McKinsey On Investing
McKinsey onInvestingPerspectives and research for the investing industryNumber 5, November 2019
McKinsey on Investingis written by experts andpractitioners in McKinsey’s globalinvestor-focused practices,including our Private Equity &Principal Investors, Wealth & AssetManagement, and Capital Projects& Infrastructure Practices.Editorial Board:Pooneh Baghai, Alejandro Beltrande Miguel, Onur Erzan, MartinHuber, Duncan Kauffman, BryceKlempner (lead), Hasan Muzaffar,Rob Palter, Alex Panas, VivekPandit, Mark Staples, MarcosTarnowskiTo send comments or requestcopies, email us:Investing@McKinsey.com.Editor: Mark StaplesCover image: Mike Kiev/Getty ImagesContributing Editors:Roberta Fusaro, Heather Ploog,Josh RosenfieldArt Direction and Design:Leff CommunicationsManager, Media Relations:Alistair DuncanData Visualization:Richard Johnson,Jonathon RivaitManaging Editors:Heather Byer, Venetia SimcockEditorial Production:Elizabeth Brown, Roger Draper,Gwyn Herbein, Pamela Norton,Katya Petriwsky, Charmaine Rice,John C. Sanchez, Dana Sand,Sneha Vats, Pooja Yadav,Belinda YuMcKinsey Practice PublicationsEditor in Chief:Lucia RahillyExecutive Editors:Michael T. Borruso,Bill Javetski,Mark StaplesCopyright 2019 McKinsey &Company. All rights reserved.This publication is not intended tobe used as the basis for trading inthe shares of any company or forundertaking any other complex orsignificant financial transactionwithout consulting appropriateprofessional advisers.No part of this publication may becopied or redistributed in any formwithout the prior written consent ofMcKinsey & Company.
Contents3More than values: The value-basedsustainability reporting thatinvestors want42Nonfinancial reports helped stimulatethe growth of sustainable investing.Now investors are questioning currentpractices—and calling for changesthat executives and board membersmust understand.11Catalyzing the growth of theimpact economy48A mature impact economy wouldhelp power economic growthwhile solving global social andenvironmental challenges. Here’swhat it will take to accelerate theimpact economy’s development.22Advanced analytics in assetmanagement: Beyond the buzzPricing: The next frontier of valuecreation in private equity57Private equity exit excellence:Getting the story rightWhile a successful exit has manyelements, a clear and evidence-backedequity story detailing an asset’spotential may be the most important.Three key principles can help fundsmaximize exit returns.Private equity opportunities inhealthcare techHow private equity can maximizevalue in US financial servicesThe industry may be on the cuspof a new and less forgiving era.Private owners can take steps nowto get ready.65Few private equity firms focus onpricing transformations, though suchprograms can create substantialvalue. Here’s how pricing value can becaptured at any stage in the deal cycle.36Not yet. Despite rising corporatedebt levels, research showscompanies can cover their obligationsfor now. But they should prepare fora possible downturn by stress-testingtheir capital structure.Although private equity firms havebeen hesitant to invest in healthcaretech, they have reason to invest inpromising targets now.Leading firms are applying advancedanalytics across the full assetmanagement value chain—andgetting results.29Is a leverage reckoning coming?A turning point for real estateinvestment managementAs institutional investors flock to realestate, investment managers mustavoid getting stuck in the middle of themarket—too big to be nimble yet toosmall to reach scale.73Highlights from McKinsey’s2019 sector researchThis year has seen intriguing newdynamics in many sectors. In thiscompilation, McKinsey experts breakthem down. All articles and reportsare available on McKinsey.com.
