Private equity (PE) funds are becoming a popular asset class as investors seek out alternative investments to boost returns in these challenging times.
Of the many PE offerings in the market, Canada-based Sarona Asset Management is one of the few that select companies based on its environmental, social and governance (ESG) criteria to deliver strong and consistent returns to investors. The strategy has paid off, with the firm generating better returns than listed equities.
“[Through the PE funds we invest in,] we deliver growth capital to entrepreneurs in the target markets, helping them to develop their companies and communities in a sustainable way while generating profit for our investors,” says Sarona co-managing partner Vivina Berla.
“Our fund feeds into existing PE funds. We do not invest directly in companies. Our responsibility is to identify fund managers or general partners that are based in our target countries, whose investment principles are well aligned with ours.”
Berla was speaking to Personal Wealth on the sidelines of the Malaysian Private Equity Forum 2016, organised by Kumpulan Wang Persaraan Diperbadankan (KWAP). She has more than two decades of experience in institutional asset management, of which more than 10 years were spent in private equity.
With an investment universe of 850 funds, the firm’s Sarona Frontier Markets Fund currently invests in 30 PE funds across 51 countries in Africa, Asia and Latin America. Two of these funds are based in Malaysia.
“Growth that matters” is the firm’s investment principle. Berla believes that ESG criteria is about doing business the right way as it enables the generation of profit while making an impact on the environment, society and corporate governance.
“Currently, it seems that in the quest for maximising profits and returns, some players in the traditional industry have forgotten that ESG criteria are important elements in mitigating risk as well as increasing returns,” she says.
“This is especially true in the PE structure, where the investment horizon is longer term. When ESG-related issues are addressed properly, it is possible to make the right investment and generate better profits than the companies for which ESG-related issues are not handled properly.”
Sarona’s investors tend to be divided into two groups — those looking to make a difference in the development finance space and traditional asset owners trying to generate alpha by investing in private markets they have never been in before. With a minimum investment of US$1 million, the company’s investors include high-net-worth individuals, family offices, pension funds and insurance companies.
How does the fund appeal to its investors? Berla says PE funds are typically able to generate returns that are 5% to 10% higher than listed equity. While she is reluctant to reveal the returns the fund has provided its investors, she cites the example of another player that is involved in the same thing.
“In the frontier and emerging markets that Sarona invests in, PE is a relatively new segment. The longest-standing investor in these markets is probably IFC. Over the years, it has generated between 15% and 20% annualised return on investment by investing in PE.”
IFC is a development financial institution and part of the World Bank Group. It also applies stringent ESG criteria in its investment approach.
Berla says Sarona, which was established in 2010, has the same investment strategy as IFC in that it seeks opportunities in sectors that are set to benefit from the rapidly rising middle class in its target market. The sectors include education, healthcare, financial services, transport and logistics, and information and communications technology. The firm also focuses on small to mid-cap companies in their expansion stage as it believes they represent one of the best risk-adjusted opportunities in these fast-growing markets.
Higher returns are often accompanied by higher risk. This is especially true when Sarona invests in frontier and emerging markets. Berla believes that the ESG-criteria and diversification can help investors mitigate a large portion of investment risks.
“We are trying to manage macro risk, such as political risk and currency risk, which are real and present in all the countries we invest in. But we invest in over 50 countries [in frontier markets] and at the end of the day, the risks are reduced because of how diversified we are,” she says.
“What remains, I think, is the risk of investing with Sarona, and the risk of us picking the right managers, followed by the managers picking the right companies to invest in. But given the amount of work we do, our experience in selecting the best managers in the regions as well as diversification, I think the risk of us losing our investors’ capital is almost zero.”
Investors can use quantitative measures to pre-screen and evaluate listed equities. But PE investors or fund managers need to do a lot of work before deciding to buy into investments as there is a lack of publicly available data on private companies, says Berla.
“The fund managers need to do their own due diligence. They need to sit down with the company owners, understand the situation [at the companies], ask them the right questions, and then agree on an action plan to improve the ESG practices of the companies,” she adds.
Despite this, it does not mean that private companies are more difficult to pick than public-listed ones. Berla think these two are different business altogether.
“Public-listed companies may have a lot of data available in the market, making it easier for evaluation. However, investors have no say or control over how the companies are run. They have no real ability to change these companies.”
PE, on the other hand, is a different type of investing. Investors or fund managers must identify the companies they like and establish a relationship with their management team before investing in them.
