Following on from an introduction to the ecological restoration sector, Agri Investor interviewed Mark Canavan, portfolio manager at New Mexico Educational Retirement Board and an LP in fund manager Ecosystem Investment Partners’ second fund, to hear about his investment process and decision to commit to the sector.
“Historically I have stayed away from anything environmentally levered or with too much of a social angle because that can be a great way to lose a lot of money. But this was the first time I saw an environmental deal that made pragmatic sense and without any subsidies involved. And mitigation banking serves an economic purpose for us; returning land to its natural state can be beneficial economically: that was a much more powerful concept for me as an investor.”
Canavan spent a lot of time doing due diligence on the regulatory and political risks involved in ecological restoration investment and watched a proposition to freeze the Californian Global Warming Solutions Act of 2006, which puts caps on greenhouse gas emissions in the state, until unemployment dropped to 5.5 percent or below for four consecutive quarter, fail dramatically in a statewide election by a 23 percent margin.
“This was a pivotal moment for me as I realised that the mitigation regulations, some of which have been in place for over 40 years, were not going away,” he said adding that interviews with CEOs of development companies, engineering firms and environmental institutions conclusively found that environmental regulations would only get more stringent, not easier.
“It’s just a series of laws and regulations you have to comply with and during my due diligence I realised there was no way these laws were going away; these concepts are deeply engrained in the American psyche.”
As with any private investment, the management team was another focus for Canavan in his search, and some investment teams he interviewed ran into a problem seen in other agriculture-related investments: they did not have the necessary financial experience and understanding of what institutional investors needed, he argued.
“Sometimes there was a conflict of interest and the environmental aspect of the investment overrode the team’s fiduciary duty to its investors,” said Canavan. “What I found attractive about EIP was that Fred Danforth, one of the founders, didn’t start out as an environmentalist and had already raised and invested four private equity funds in the past on his own platform. I therefore knew that EIP was about making money and he understood my fiduciary duty is to the beneficiaries of the pension plan to achieve the best risk adjusted return possible. My duty is not to the underlying social cause. If a social or environmental good is a by product of what I do then that is fine, but it is not a duty. Achieving a return that assures our beneficiary’s retirement is my duty. ”
So what are the challenges?
The due diligence process took a lot longer than other real assets. And there is a huge J-curve, of around two to three years to take into account that some investment committees might find hard to swallow, said Canavan. But after that its “pure cash flow”. “Once it is up and running and the credits start to sell, it is basically a cash flow vehicle. There isn’t any capital appreciation like with other real estate such as farmland; you can’t sell it for what you bought it for because you have taken future development off the table forever. So you value it off the future cash flow of these mitigation banks.” Canavan’s “conservative” return expectations are in the 13 percent domain net of all fees.
And what about the fund structure? Canavan has typically stayed away from funds in the agriculture market, opting for separate accounts (until recently), and he has questioned the private equity fund structure in the past, but it works in this case, he argues.
“This isn’t like buying land which could go on forever; these are limited life deals and fit with the 7-12 year life of a typical private equity fund.”
While EIP is the only fund that has suited NMERB’s portfolio until now, Canavan believes there is room for a lot more in this sector. “I shouldn’t say this because the more investors in the sector, the more returns are compressed, but I think there is plenty of scale to be had here,” he said. “You won’t see multi-billion dollar funds anytime soon, because the space doesn’t lend itself to that scale. It would take too long to deploy and would involve buying existing mitigation banks that I don’t think is a great strategy. But there is opportunity here for fund sizes of a few hundred million. And as I said, these regulations and policies are here to stay.”