IntroductionWelcome to the fifth volume of McKinsey on Investing, developed to share the best of our recent researchand thinking relevant to investors. Colleagues from around the world and across many disciplines—including asset management, infrastructure, institutional investing, and private equity—collaborated todevelop these insights. We hope this combination of perspectives will provoke reflection and dialogueand prove an insightful guide to some of the best current practice in the investment industry.We begin with a pair of articles drawn from our latest research on responsible investing. The first piece looksinto investors’ desire for greater consistency and reliability in sustainability metrics—an urgent need assustainable-investment strategies swell to more than 30 trillion in assets. The second draws on interviewswith more than 100 investors and others to sketch out what a true impact economy might look like.Four more articles offer a range of strategies for private investing. One explores how leading assetmanagers are already deriving considerable benefits from advanced analytics. Another investigates pricing,a lever that many GPs have not fully tapped. As the economic cycle winds down, exits are top of mind formany GPs; the third article in this section offers insights into how to craft a persuasive exit narrative. And afourth article considers the current state of leverage across the corporate landscape.Finally, we are pleased to offer in-depth looks at opportunities for private managers in three sectors:European healthcare technology, US financial services, and global real estate. We close the issue withcapsule summaries of some of the most investor-relevant industry research published by McKinsey in 2019.We hope you enjoy these articles and find in them ideas worthy of your consideration. Please let us knowwhat you think: you can reach us at Investing@McKinsey.com. You can also view these articles and manyothers relevant to investing at McKinsey.com and in our McKinsey Insights app, available for Android and iOS.The Editorial BoardPooneh BaghaiAlejandro Beltran de MiguelOnur ErzanMartin Huber2Duncan KauffmanBryce KlempnerHasan MuzaffarRob PalterMcKinsey on Investing Number 5, November 2019Alex PanasVivek PanditMark StaplesMarcos Tarnowski
More than values:The value-basedsustainability reportingthat investors wantNonfinancial reports helped stimulate the growth of sustainableinvesting. Now investors are questioning current reportingpractices—and calling for changes that executives and boardmembers must understand.by Sara Bernow, Jonathan Godsall, Bryce Klempner, and Charlotte Merten Vgajic/Getty ImagesMore than values: The value-based sustainability reporting that investors want3
As evidence mounts that the financial performanceof companies corresponds to how well theycontend with environmental, social, governance(ESG), and other nonfinancial matters, moreinvestors are seeking to determine whetherexecutives are running their businesses with suchissues in mind. When companies report on ESGrelated activities, they have largely continuedto address the diverse interests of their manystakeholders—a long-standing practice thatinvolves compiling extensive sustainability reportsand filling out stacks of questionnaires. Despiteall that effort, a recent McKinsey survey uncoveredsomething that should concern corporate executivesand board members: investors say they cannotreadily use companies’ sustainability disclosures toinform investment decisions and advice accurately.¹What’s unusual and challenging about sustainabilityfocused investment analysis is that companies’sustainability disclosures needn’t conform to sharedstandards in the way their financial disclosures must.Years of effort by standard-setting groups haveproduced nearly a dozen major reporting frameworksand standards, which businesses have discretionto apply as they see fit (see sidebar, “A short glossaryof sustainability-reporting terms”). Investorsmust therefore reconcile corporate sustainabilitydisclosures as best they can before trying to drawcomparisons among companies.Corporate executives and investors alike recognizethat sustainability reporting could improve in somerespects. One advance that executives and investorsstrongly support, according to our survey, is reducingthe number of standards for sustainability reporting.Many executive respondents said they believe thiswould aid their efforts to manage sustainabilityimpact and respond to sustainability-related trends,such as climate change and water scarcity. And manyinvestors said they expect greater standardizationof sustainability reports to help them allocate capitaland engage companies more effectively. While these14findings might not surprise readers involved withsustainable investing or sustainability reporting, itwas striking to learn that investors