In depth: Carlyle’s head of impact on the firm’s approach to climate change

The asset manager’s head of impact Megan Starr explains why Carlyle isn’t pressing the brakes on its climate change resilience plans.

For The Carlyle Group, the swift and unexpected nature of the coronavirus pandemic, and its ensuing effects on economies and the private equity industry, goes to prove why it’s even more important than ever to drive forward a climate change agenda.

We caught up with head of impact Megan Starr to find out how the firm is keeping climate change a priority.

Megan Starr
Megan Starr

Carlyle has a cross-portfolio approach to impact rather than a dedicated impact fund. That means you are dealing with a vast array of different investments, some of which would not be classed as impact investments or even climate friendly. How do you reconcile that big picture of investing in some companies that are really at the forefront of this and others in industries where it’s a very different story?

We take a really pragmatic approach at looking at the economic reality of the world as it exists today. There are definitely some sectors and industries that we think are fundamentally misaligned with a lower carbon future, where we will not invest because we don’t see a change thesis there. In general, I’m much more focused, though, on saying, ‘Can we evaluate our ability to partner with a company or with an asset and help provide the capital and the expertise and the time to really drive change?’ The only way we shift the global economy towards a lower carbon future is by helping bring everyone possible along, as opposed to just focusing on this small percentage of pure play green investments. That’s not to say we should ignore the pure-play green investments, we see a lot of growth potential there, but I also think we need to look more holistically in order to drive change on the most meaningful scale.

Carlyle recently partnered with nonprofit Business for Social Responsibility for a three-hour climate scenario workshop. What did that look like?

We brought together global employees across functions and asset classes to start thinking critically about how we better understand a range of plausible scenarios, and from those scenarios, what would better position our portfolio today for those worlds?

We had some sample portfolio companies and we tried to hone in on sectors we thought would be most relevant, but we also had deal team representatives from across asset classes who were able to talk about their specific portfolios and investment purviews.

The scenarios we used were broad based, because what BSR taught us is climate doesn’t happen in a vacuum; whatever is happening in the climate, there’s a broader global shift going on. We looked at three different 2030 scenarios, each tied to a different one of the Intergovernmental Panel on Climate Change’s representative concentration pathways, but there were broader socio-economic trends that were going along with that. There was a description and some clarifiers about each of the different pathways given as pre-reading materials, so everyone could start to think through portfolio implications for their investments.

Did anything come out of this exercise you weren’t expecting?

We found that under these very different scenarios, some themes held true, which meant they were themes to be looking into regardless of where the future goes. Then there were some outcomes that were very divergent, where if the world went in wildly different directions, then it could have wildly different implications on the portfolio. I hadn’t thought about it in that way before. The areas of convergence [such as demand for renewable energy], those are really interesting, because those are investment themes you should just consider regardless. And divergent, that’s where you really have to think about mitigating against left tail risks, that there’s a low probability of it happening, but it would be a high impact risk.

You then presented your findings to senior leadership. What was the feedback?

We weren’t hoping to come up with an ‘answer’ from these scenarios, we were hoping to make people think in different ways and start developing the kind of agility and forward thinking of how we integrate this as we make investment decisions on a go-forward basis. Our CEOs were digging into it from a curiosity standpoint around relevant investment implications, [asking] ‘Have we thought about that? How are we preparing for this? Do we have data on that?’

At the beginning of 2020, there was a lot of momentum building around the E in ESG. It seems that during covid-19, focus has shifted more to the S side.  How do you combat the narrative that struggling portfolio companies and the wider business community have ‘bigger things’ to worry about now than the environment?

It’s not that climate change has become less relevant, it’s just that this S topic, which I think has historically been slightly more nebulous or harder to quantify, has really risen to the fore.

Climate change is a one-way economic, fundamental shift. During covid-19, some of our companies had significantly disrupted business models and were reevaluating all aspects of their business to think about efficiencies and cost savings. Energy was a natural place to look. It was actually a great incentive to say ‘How do we think about efficiencies in terms of our energy use?’ Because it’s great from a climate standpoint, but also from a bottom line standpoint. I think reinforcing these areas where there are ROI-positive interventions [is helpful].

Do you see a link between preparing the portfolio for the effects of climate change and the impact of covid-19?

