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
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:
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.
1Developed together with MSCI and CarbonDelta.
2Calculated by dividing GHG emissions by a relevant measure of activity. For a typical company, this is usually revenues.
3Determined by attributing emissions of investees or loan recipients to the provider of finance.
4As of January 2022.
5MSCI’s flagship global equity index, which is designed to represent performance of the full opportunity set of large and mid-cap stocks across 23 developed and 24 emerging markets.
6Assumptions are for modeling purposes only and alternative assumptions may result in significant or complete loss of capital. There can be no assurance that strategies will achieve comparable results, that targeted diversification or asset allocations will be met, that a strategy will be able to or will ultimately elect to implement the assumptive investment strategy and approach described in the model. Past performance is not necessarily indicative of future results.
7NB intermediate capital market assumptions estimated using a building block approach.
8NB intermediate capital market assumption as of 2022
9By comparing the Debt/EBITDA in the past 10 years from 2012 to 2022 of public companies included in the MSCI ACWI index and private companies from the S&P global LCD dataset.
10Assuming NB’s forward-looking capital market assumptions for public and private cost of equity, ACWI cost of debt values as of 4/30 (from Bloomberg) for public market cost of debt, and an additional spread on ACWI cost of debt for private market cost of debt.
11The astute reader may notice here that the WACC (more specifically the equity cost of capital) in theory should also affect the denominator of the Climate VaR ratio which include equity valuations. This could increase the climate impact on private assets compared to publics. For simplicity, we assume here that the (private) equity value is based on market pricing and may be driven by factors beyond the theoretical WACC framework.
ESG-RELATED DISCLOSURES
The use of ESG factors could result in selling or avoiding investments that subsequently perform well or purchasing Investments that subsequently underperform.
As used in this document, NB Private Markets consists of the following investment strategies that are classified as ESG-Integrated by the Neuberger Berman ESG Product Committee: Private Equity Investment Portfolios and Coinvestment Platform, Private Equity Secondary Platform, Almanac, Private Credit Platform, Marquee, NB Insurance-Linked Strategies Platform, Renaissance and NBAIM Fund-of-Funds Platform. Unless explicitly noted, the ESG integration processes described in this document applies solely to the Private Equity Investment Portfolios and Co-investment Platform (“NB Private Equity”).
This material is intended as a broad overview of the portfolio managers’ style, philosophy and process and is subject to change without notice. Many of the firm level processes described herein are subject to Neuberger Berman’s policies and procedures, including certain information barriers within Neuberger Berman that will, from time to time, limit communications between the NB Private Markets team and the public side investment and ESG teams.
RISK CONSIDERATION RELATING TO PRIVATE EQUITY FUNDS
Prospective investors should be aware that an investment in any private equity fund is speculative and involves a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of such investment and for which the investment does not represent a complete investment program. An investment should only be considered by persons who can afford a loss of their entire investment. This material is not intended to replace any the materials that would be provided in connection with an investor’s consideration to invest in an actual private equity fund, which would only be done pursuant to the terms of a confidential private placement memorandum and other related material. Prospective investors are urged to consult with their own tax and legal advisors about the implications of investing in a private equity strategy, including the risks and fees of such an investment. You should consider the risks inherent with investing in private equity funds:
Market Conditions.Private equity strategies are based, in part, upon the premise that investments will be available for purchase by at prices considered favorable. To the extent that current market conditions change or change more quickly anticipated investment opportunities may cease to be available. There can be no assurance or guarantee that investment objectives will be achieved, that the past, targeted, or estimated results be achieved or that investors will receive any return on their investments. Performance may be volatile. An investment should only be considered by persons who can afford a loss of their entire investment
Legal, Tax, and Regulatory Risks
Legal, tax and regulatory changes (including changing enforcement priorities, changing interpretations of legal and regulatory precedents or varying applications of laws and regulations to particular facts and circumstances) could occur that may adversely affect a private equity strategy.
Default or Excuse. If an Investor defaults on or is excused from its obligation to contribute capital to a private equity fund, other Investors may be required to make additional contributions to replace such shortfall. In addition, an Investor may experience significant economic consequences should it fail to make required capital contributions
LeverageInvestments in underlying portfolio companies whose capital structures may have significant leverage. These companies may be subject to restrictive financial and operating covenants. The leverage may impair these companies’ ability to finance their future operations and capital needs. The leveraged capital structure of such investments will increase the exposure of the portfolio companies to adverse economic factors such as rising interest rates, downturns in the economy or deteriorations in the condition of the portfolio company or its industry.
Highly Competitive Market for Investment Opportunities.The activity of identifying, completing, and realizing attractive investments is highly competitive and involves a high degree of uncertainty. There can be no assurance or guarantee that a private equity strategy will be able to locate, consummate and exit investments that satisfy rate of return objectives or realize upon their values or that it will be able to invest fully its committed capital.
Reliance on Key Management Personnel. The success of a private equity strategy may depend, in large part, upon the skill and expertise of investment professionals that manage the strategy.
Limited LiquidityThere is no organized secondary market for investors in most private equity funds, and none is expected to develop. There are typically also restrictions on withdrawal and transfer of interests.
Epidemics, Pandemics, Outbreaks of Disease and Public Health Issues. Private equity funds’ operations and investments could be materially adversely affected by outbreaks of disease, epidemics and public health issues in Asia, Europe, North America, the Middle East and/or globally, suchas COVID-19 (and other novel coronaviruses), Ebola, H1N1 flu, H7N9 flu, H5N1 flu, Severe Acute Respiratory Syndrome, or SARS, or other epidemics, pandemics, outbreaks of disease or public health issues. In particular, coronavirus, or COVID-19, has spread around the world since its initial emergence in December 2019 and has negatively affected (and will likely continue to negatively affect or materially impact) the global economy, global equity markets and supply chains (including as a result of quarantines and other government-directed or mandated measures or actions to stop the spread of outbreaks). Although the long-term effects of coronavirus, or COVID-19 (and the actions and measures taken by governments around the world to halt the spread of such virus), cannot currently be predicted, previous occurrences of other epidemics, pandemics and outbreaks of disease, such as H5N1, H1N1 and the Spanish flu, had material adverse effects on the economies, equity markets and operations of those countries and jurisdictions in which they were most prevalent. A recurrence of an outbreak of any kind of epidemic, communicable disease, virus or major public health issue could cause a slowdown in the levels of economic activity generally (or push the world or local economies into recession), which would be reasonably likely to adversely affect the business, financial condition and operations of private equity funds. Should these or other major public health issues, including pandemics, arise or spread farther (or continue to worsen), private equity funds could be adversely affected by more stringent travel restrictions (such as mandatory quarantines and social distancing), additional limitations on fund operations and business activities and governmental actions limiting the movement of people and goods between regions and other activities or operations.
Valuation Risk.. Due to the illiquid nature of many fund investments, any approximation of their value will be based on a good-faith determination as to the fair value of those investments. There can be no assurance that these values will equal or approximate the price at which such investments may be sold or otherwise liquidated or disposed of. In particular, the impact of the recent COVID-19 pandemic is likely to lead to adverse impacts on valuations and other financial analyses for current and future periods
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