also support legalmandates requiring companies to issue sustainabilityreports (Exhibit 1). In this article, we offer executives,directors, and investors a look at how sustainabilityreporting has evolved, what further changesinvestors say they want, and how investors can bringabout those changes.Reporting today: Focusedon externalities, inconsistent,yet informativeThe current practice of sustainability reportingdeveloped in the 1990s as civil-society groups,governments, and other constituencies calledon companies to account for their impact on natureand on the communities where they operate. Amilestone was passed in 2000, when the GlobalReporting Initiative (GRI) published its firstsustainability-reporting guidelines. The followingyear, the World Business Council for SustainableDevelopment and the World Resources Institutereleased the Greenhouse Gas Protocol. Thesame period also saw the creation of voluntaryinitiatives, such as the UN Global Compact andthe Carbon Disclosure Project (now CDP),encouraging corporations to disclose informationon sustainability. Since the financial crisis,additional frameworks and standards haveemerged to help companies and their investorsdevelop a greater understanding of the risks andbenefits of ESG and nonfinancial factors. Forexample, the International Integrated ReportingCouncil (IIRC) advocates integration of financialand nonfinancial reports, the SustainabilityAccounting Standards Board (SASB) identifiesmaterial sustainability factors across industries,and the Embankment Project for InclusiveCapitalism assembles investors and companies todefine a pragmatic set of metrics to measure anddemonstrate long-term value to financial markets.For this research, we conducted a survey of 107 executives and investors, representing 50 companies, 27 asset managers, and 30 assetowners. The survey, carried out in January and February of 2019, covered Asia, Europe, and the United States. We also conducted interviewswith 26 representatives of asset managers, asset owners, corporations, standard-setting organizations, nonprofit organizations, andacademic institutions.McKinsey on Investing Number 5, November 2019
More than values: The value-based sustainability reporting that investors wantExhibit 1 of 4Exhibit 1Investors and executives say that reducing the number of sustainability-reporting standardswould be beneficial—and even that there should be legal mandates for reporting.Respondents who agree with statement,¹ %Companies should be required bylaw to issue sustainability reportsThere should be fewer sustainabilityreporting standards than there are today14822866There should be 1 sustainabilityreporting standard75Investors58Executives% of investors who agree or strongly agree that more standardizationof sustainability reporting would enable the following actions1:help my firmallocate capitalmore effectively851help my firmmanage riskmore effectively83InvestorsExecutives% of executives who agree or strongly agree that more standardizationof sustainability reporting would enable the following actions1:help my companybenchmark itselfagainst its peers80enhance mycompany’s abilityto create valueor mitigate risk68Respondents who answered “agree” or “strongly agree.” For investors, n 57; for executives, n 50.Source: McKinsey Sustainability Reporting SurveyGiven the proliferation of reporting frameworksand standards, companies have had to decide forthemselves which ones to apply. These frameworksand standards allow businesses considerablefreedom to choose their sustainability disclosures.Many companies select their disclosures byconsulting members of stakeholder groups—consumers, local communities, employees, governments, and investors, among others—about whichexternalities, or impacts, matter most to themand then tallying the stakeholders’ interests insome way. More recently, stakeholders have askedfor increased disclosure about how companiesaddress opportunities and risks related tosustainability trends, such as climate change andwater scarcity, which can meaningfully affecta company’s assets, operations, and reputation.The scope and depth of these disclosures differconsiderably as a result of the subjective choicescompanies make about their approaches tosustainability reporting: which frameworks andstandards to follow, which stakeholders to address,and which information to make public. AccordingMore than values: The value-based sustainability reporting that investors want5