“After making an investment, they will sit on the board with the management team and steer the company in a better direction. They will have control over the company. As such, the ability to make a difference is greater,” she points out.
How does Sarona ensure that the fund managers are doing their jobs in terms of enhancing ESG-related practices in the fund’s portfolio companies? Berla says this boils down to aligning the vision of the fund managers and company owners with the vision of the PE investors.
“We need to ensure that all parties understand and agree that putting in place good ESG practices is going to increase the value of the companies. This will help companies to progress towards the best possible internationally accepted standards of ESG,” she says.
Private companies in countries in which Sarona operates usually have a lot of room for improvement in terms of business practices, says Berla. This is especially true at the beginning of the relationship between the fund manager and company owner.
“There are usually a lot of problems. They may have no financial book at all, or have three financial books at once. These companies may not have good business practices or treat their employees poorly,” she adds.
Hence, Sarona has to ensure that these issues are handled accordingly by the fund manager, with ESG-related practices put in place. This makes picking the right fund manager even more critical.
How does Sarona filter the 850 funds it can invest in? Before investing in a PE fund, the firm reviews the fund manager’s responsible investment policy, discusses the fund’s governance, meets staff with investment responsibilities to assess their skills and discusses minimum responsible investment expectations that the managers must meet.
After an investment is made, the firm will understand how the manager influences and supports its portfolio companies’ management of ESG-related risks and pursuit of related opportunities. It will also assess the fund manager’s policies, processes and systems for identifying ESG-related value drivers and managing material risks pre-investment.
Berla says fund managers are held accountable by a legal agreement that requires them to ensure that the companies have appropriate ESG-related practices in place. The firm has an internal fund manager score for ESG assessment when evaluating their performance.
Measuring positive impact
Sarona Asset Management is a member of the Global Impact Investing Network’s (GIIN) investors’ council. Other members include Credit Suisse, Ford Foundation, Goldman Sachs Urban Investment Group, JP Morgan, Morgan Stanley and Zurich Insurance Group.
“GIIN is a network of like-minded companies and individuals who are explicitly seeking to invest and deliver financial returns while making a positive social and environmental impact on the communities in which they operate. The network believes in the importance of measuring the impact it has,” says Sarona co-managing partner Vivina Berla.
As such, the firm publishes an annual value report on how much impact it has had on the companies and funds it invests in. “In terms of measuring impact, we have chosen six key impact objectives — creating jobs, improving job quality, empowering women, reducing environmental footprint, improving governance and building sustainable communities,” says the 2016 report.
According to the report, some of the positive impact resulting from Sarona’s efforts last year included US$140 million in corporate taxes that went towards sustaining local government services — a 10% increase from 2014. There was a 19% drop in reported occupational injuries per company while more than 50% of employers provide health insurance, maternity and paternity leave and disability coverage.
Sarona has created innovative products and solutions by working with a variety of stakeholders, including partner funds, government agencies and development financial institutions. It is also a signatory of the United Nations Global Compact’s Principles for Responsible Investment (PRI) initiative, which works to understand the investment implications of ESG factors and supports its international network of signatories in incorporating these factors into their investment decisions.
“We are one of the signatories of the PRI and we encourage our underlying fund managers to sign up to the same principles and report to us according to the impact matrix that we have set out to achieve,” says Berla.
Strong focus on ESG
Vivina Berla, co-managing partner of Sarona Asset Management, says the firm’s focus on environmental, social and governance (ESG) criteria came about after she and her partner, CEO Gerhard Pries, observed a gap in the market.
“Many players were investing in private equity (PE) for the opportunities of creating value and generating returns. But we did not find anyone in the private sector focusing on profit generation while creating a positive impact on the community and environment,” she recalls.
“When we met, we recognised that there was a desperate need to avoid the mistakes PE made in developed markets when investing in emerging and developing economies.”
The firm’s activities are based on three pillars — private investments in frontier and emerging markets, seeking strong financial returns and practising ethical, social and environmental values. According to its 2016 annual value report, it has deployed about US$180 million in capital since 2010.
Over the last three years, its assets under management have grown at an encouraging compound annual growth rate of 55%. However, the demand for growth capital currently surpasses supply.
“The World Bank estimates that 70% of all micro, small and medium enterprises do not have access to formal credit facilities. The current credit gap is estimated at US$1.2 trillion to US$2.6 trillion. Meeting this demand through responsible investment can have significant positive impact on the communities where capital is needed,” says the report.