 companies with at least 3 years’ worth of headcount data over the period to the corporation’s shareholders. 2015-2018, controlled for anomalous growth (e.g., apparent acquisitions/divestitures, very low headcount, etc.). 3 We do not believe such employment growth was accidental suggests that workforce investments that lead to positive or incidental, but stems directly from investor intervention: social outcomes – higher retention rates, enhanced employee industry and product market expertise, and the doors opened engagement, and greater sense of purpose – tend to yield and strategic guidance provided by professional networks and financial returns not evident to observers solely focused on a global footprint. While few of these portfolio companies accounting data. would meet the screen of a “pure” impact fund, the beneficial social outcomes would not have occurred in the absence of FIGURE 3 investment – here, value creation is demonstrably positively Workplace Investments in Employee Retention correlated with increased social value in the form of new jobs. Generate Outsized Returns16 FIGURE 2 Cumulative Return of an Equity Strategy Long Low Turnover Firms and Short High Turnover Firms Positive Relationship Between Carlyle Payroll Growth and Returns15 600%

2.50x 2.30x 400% 2.10x Return 1.90x 1.70x 200% 1.50x 1.30x 1.10x 0% 0.90x

0.70x 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 0.50x -40% -20% 0% 20% 40% FIGURE 4 Cumulative Headcount Growth, 2015-2018 Businesses with High Employee Engagement Average MOIC by Headcount Growth 1.9x See Markedly Better Results across Several 1.90x Performance Metrics17 1.70x 1.6x Median Outperformance of Top-Quartile Businesses over 1.50x Bottom-Quartile, Ranked by Employee Engagement 1.30x 70% 1.2x 59% 1.10x 60% 1.10x 50% 0.90x 0.70x 40% 0.50x 30% <0% 0-15% >15% 21% 20% 17% Cumulative Headcount Growth, 2015-2018 10% Human Capital and Returns 0% Arithmetically, increasing payrolls does nothing to boost Productivity Profitability Turnover financial returns in and of itself. It is only when marginal sales Percentage of Business Units with Above-Median Composite grow at a faster rate than marginal employment that firm- 90% Performance Scores, Ranked by Employee Engagement level productivity increases at the rate necessary to hit return 80% targets. While “human capital” often refers to the managerial 70% talent and professional networks of people at the top of an 60% organization, research and experience indicate that the experi- 50% ential knowledge and motivation of the broad employee base 40% is equally as important to company performance. 30% 20% Firms with lower employee turnover dramatically outperform 10% their high turnover counterparts (Figure 3), as the frictional 0% costs of hiring and retraining more than offset any perceived 1st 5th gains from “holding the line” on compensation. Moreover, 99th 95th 90th 80th 70th 60th 50th 40th 30th 20th 10th Employee Engagement Percentile survey data also make clear that employee engagement reliably predicts productivity and profitability at the indi- vidual firm and business unit level (Figure 4). Our experience 16 Fedyk, Hodson; Trading on Talent: Human Capital and Firm Performance (November 18, 2017). Harvard 15 Carlyle Analysis of Portfolio Company Data, February 2020. Some companies lack data for 2015 or 2018, but Business School all companies have at a minimum 3 years’ worth of data. 17 Gallup; The Relationship Between Engagement at Work and Organizational Outcomes; 2016. 4 Diversity Improves Decision-Making Returns on Investment in Sustainability In addition to issues of employment and job satisfaction, a Of all the issues for which investors seek opportunities to total improvement approach prioritizes additional elements of make an impact, perhaps none is as consequential as climate human capital. For example, many impact-oriented investors change. Whether through pure-play impact, infrastructure, prioritize diversity and inclusion and look to channel capital or dedicated clean energy funds, billions of dollars have to businesses with diverse boards, founders, and leadership been raised for investments in renewable and sustainable teams.18 The data from our own companies support the source of energy, energy storage, and carbon capture tech- growing consensus that diversity should be a priority of all nology and much more is needed. When including expected funds with governance rights and influence, not just because industry and public outlays, total investments in this space it is a socially-desirable outcome, but also because diversity are expected to exceed $300 billion per year through 2040, improves decision-making and financial outcomes. with more than $550 billion required annually to reach the net zero emission goal of the Paris Agreement.21 FIGURE 5 While dedicated renewable energy funds will remain the Annualized Cumulative Earnings Growth Averages by primary channel to address opportunities from climate 19 Board Diversity Rank change, shifts in public consciousness have increased the returns on broader investments in sustainability. The past Average 14.0% two years have witnessed a sharp rise in the use of the 12.3% 12.0% phrase “climate crisis” – in lieu of “climate change,” 10.3% 10.0% “climate risk,” or “global warming” – to describe the 8.0% nature of the threat facing the planet (Figures 6 and 7). Such usage conveys a sense of urgency that has also been 6.0% increasingly reflected in asset prices. 4.0% 2.0% 0.5% FIGURE 6