Covid-19 demonstrated how these exogenous shocks can really impact businesses in ways you couldn’t possibly have predicted.

Our [former] chief technology officer Georgette Kiser, and now operating executive, ran a disaster scenario workshop a few years ago with firm leadership, looking at the potential for extreme weather-related events and how it could impact our business. They had this kind of war room scenario and were looking at a storm that was heading up the East Coast, potentially impacting our data centres, our physical locations, etc. As a result of that exercise, we found we really needed to invest more heavily in better remote working technology, much better firm-wide communications, our ability to communicate with people quickly, efficiently, seamlessly, and more IT and data resiliency. We implemented a lot of those changes, and frankly, it was because of those changes that we were able to shift to remote work so quickly during the covid-19 early days.

How much are you thinking about the potential for equity erosion in portfolio companies caused by climate change, and how are you trying to factor that in?

The question is how do we start to better price those risks and price those opportunities, using the same tools and toolkits that we traditionally have to price risk, but also bringing in new ones, because we need different data, we need different insights. For example, we were looking at some hard assets this past winter that were on coastal real estate. We worked with an external climate risk consulting firm on that, which helped us model out things like sea level rise, potential weather-related events, and importantly, insurability to those assets. The key is not just understanding better what those risks could look like, but also understanding what we can do over our hold period to make assets potentially more resilient. That could look like installing natural defenses like coral reefs or oyster beds, finding ways to build in more resilient infrastructure, finding ways to potentially decrease the insurance costs because of that resilience.

It’s the same private equity model, but you have to expand your aperture of expertise and data and analysis and include a lot more science. It’s both a matter of increasing the tools and analysis we have, but also using them in the same way we interpret data as private investors, because it has to translate through to how we think about investments.

An asset or a company might be fine today, but how will it look in three to five years when you go to exit it, and does its exit path change because the world is shifting rapidly? I think ESG is a lens for finding untapped alpha in a rapidly changing world; that’s going to become more and more true with the energy transition.

Do you think the private markets model allows you to achieve more in this arena than other ownership models?

A lot of efficiencies have been priced in in private markets, so as private investors think about where they add value, it’s not as much about the traditional LBO model anymore. It’s this idea of ‘How do we really transform and grow companies?’ That’s through finding new growth markets, that’s through making businesses better run, more efficiently run, all these dimensions of business excellence. What we’ve found is ESG is really a proxy for management excellence across those different indicators. Because as private investors we tend to have a longer hold period, three to five years on average, because we have the ability to invest more in companies, and because we have this total improvement orientation – because we buy a company at a certain price and we want to sell it for a higher price – we have an incentive to transform businesses over our hold period. ESG and impact themes are increasingly core to these transformations.

What are the next steps for Carlyle?

We’re focused on continuing to integrate these decisions at the firm-wide level: where we think about doubling down on investment opportunity, where we think about potentially pulling back because of potential risks.

I’m really excited about how we start working with our individual portfolio companies. We did a piece of research this past February in which we found if you can take a traditional energy company from zero percent revenues from renewables to 40 percent over your hold period, you can potentially double your trailing EBITDA exit multiple. This is not a binary issue of a climate aligned business or not climate aligned business, it’s about that growth trajectory and where financial and climate incentives align, because we’re seeing the market price in resilience and expertise on these issues.

We saw through our initial disaster planning exercise a few years ago just how unbelievably important future proofing your business can be. With climate change, and covid-19 and analogous exogenous shocks, we see this as more critical than ever. We’re focused on how we internally build the competencies, agility and skill set to be forward thinking, and how we instill that in our portfolio companies. None of us knows what the future will bring, but we know if our management teams are agile and forward-thinking and quick on their feet, thinking about where the world’s going, they’ll be much better prepared to weather these potential shocks.

What we’re seeing [through covid-19] is the world can change on a dime, and it can change during your hold period. If you’re an illiquid investor, that could have significant implications. Even if the world doesn’t change while you’re holding an asset, it might change enough such that your exit opportunities have shifted, so it’s actually just much better investment planning if you can make that asset more resilient over your hold period. Our bet is investors will continue valuing that and so your exit opportunities will be potentially expanded if you’re really thoughtful about that.