Now that we have moved over to the buy side, we wanted to point out a couple of trends that we are seeing lately in terms of where money is flowing (and as such, where investment bankers will want to expand their coverage).
ESG Friendly Investing
The first is ESG – environmental, social and governance – as part of a broader ethical investing trend. Today, investors are looking beyond returns as stakeholders decide that there is a social mandate when it comes to stewarding capital.
Individual investors have championed the divestiture or omission of “sin stocks”, or companies in the business of what they feel is unethical. The most common themes being alcohol, gambling, private prisons, marijuana, fossil fuels, firearms (Smith and Wesson), and recently human rights. Similarly, governments have offered tax incentives and asset managers have been willing to accept lower yields for “green bonds” that meet certain criteria.
Big business is quick to recognize opportunities, and as the investing demographic changes and ESG becomes more top of mind, financial institutions such as Blackrock, PIMCO and Fidelity are looking at financial solutions that can cater to today’s needs (and collect higher fees for more structured funds with stricter investment parameters).
Millenials and Generation Z are much more interested in ESG than Baby Boomers and Generation X/Y. As such, mutual funds are being marketed as products that can offer returns as well as meeting defined investment principles. At the same time, these funds will also have to be benchmarked against other active managers with the same mandate.
Roboadvisors, a preferred vehicle for newer investors who are buying into the passive management plus rebalancing narrative, are also offering ESG screens (with the conmensurate higher management expense ratios/MERs). Now, people are able to invest and feel good doing it.
But now, the ESG mandate has grown beyond a retail product because institutional investors with defined social mandates such as public pension funds, private investment pools, endowments and not-for-profits now demand that their sub-managers are investing in line with their personalized ESG standards.
Investing, like many other topics, has become politicized. As state funds such as Norway’s begin to divest in line with their beneficiaries’ demands (for example fossil fuels, although they have also mentioned that this is a portfolio diversification initiative as most of the wealth is derived from natural resource exploitation), pensions and university endowments are starting to grow their ESG teams and demand compliance from their asset managers.
Same ideas branching into new categories include impact investing.
ESG in Investment Banking
As corporate finance advisory outfits, investment banks have to adjust to the new reality as the volume of questions from clients ramps up on both ends.
For entities that issue securities, ESG is an opportunity and a threat. For firms that are able to show that they are advancing certain ESG goals, this is an opportunity to broader the size of their investment base. For bonds, this means a lower coupon or interest rate. For stocks, this means trading at a higher multiple. These can translate into huge effects for cost of capital.
For firms that are fairly or unfairly targeted under the ESG umbrella, for example oil and gas and miners, they need to develop an investor relations platform that assures institutional investors that they are on the right side of a low-carbon future and not working with oppressive regimes run by dictators.
Now, at marketing events such as investor roadshows that are run by investment banks, asset managers ask about ESG strategy and may ignore an otherwise strong investment thesis if the ESG answers are not there.
An opportunity exists for investment banks to add value for both ESG focused buy side investors looking to deploy more capital to meet their mandates as well as for firms that need access to capital. ESG conferences are starting to spring up, especially with a focus on large cap firms as they are the ones that are most favored by institutional investors. Likewise, corporates, asset managers and investment banks are all starting to grow headcount for ESG teams.
Infrastructure Funds Will Grow
Infrastructure and real assets are continuing to make up a larger proportion of the asset mix for institutional investors. With more and more buy side capital, again from pensions, insurers and other institutional investors looking to deploy funds into infrastructure, returns that they can demand are falling as asset prices are bid up.
It makes sense that infrastructure has become more attractive as an asset class as the stock market is richly valued, there is much uncertainty and less runway left in a tired bull market where stocks have consistently gone up while bonds/fixed income continue to suffer from low interest rates.
Infrastructure is uncorrelated with public equity markets and offers a fixed stream of cash flows for a long period of time – if anything it is a fixed income substitute similar to real estate in today’s market, with the additional bonus of serving as an inflation hedge (infrastructure projects can have revenues linked to inflation). Returns are protected to some extent because of the sheer amount of capital required to purchase large infrastructure projects – something that you or I cannot do.
In fact, after a small run up in interest rates in 2018/2019, trade war jitters and pressure on the central bank have resulted in 10-year government bond yield starting to decline again to the 2% range, making infrastructure much more attractive. Infrastructure yields are correlated with the risk free interest rate, which means that asset prices have been going up.
Capital Recycle Through Sale-Leaseback Transaction
This means a big opportunity for investment bankers that specialize in the infrastructure space. One is through valuation arbitrage through sale-leaseback transactions. For companies where the core business lies elsewhere, such as mines or power generators, an opportunity exists to crystallise value through the carving out of some of their assets and offering to lease back the toll roads or power plants at a fixed rate per year at a much higher implied cash flow multiple.
For instance, should a mining company trade at 3.5x EV/EBITDA, it can synthetically create an infrastructure asset by moving one of its power plants (which is purely a cost on the income statement) to a private equity firm or infrastructure firm (or the infrastructure arm of a financial sponsor) for $500 million while agreeing to a fixed charge of $50 million a year for the right to use the power generated. This is effective capital recycle by selling at 10x EV/EBITDA while trading at 3.5x, with the proceeds being cheap capital to conduct share repurchases or fund capital expenditures.
Project Finance Infrastructure
Also, infrastructure is usually synonymous with project finance. Paired with government expenses, PF can be a very low risk way (although the cost of capital ends up being higher for the corporate) for a corporate to bring a project to fruition as the needs of all stakeholders are met, reducing the commercial risks of lenders and other creditors.
For banks with large balance sheets and a low cost of funds (long-dated deposits), this is a lucrative business opportunity.
The total market for infrastructure should continue to increase as governments understand the importance of investing in socially beneficial projects while wanting to keep costs low – pushing the onus of development on public-private partnerships or P3s.
Buy side firms are likewise trying to beef up their infrastructure arms by billions. Firms such as GIC, Global Infrastructure Partners, Partners Group and most state funds and pensions continue to see their clients demand more strong, uncorrelated returns. Infrastructure should accordingly be a space that continues to see its market grow