PDI: Why Do We Need Regenerative Investment Structures?
A Company’s Ability to Operate Responsibly Can be Supported or Inhibited by Capital Structures, Time Horizons, and Ticket Sizes
It can be difficult for companies to have positive impacts and avoid unintended negative consequences (risks) if those companies aren’t backed by supportive investment structures.
Consider WeWork and the classic venture capital (VC) model to “move fast and break things” (Mark Zuckerberg), “Blitzscale” (Reid Hoffman), and “hunt unicorns.” Backed by VC capital seeking to make larger investments, WeWork was incentivized to grow at an unsustainable pace — cutting corners on responsible business practices, and even engaging in anti-competitive behavior that boxed out opportunities for smaller co-working companies with high potential.
As Charles Duhigg writes in How Venture Capitalists Are Deforming Capitalism: “In recent decades, the gambles taken by VCs have grown dramatically larger… ‘Honestly, it stopped making sense to look at investments that were smaller than thirty or forty million,’ a prominent venture capitalist told me.” The article also cites a 2018 paper which argued that, “thanks to the prodigious bets made by today’s VCs, ‘money-losing firms can continue operating and undercutting incumbents for far longer than previously.’” It reflects that, “In the traditional capitalist model, the most efficient and capable company succeeds; in the new model, the company with the most funding wins. Such firms are often “destroying economic value” — that is, undermining sound rivals — and creating “disruption without social benefit.”
The VC research firm, CB Insights, often refers to such dynamics as “foie gras’ing” start-ups with capital. They find that investors are seeking larger and larger deals and encouraging companies to absorb more capital, but “after IPO, the most highly funded startups tend to underperform those who raised less.” Meanwhile, “plenty of companies that raised <$100M have seen top exits.”
Corporate Consolidation and the Gap Between the Real and Market Economies: “Consolidation of Capital Flows” as an Overlooked Factor
As developed markets grow concerned about corporate consolidation, and as investors seek diversification, strong returns, and reduced systemic and systematic risk, smaller deals with more regenerative investment structures — such as revenue based financing and redeemable equity as we discuss in our ESG 2.0 working paper — may be a key part of the answer. To date, these deals are demonstrating a track record of offering risk adjusted returns in the middle of the risk-return spectrum, similar to the returns of the recently emerged private credit asset class.
Shifting some capital allocation from higher risk asset classes like VC and private equity (PE), and some allocation from lower returning asset classes in fixed income, to these investment structures can mean reliable yields with attractive risk-reward characteristics, fewer equity bubbles, more balanced wealth creation among a wider set of businesses and entrepreneurs, stronger innovation in a dynamic economy, more competition, and enhanced diversification. Reflecting on this list, we also see a potential narrowing of the gap between the “market economy” and “real economy.”
This is not to say the VC model is always bad — it’s just that most companies don’t have hockey stick style growth and yet can still be attractive investment opportunities given an appropriately tailored capital structure. Institutional investors seeking a ~7% rate of return from a diversified portfolio of asset classes could do well to shift some allocations to this more balanced risk-reward area of the risk-return spectrum. Why leave these opportunities out of capital markets when they can generate risk-adjusted returns while reducing systemic and systematic portfolio risks?
On a related note, and for more on issues related to corporate consolidation, we also highly recommend checking out this paper co-authored by our Board Chair, Denise Hearn: Stakeholder Capitalism’s Next Frontier: Pro- or Anti-monopoly?
Perhaps reaching these companies in the “missing middle” financing gap is what the Japanese Prime Minister is aiming for in his efforts to tap vast pension fund assets in a drive to create more start-ups. But the critics of this strategy have valid concerns if pursued with VC capital alone. Will portfolios be overburdened at the high end of the risk-return spectrum? Will the pension fund assets be contributing to inflating valuations of such portfolio companies, thereby enhancing the risk of asset bubbles?
To address these concerns, one might consider integrating revenue based financing and redeemable equity strategies to reach more SMEs. The question then becomes, how can we lift up fund managers who are pursuing these strategies and — to a certain extent — encourage incumbent fund managers to add such strategies, as well?
It is important to consider that the path to a dynamic and well-connected real and market economy cannot be led by incumbent fund managers alone, as the consolidation in the asset management industry itself is contributing to corporate consolidation among other risks. Recent trends illustrate asset owners and allocators consolidating their capital flows with very few of the same incumbent managers chasing (or even exchanging) similar strategies and deals. This increases the probability of systemic risks like equity bubbles and credit crises (as we explain in our ESG 2.0 paper), as well as systematic risks such as inequality, since these fund managers reap fees proportionate to assets under management (AUM).
In their latest Global Fund Strategies Report, Pitchbook notes, “PE funds closed during the quarter were larger than their predecessors, and median step-up increased to 62.4%. The current fundraising environment is crowded with numerous GPs raising capital, often seeking sizable step-ups that may be overwhelming LP funding abilities.” Competition and diversification are important not only among companies, but also across the asset management industry. How can behemoth asset owners and allocators access smaller deals and benefit from multi-layered diversification — across companies, fund managers, and investment structures (or asset classes) — without disproportionate transaction costs?
We know that “deconsolidating capital flows” is not easy for institutional investors, who have significant capital to put to work and incentives to remain aligned with the status quo in terms of asset classes and larger managers with strong track records. While we elaborated on these dynamics in depth in our ESG 2.0 working paper, we were particularly concerned by recent news in Institutional Investor highlighting how some of the largest PE fund managers are dominating the fundraising market, using “‘fear and intimidation tactics’ to raise money for new funds,” and depleting capital that might be available for other managers, including diverse and emerging fund managers. Are these mega-funds even worth all of the trouble if they are actually consolidating capital flows, and in the long-run, contributing to systemic and systematic risks?
