Doing well by doing good: the case for sustainable impact investing

For decades many have assumed that sustainable investing is an altruistic trade-off to more conventional investment/yield return strategies. But this is no longer the case, argues Jud Hill, managing partner at Blue Star Capital.

For decades many have assumed that sustainable investing is an altruistic trade-off to more conventional investment/yield return strategies. Due to increasingly important investment drivers such as energy prices, water shortages, population growth (and the shift from cereal to protein diets), advanced technology solutions and regulatory change, this assumption has been debunked, argues Jud Hill, managing partner, Blue Star Capital.

The new paradigm in sustainable investment is referred to as “doing well by doing good”. This shift is supported by many family offices and progressive pension funds and endowments that have fully embraced this new perspective, along with applying the new metric of environmental and social governance (ESG). Here are some agriculture-related examples:

Smart farming

Recent advances in such tools as geo-positioning, laser levelling of fields, drip and micro irrigation, advanced weather and data management hardware, and software analytics have led to the next generation of advanced agronomy – a smarter “green revolution”. In practice it can work as follows:

Farmland that has senior, fully-adjudicated water rights and average productivity is identified and acquired at market prices. An additional investment is made in the acreage with those smarter techniques, typically adding an additionally 10 percent in capex to the base asset investment. Best practices are then applied.

Typically there is an allocation of 3 acre feet of water per acre within a water right. Applying smart water usage strategies, only about one-third of this allocation is typically necessary, allowing the other two-thirds to be conserved for the community and used, essentially, as a water bank for other higher and better uses.

These conserved water volumes can then be structured and monetised under long-term usage agreements with the community for other municipal or commercial purposes. This approach fosters longer-term stewardship of the water asset and eliminates potential political misalignment. For example, town officials in periods of severe drought will overpump the aquifer to keep lawns green while potentially destroying aquifers via salt water intrusion or geological collapse. Investors with a long term investment to the water asset will allow the grass to turn brown. This is not a hypothetical; it has occurred in practice.

Now the more subtle advantages are also realised. Using less water, which is the primary carrier of other inputs such as fertilisers, crops are only watered when thirsty and feed when hungry. Money is saved by using less energy, less fertilisers and less water, and this lowers input cost by as much as 25 percent. The crop yields are also improving, in most cases by 10 to 20 percent. It’s great economics – lower your input costs and increase your profits.

The environment also wins. Less runoff of unused fertiliser will dramatically reduce eutrophication, improving the health of the watershed while also improving the lives and economy of the local community. A true win-win.

I have applied these exact practices and seen returns on invested capital exceeding 2x and 25 percent IRR. This approach also lends itself well to family offices or perpetual private equity funds that are looking for long-term predictable yields (potentially for decades) rather than more standard 3- to 6-year holds in more conventional time series funds.

Another good example of smart farming, albeit still early in commercialisation, is the practice of hydroponics and aeroponics. In particular, aeroponics can be used in urban areas without soil, in the air with using water mists with nutrients. This approach can consume 95 percent less water and 50 percent less fertiliser and is grown close to the customer. This technique is limited to high-value crops such as lettuce and herbs.

Wetland mitigation banking

When a developer builds a new housing or commercial development, a wetland is typically impacted or destroyed. Historically, the regulations required the developer to “self-mitigate” and build a replacement wetland or pay an “in lieu” fee to the US Army Corps of Engineers (USACE) which would supposedly build a wetland within the same watershed. Neither of these two options have worked well, if at all.

Recent regulatory changes now require the impacting entity to secure wetland mitigation credits from a private wetland mitigation bank (WMB) if available. This is currently a highly-fragmented market place with over 1,000 small private WMBs. Fewer than 100 are larger than 1,000 acres. The current annual market for these credits is approximately $4 billion and growing at approximately a 25 compound annual growth rate. There is a need for well-capitalised investors with domain expertise to consolidate this market, as well as provide capital to build replacement wetlands of larger than 1,000 acres.

The investment works as follows:

A need is identified for a WMB in a watershed management area. A large previously- impacted wetland is identified, typically one that was filled in by farmers decades ago, and te land is optioned from the farmer for sale at market price. The land is not very productive, as it was previously hydric wet soil, and most farmers love the idea that we plan to restore a wetland that existed decades ago. A preliminary reconstruction plan is developed and submitted to the USACE. Then a preliminary approval is granted by USACE and a pre-sale of a portion of the credits is made to customers, such as Home Depot, pipeline companies or state transportation departments. The wetland is then constructed and formally certified by the USACE. The balance of credits are sold over a 3- to 4-year period. Finally, the restored wetland is donated to a trust, and maintained and protected in perpetuity.

This approach is also applicable to stream credits as well as restoration credits following natural disasters such as hurricanes.

Only a few private equity firms have the domain expertise and are currently investing in this sector. Returns are typically greater than mid-20 IRRs and 2.5X ROIs. This investment opportunity allows for not only the preservation of capital (low beta) but very attractive returns (high alpha). Again, the investor, the developer and the environment win.

Waste water and biological solids recycle and reuse

There are numerous examples over the last few years of cost-effective recycle/reuse solutions being deployed for municipal and industrial waste waters and solid waste. A few examples include:

Recycling animal processing wastes into reusable feed stocks and fertilisers. These include waste from concentrated animal feeding operations where the poultry and hog waste are no longer kept in large earthen ponds (which typically overflow and kill the flora and fauna in nearby streams) but rather converted to methane and fertilisers.

Recycling municipal waste water for other uses such as golf courses and common grounds irrigation or ground water recharge. Thirty years ago I helped pioneer what are now called grey water recycle or “purple pipe” solutions.

Recycling frack water to either clean brine to be used again in extracting hydrocarbons from deep formations or distilling produced water to fresh water for surface discharge or other reuse purposes. There is a misapprehension in the practice of horizontal drilling or “fracking” that vast quantities of water are being polluted or destroyed. The reality is the Environmental Protection Agency recently reported there are no examples of groundwater being contaminated by produced water. Fracking occurs at 10,000 feet below the surface whereas ground water is usually at 1,000 feet or above. Ironically, because the old approach of vertical wells would need to drill over 100 wells for every  horizontal well to extract the same yield, increasing the risk of contaminating the freshwater aquifer. Although, clearly we should strive to mitigate carbon emissions, we will need to adapt and apply best environmental practices for the foreseeable future

Summary

The majority of these examples are beyond the technology and adoption risk phase and only require the assessment of the execution risk. The execution risk is primarily based upon choosing proven management teams – “betting on the jockey not the horse”.

There are dozens of other examples that represent sustainable investing. It just requires committed investors. Over the last thirty years of my career, I have maintained that being an environmentalist and a reasoned capitalist are not diametrically opposed but critical attributes in responsible investing.

Investors that appreciate this new paradigm and align with managers that have commensurate domain expertise can deploy capital with modest risk along with top quartile private equity returns and “do well by doing good”.