Cumulative Earnings Growth Growth Earnings Cumulative 0.0% Since Acquisition, Annualized No Somewhat Diverse News Mentions of “Climate Crisis” by Month22 Diversity Diverse 65,000 Weighted Average 12.0% 55,000 9.8% 45,000 10.0% 8.2% 35,000 8.0% 25,000 6.0% 4.8% 15,000 4.0% 5,000

2.0% (5,000) Cumulative Earnings Growth Growth Earnings Cumulative Since Acquisition, Annualized 0.0% No Somewhat Diverse Jul-18 Jul-13 Jan-16 Jan-11 Jun-16 Jun-11 Oct-19 Oct-10 Oct-14 Apr-17 Apr-12 Feb-18 Feb-13 Sep-17 Sep-12 Mar-15 Dec-18 Dec-08 Dec-13 Aug-15 Aug-10 Nov-16 Nov-11 May-19 May-09 Diversity Diverse May-14

By promoting divergent viewpoints, board diversity contrib- FIGURE 7 utes to more deliberative decision-making processes and more effective governance.20 Over the past three full years, Investment Research Reports Including “Climate 23 the average earnings growth of Carlyle portfolio companies Crisis” by Year with two or more diverse board members has been nearly 90 12% per year greater than the average of companies that 80 lack diversity (Figure 5). After controlling for industry, fund, 70 and vintage year, companies with diverse boards generate 60 50 earnings growth that’s five times faster, on average, with 40 each diverse board member associated with a 5% increase 30 in annualized earnings growth. 20 10 0 2011 2012 2013 2014 2015 2016 2017 2018 2019

18 C.f. Consumer Technology Association Diversity Investment, 2019. 19 Carlyle Analysis of U.S. Portfolio Company Data, February 2020. “Diversity” refers to female, Black, Hispanic or Asian. 21 International Energy Agency, 2019 World Energy Outlook. 20 Carter, D, Simkims, B, Simpson W. “Corporate Governance, Board Diversity and Firm Value”, The Financial 22 Carlyle Analysis; Google Trends. Review 2003 23 Carlyle Analysis; S&P Capital IQ Database. 5 In today’s market, consistent FIGURE 9 Private Firms More Sensitive to Investment outperformance requires a total Opportunities than their Public Counterparts25

improvement mindset that is able Average Annual Change in Gross Fixed Assets

to both perceive and capitalize on Private Firms Public Firms the financial returns generated in 0.12

pursuit of societal goals. 0.10

0.08 As public fears of the nearer-term consequences of climate change have intensified, enormous disparities in energy 0.06 sector multiples have emerged. Today, the valuation assigned to a given energy company largely depends on 0.04 where its assets sit on the clean energy spectrum (Figure 0.02 8), creating compelling financial incentives to accelerate the energy transition in advance of changes in underlying 0.00 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 energy consumption. Sensitivity to Investment Opportunity FIGURE 8 Private Firms Public Firms 0.14 Valuation Multiples Have Adjusted to Energy Transition Risk in Advance of Changes in 0.12 Fundamentals24 0.10

Renewable 0.08 90.00X Infra/Facilities 80.00X 0.06

70.00X 0.04

60.00X 0.02

50.00X Opportunities Investment Sensitivity to 0 40.00X EV/Battery/ 0 0.05 0.1 0.15 0.2 0.25 Multiple Manufacturers Industry-Specific Sensitivity in Share 30.00X Prce to Changes in Earnings Integrated 20.00X Oil and Gas FIGURE 10 10.00X S&P Global Wind Turbine/ 0.00x Utilities Solar Tech Adding Renewables Capacity to O&G Assets Can Produce Significant Multiple Expansion26 Energy Transition R² = 0.6781 Thanks to longer holding periods and investment horizons, 20.0x companies backed by private capital tend to invest more 18.0x than their public counterparts and that investment tends 16.0x to be more sensitized to changes in relative valuations (Figure 9). These climate-related shifts in asset prices incent 14.0x private investors to reduce carbon footprints and deploy 12.0x capital into green energy and related storage technology. 10.0x Increasing renewables’ (photovoltaic solar and wind) share EV / TTM EBITDA of total revenue from zero to 40% could lead to a doubling 8.0x of the typical energy company’s trailing Ebitda multiple 6.0x (Figure 10). Ironically, investments in oil and gas companies 4.0x offer the strongest financial incentives to accelerate the 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% global transition to clean energy – a fact not lost on private market investors with a total improvement orientation.