This is why PDI is workshopping solutions with asset owners and allocators. Our workstreams 1–3 support investors in assessing the risk-reward dynamics of status quo allocation practices — particularly in the context of an allocator’s fiduciary duty (which is often intergenerational for pension funds), as well as to improve their internal investment governance and financial analysis practices. Many are recognizing that the traditional 60/40 portfolio is no longer working. The key is not to be prescriptive in advancing changes, but to co-create flexible solutions that can be tested and fine-tuned over time. These interventions are essential pathways to enable investors to access more regenerative investment opportunities and become less dependent on extractive, procyclical models.
Beyond Consolidation: Examples of Other Investor-level Impacts and Risks to Measure and Manage
Incentivizing growth at all costs can also have other devastating consequences, increasingly witnessed in less developed markets like Sub-Saharan Africa, where our team has significant experience. A recent Bloomberg article, Tesla-Backed Startup Made Cheap Power a Debt Burden for the World’s Poorest, illustrates how high return expectations in relatively short time frames encouraged residential solar companies to grow more quickly than was sustainable, focusing on near-term key performance indicators for staff relating to sales, but overlooking customers’ ability to repay financing packages. While investors may have had the best of intentions in providing access to clean energy to households, the growth, return, and timing expectations of predominant private capital structures are often not well-suited for markets focusing on vulnerable populations in less developed markets.
Investment structures can also inhibit a clean energy transition when it comes to the development of larger projects, like wind, solar, and geothermal. Members of our team experienced this first-hand in (prior to PDI) development of such projects in Sub-Saharan Africa, where a 10-year closed-end fund structure was not long-term enough or suitable to accommodate the stages required in developing such infrastructure. For this reason, we turned to structuring permanent capital vehicles versus closed-end fund structures. Holding companies and evergreen funds are examples of such innovations. At a recent Private Equity International conference in London, we were pleased to hear about a growing focus on this issue from Clara Barby of Just Climate as investors understand how they can practically fulfil their Net Zero commitments.
It is important to keep in mind that investment structures not only affect companies and projects, but countries and municipalities depend on investor financing that can either be regenerative or extractive, as well. In Zambia, the country’s ability to transition to a clean economy in a manner that aligns with a “Just Transition” may be inhibited by the terms of debt held by institutional investors.
And, of course, investors themselves can have negative impacts on society. In the UK, figures published in May by the Office for National Statistics showed “average earnings in finance were 25 per cent higher in cash terms… outstripping the 15 per cent growth seen over the same period in mean earnings across the economy…” These dynamics speak to one of the key issues PDI was founded to address — that excessive compensation of fund managers and investors can systemically exacerbate inequality, taking us farther and farther away from, for instance, United Nations Sustainable Development Goal (SDG) 10: Reduced Inequalities.
The Need for Thoughtful Solutions
Over the past few months, some PE fund managers have recognized the need to address wealth inequality through embracing worker ownership models. In our discussions with Marjorie Kelly and Karen Kahn at Fifty By Fifty, we emphasize that such efforts are strong steps in the right direction, but alone cannot meaningfully narrow wealth gaps. As we put it in a recent interview with Oscar Perry Abello of NextCity in his article Former Wall Street Pro Says to Tackle Inequality, Start With Changing Wall Street, “As long as the wealth of the fund manager executives is growing at an exponentially faster rate than workers or beneficiaries of portfolio companies, the wealth gap is going to grow… That matters because when wealth pools to very few individuals in the economy, they have the ability to buy up assets like real estate or public equities and that pushes up the valuations or increases the barriers to entry for everyone else. This is happening right now before our very eyes.”
We highly recommend reading the other pieces written and curated by Fifty By Fifty that review recent developments in mainstream PE and worker ownership models. And this recent article, Bolt Loaned Employees Thousands to Buy Stock — Then Laid Them Off, is also worth a read. Worker ownership is not without its risks, and it is especially important to consider the health of a company’s capital structure and financing when pursuing such strategies. In the coming months, we expect to share news about emerging principles for best practices relating to worker ownership models for mainstream finance.
Similarly, as regions globally experience the pinch of unaffordable housing markets, some investors see an opportunity to invest in more affordable housing. But what are best practices for investing in affordable housing, and where does one draw the line between the “financialization” of housing and investing in solutions? To this end, PDI is collaborating with The Shift, founded by the former United Nations Special Rapporteur on the Human Right to Housing, on a set of emerging directives that will help guide responsible investment in affordable housing.
Unfortunately, most frameworks and tools for mainstream investors relating to responsible investing are focused on portfolio company operations rather than investor-level activity. These frameworks aim to help investors manage risk, but systematic risks like inequality and systemic risks like credit crises and asset bubbles are not only caused by companies, but investors themselves. And, if a company’s capital structure overburdens it with debt or unrealistic growth expectations, then a portfolio company’s ability to operate responsibly will be inhibited. These risks then boomerang back to investors’ portfolios in long-term feedback loops, and investment teams are not incentivized nor do they have the tools to measure and manage these risks in their asset allocation strategies.
Because capital structures, fund structures, and asset allocation strategies are so critical to responsible and regenerative investment, a meaningful change in practice will require stronger alignment between capital stewardship teams and investment “deal” teams at asset owners and allocators. We are encouraged by recent efforts by regulatory bodies globally, including in the US and Europe, to reduce greenwashing. But truly understanding greenwashing and what distinguishes a holistic approach to responsible investing from one only focused on portfolio companies requires a deeper evaluation of markets, the economy, and their impacts on the world. Otherwise, we risk incremental change at best — similar to running on a treadmill, or playing a game of whack-a-mole, never addressing the deeper systemic roots of the problems we aim to solve.