David Hunter explains why a multi-manager approach is best when investing in the nascent renewable energy sector
Institutional investors typically allocate assets to renewable energy that are set aside for matching liabilities, to achieve long-term income or growth, or for investment in alternatives (such as infrastructure). They generally do so to achieve one or more of three aims:
- As a long-term investment to match or outperform liabilities through portfolios that have specific liability-related objectives – aiming for a stable return premium above the liabilities, cash or bonds, reflecting the increased risk
- To improve risk factor diversification by capturing return drivers that are less well represented elsewhere in a portfolio
- For a combination of social and financial objectives, to help the world transition to a low-carbon environment.
To achieve these aims, investors need portfolios that can deploy at scale and speed and/or are diversified across projects, sectors, regions and risk exposures, including (where appropriate) to higher returning opportunities or technologies.
However, of the current 100-plus renewable energy specialist managers that Renewity monitors, the majority have deal execution track records in only one or two countries or technologies.
And in most major OECD markets, managers aiming to build focused portfolios for investors’ liabilities or cash-flow objectives often face capacity constraints or declining yields when seeking to deploy at scale or speed.
We have not identified any specialist investment firm that can deliver against all the attributes mentioned above. Even if such a firm existed, it would be highly unlikely to deliver consistent excellence in every respect.
An evolving sector
At this nascent stage of the renewable energy asset class, the best way for investors to gain exposure is through a diverse portfolio of managers. In an evolving sector, and particularly as government balance sheets seek to recover from the COVID-19 pandemic, not being locked into a single manager’s strategy limitations, sourcing capabilities or specific market dynamics is likely to be a key advantage.
While you could say this logic holds true across many asset classes, there are many reasons why a multi-manager approach
is pertinent for renewable energy. Most significantly, energy markets are ‘national security assets’, reliant on a network of interconnected local relationships that are critical to efficient project origination, financing, yield management and exit. This rarely translates fully across national boundaries (and sometimes, in the US, across states), making it difficult for global generalists to be effective.
The best local managers are typically more specialist or independent, more directly motivated, and often better aligned than multi-strategy fund managers. While elements of this assertion may be debatable – particularly as the sector’s performance reporting and benchmarking is still developing – the claim is consistent with the widely held belief that specialist managers outperform generalist practitioners in most asset classes.
Third, technology evolution is rapid yet sporadic, often making significant leaps forward. Advances in engineering can abruptly and substantially affect energy production input costs, output volume or pricing. Such changes can substantially impact the key return or risk characteristics, even during the lifetime of apparently ‘solid’ asset technologies.
Individual energy markets and their regulations can also change rapidly, including in developed economies. Examples can be seen in the renewable energy subsidy policy changes made by Spanish, Italian and, more recently, French governments. Local disruption due to social or environmental factors can also undermine concentrated project portfolios.
Portfolio approach
Deployment issues are an important and underestimated aspect of illiquid investing generally, and could have a material impact on long-term strategies. For example, in a diversified global multi-manager portfolio, we would anticipate 10-15 or more drawdowns in a year across underlying managers, compared to three or four with any single manager.
The more frequent and flexible deployment (and exit) options available via a multi-manager approach also bring rebalancing advantages, improved liquidity and market timing benefits. Such advantages no doubt explain why more regular allocation and/or realisation of assets produces better long-term risk-adjusted returns in asset classes such as infrastructure, according to statistics from the EDHEC Business School.
Building exposure through a portfolio of managers can also provide access to the broader renewables value chain. Most renewable energy funds offer exposure to generation, transmission, distribution, storage and grid efficiency, missing out on the ‘picks and shovels’ part of the industry. This includes companies involved in developing and construction, battery storage technology or manufacturing, as well as solar panel manufacturers or electric vehicle charging businesses.
Investors should seek an active allocation to these market segments as part of their renewable energy strategy. As well as reducing risk in the overall portfolio through additional factor diversification, this approach can also enhance returns through exposure to differentiated growth opportunities in other parts of the renewable energy value chain.
Risk mitigation is another important factor. The renewable sector is expanding rapidly, and this can lead to new and not-so-new manager and sector risks. The range and variety of managers and strategies in the sector offer good diversification. Moreover, the increased data and analysis obtained through reporting on more deals helps to provide better risk management under the multi-manager approach.
Finally, as substantial capital is drawn to renewable energy and other sustainable strategies, key individuals with longer deal track records increasingly command a premium, which has resulted in an increase in key personnel instability risks across all managers in the sector.
Leading the way
As with most investing, avoiding significant downside events through diversification and other strategies inevitably improves risk-adjusted returns. Perhaps most critically, a multi-manager business – itself driven by an imperative that requires scale – has the power to deliver the largest, widest and quickest social and environmental impact for investors and stakeholders.
A number of the UK’s larger pension schemes have already adopted the multi-manager approach for renewable energy investments. This is a positive step, showing that a broader exposure to sectors, regions and technologies not only improves beneficiaries’ risk-adjusted returns, but is also crucial to help drive the global transition to clean energy and the renewable energy investment required to meet the 2015 Paris Agreement goals.
With 2021 being the year in which the UK is hosting COP26, both its own and global long-term institutions have a major opportunity to lead the way when it comes to tackling climate change.
David Hunter is chief investment officer of Renewity