25 Asker, John William and Farre-Mensa, Joan and Ljungqvist, Alexander, Corporate Investment and Stock Market Listing: A Puzzle? (October 4, 2014). Review of Financial Studies 28, no. 2 (February 2015): 342-390. 24 Carlyle Analysis; S&P Capital IQ Database. 26 Carlyle Analysis of S&P Capital IQ Data, February 2020. 6 Investing for Impact Jason Thomas is a Managing Director and Head of Global Research at The Carlyle Group, focusing on Pure impact funds channel capital in pursuit of important social economic and statistical analysis of Carlyle portfolio and environmental goals; their potential to catalyze change in data, asset prices and broader trends in the global these areas and seed new growth opportunities make them economy. He is based in Washington, DC. an important part of the investment ecosystem. But the bifur- Mr. Thomas serves as Economic Adviser to the cation of the market into “impact” and “traditional” funds firm’s corporate Private Equity, Real Estate and can create a false dichotomy in the minds of observers that Credit Investment Committees. His research helps assumes high returns impose social costs, or that beneficial to identify new investment opportunities, advance outcomes necessarily require some financial concession. strategic initiatives and corporate development, and support Carlyle investors. The same societal values that motivate investors to allocate Prior to joining Carlyle, Mr. Thomas was Vice towards impact funds have become increasingly reflected President, Research at the Private Equity Council. in broader asset prices. Above-market returns often come Prior to that, he served on the White House staff directly because of – not in spite of – actions that advance as Special Assistant to the President and Director the social goals of the impact investor – as demonstrated for Policy Development at the National Economic by the examples here highlighting the financial impacts of Council. In this capacity, Mr. Thomas served as greater inclusion and diversity, environmental sustainability, primary adviser to the President for public finance. and responsible governance. In today’s market, consistent Mr. Thomas received a BA from Claremont McKenna outperformance requires a total improvement mindset College and an MS and PhD in finance from George that is able to both perceive and capitalize on the financial Washington University, where he studied as a Bank returns generated in pursuit of societal goals. of America Foundation, Leo and Lillian Goodwin Foundation, and School of Business Fellow.

Mr. Thomas has earned the chartered financial analyst Economic and market views and forecasts reflect our judgment as of designation and is a Financial Risk Manager certified the date of this presentation and are subject to change without notice. by the Global Association of Risk Professionals. In particular, forecasts are estimated, based on assumptions, and may change materially as economic and market conditions change. The Carlyle Group has no obligation to provide updates or changes to these Megan Starr is a Principal and Global Head of Impact forecasts. for The Carlyle Group. She is based in New York. Certain information contained herein has been obtained from sources Prior to joining Carlyle, Ms. Starr was a Vice President prepared by other parties, which in certain cases have not been updated within Goldman Sachs’ through the date hereof. While such information is believed to be reliable Division, where she helped build the Environmental, for the purpose used herein, The Carlyle Group and its affiliates assume Social and Governance (ESG) and impact investing no responsibility for the accuracy, completeness or fairness of such business. Previously, Ms. Starr was Chief of Staff information. of The JPB Foundation, a $3.8 billion private family References to particular portfolio companies are not intended as, and foundation based in New York City. should not be construed as, recommendations for any particular company, investment, or security. The investments described herein were not made Ms. Starr received an MBA and a certificate in by a single or other product and do not represent all of public management and social innovation from the investments purchased or sold by any fund or product. Stanford University’s Graduate School of Business, where she was an Arbuckle Leadership Fellow, This material should not be construed as an offer to sell or the solicitation and an AB in environmental science and public of an offer to buy any security in any jurisdiction where such an offer or policy from Harvard College, where she graduated solicitation would be illegal. We are not soliciting any action based on magna cum laude. this material. It is for the general information of clients of The Carlyle Group. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors.

CONTACT INFORMATION Jason Thomas Head of Global Research [email protected] (202) 729-5420

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