Investors are beginning to link the performance-related element of their real estate managers’ compensation – known as the promote or carried interest – to decarbonisation progress. Ivanhoé Cambridge, the C$77 billion ($56 billion; €51 billion) real estate business of Canada’s Caisse de dépôt et placement du Québec, and Bouwinvest, a real estate investment office for three Dutch pension funds, have both structured a handful of fund investments in this way, and both are looking for more.
“This is a very clear path towards value preservation and value creation for us… We’re trying to implement green financial incentives with our partners,” Michael Neuman, head of industrial for the US and LATAM at Ivanhoé Cambridge, told delegates at the PERE Network America Forum 2023 on Wednesday. Ivanhoé Cambridge has made two such agreements – one with a student housing business, and another for an investment in the Netherlands, said Neuman. “The idea is that you underwrite with a certain level of carbon emissions and certain objectives.”
For Ivanhoé Cambridge, if the manager is able to reduce an asset’s carbon emissions, “you increase the promote of your partner, maybe through a lower hurdle or higher IRR”, said Neuman. “Or if [the manager] misses its emissions reduction targets, you reduce the promote. It’s a negotiation that you need to make with them [the fund manager]. It’s all about the money.”
Bouwinvest has “implemented some alignment [with managers] through ESG KPIs that are ultimately another hurdle to earning the promote”, senior portfolio manager Bert van den Hoek said, speaking on the same panel. “With alpha performance on ESG, the promote can be increased. But with underperformance on the ESG KPIs, the promote will be decreased,” said van den Hoek.
CPP Investments, one of the world’s largest investors with assets worth C$576 billion, may join them in this trend. “We have not started paying our partners to join us on this [sustainability] journey – we haven’t quite had to do that yet,” said Pamela Thomas, US real estate managing director for the investor. “But we do have some partners in the room so maybe that’s coming.”
Incentives linked to non-financial objectives are a nascent trend in private markets. A handful of impact fund managers have introduced impact-linked carry, pledging to forfeit a portion of their carried interest if their investments miss pre-determined impact KPIs. There have been few reports, however, of ESG-linked carried interest for private fund strategies that are not specifically investing in sustainability themes.
ESG-linked incentives for non-sustainability-themed strategies are more common in private debt. Some private credit fund managers offer ESG-linked loans (notable examples include Carlyle and Ares). And several fund managers have signed ESG-linked subscription credit facilities for their funds (notably, Carlyle, AlpInvest and PAI Partners). These credit structures offer a loan margin discount if the borrower meets ESG KPIs.
Most of the these incentive structures involve discounts on incentives or costs rather than bonuses. Neuman and van den Hoek’s onstage comments seem to indicate, however, that both Ivanhoé Cambridge and Bouwinvest offer bonuses as well as discounts on carried interest. Neither institution responded to requests for clarification prior to publication.
Structuring these ESG- and decarbonisation-linked carry agreements is challenging: progress against decarbonisation targets is “hard to measure”, said Neuman. “It’s not a done deal, it’s a work in progress.”
“We need to have quantifiable objectives,” said van den Hoek. Bouwinvest uses managers’ GRESB scores as “one of the key benchmarks” to quantify progress on ESG, van den Hoek explained. Improvements on the manager’s annual GRESB score – which awards up to five stars – “could be one of the measurable objectives that can be part of the programme.”
“If you align yourself with partners who are willing to put themselves through empirical analysis, that’s when you really align yourself with people who have the same philosophy and stand by those commitments themselves,” van den Hoek added.
The price of carbon
Ivanhoé Cambridge tracks two IRRs for its portfolio, said Neuman. “One is the real monetary cashflows and the other is the ‘green IRR’.” The green IRR incorporates carbon prices for assets’ emissions, Neuman explained. This modelling “allows you to invest in carbon reduction initiatives and make them value accretive”, he said, although he did not elaborate on the carbon pricing model Ivanhoé Cambridge uses. “Sooner or later, we’ll have to pay the price for the carbon our buildings emit.”
Neuman sees a “flight to quality” in the current financial cycle, “and sustainability is one of the quality elements of real estate. We’re either going to see a brown discount or a green premium”, said Neuman. Ivanhoé Cambridge has set a portfolio-wide net-zero 2040 target.