A short glossary of sustainability-reporting termsIn this article, we use the followingterms for certain elements of sustainability reporting:—— Sustainability disclosure. Thisdisclosure is an item of qualitative orquantitative information abouta company’s performance on atopic not addressed by standardfinancial and operational disclosures.Sustainability disclosures ordinarilyrelate to environmental, social, andgovernance matters, includingcompanies’ sustainability impact andresponses to external sustainabilitytrends. These disclosures sometimesencompass other topics, too, such asHR and intellectual property.—— Sustainability report. This reportis a document containing a set ofsustainability disclosures from anorganization for a period of time. Itcan be a stand-alone document or acomponent of the annual report.—— Sustainability-reportingrequirement. This requirement isa mandate from an authority (suchas a regulator, a stock exchange,or a civil-society group) about asustainability report’s content andnature. Some requirements apply toall companies in a given jurisdiction—for example, Directive 2014/95/EUof the European Parliament and theEuropean Council, requiring somelarge companies to issue nonfinancialdisclosures. Others, such as theUN Global Compact, apply only tocompanies that have voluntarilypledged to abide by them.Thirty-odd years of sustainability reporting haveproduced a trove of useful data. Stakeholderscan use this information to track the relativesustainability performance of companies from yearto year. By aggregating data from many companies,stakeholders can not only discern patterns and6—— Sustainability-reporting standard.This standard is a set of specificationsfor measuring and disseminatingsustainability disclosures. Examplesinclude the Global ReportingInitiative’s GRI Standards and the77 industry-specific standardspublished by the SustainabilityAccounting Standards Board.—— Sustainability-reporting framework.This framework is a set of guidelinesfor determining what topics andto the executives and investors we surveyed, thediversity of these disclosures is a defining feature ofsustainability reporting as we know it—and a sourceof difficulty, as we explain in the following section ofthis article.2disclosures a sustainability reportshould cover. The InternationalIntegrated Reporting Framework,published by the InternationalIntegrated Reporting Council (IIRC),is one example.trends in companies’ responses to sustainabilityissues but compare and rank businesses as well.Analysts in academia, government, and theprivate sector have also used these sustainabilitydisclosures to examine the link between sustainability performance and financial performance. Asubstantial body of research shows that companiesthat manage sustainability issues well achievesuperior financial results.² (Research has shownonly that these two phenomena are correlated,not that effective sustainability management leadsto better financial outcomes.)Alexander Bassen, Timo Busch, and Gunnar Friede, “ESG and financial performance: Aggregated evidence from more than 2000 empiricalstudies,” Journal of Sustainable Finance & Investment, 2015, Volume 5, Issue 4, pp. 210–33; Robert G. Eccles, Ioannis Ioannou, and GeorgeSerafeim, “The impact of corporate sustainability on organizational processes and performance,” Management Science, 2014, Volume 60,Issue 11, pp. 2835–57; Gordon L. Clark, Andreas Feiner, and Michael Viehs, From the stockholder to the stakeholder: How sustainability candrive financial outperformance, a joint report from Arabesque and University of Oxford, March 2015, insights.arabesque.com; “Sustainability:The future of investing,” BlackRock, February 1, 2019, blackrock.com.McKinsey on Investing Number 5, November 2019
Investors and asset owners appear to be taking noteof corporate sustainability disclosures and adaptingtheir investment strategies accordingly. The GlobalSustainable Investment Alliance has found thatthe quantity of global assets managed accordingto sustainable-investment strategies more thandoubled from 2012 to 2018, rising from 13.3 trillionto 30.7 trillion.³ BlackRock reports that assets insustainable mutual funds and exchange-traded fundsin Europe and the United States increased by morethan 67 percent from 2013 to 2019 and now amountto 760 billion.⁴ And research by Morgan Stanleyindicates that a majority of large asset owners areintegrating sustainability factors into their investmentprocesses. Many of those asset owners started to doso only during the four years before the survey.⁵What investors want: Financialmateriality, consistency, and reliabilityWith so much capital at stake, investors havebegun to question prevailing sustainabilityreporting practices. The shortcomings investorsnow highlight have existed for some time but weremostly acceptable to early sustainable investorsand the diverse civil-society stakeholders thatused to be the primary readers of sustainabilityreports. But now that more asset owners and assetmanagers are making investment and engagementdecisions with sustainability in mind, a loudercall has gone out for sustainability disclosures thatmeet the following three criteria.Financial materialityInvestors acknowledge that their expectations forsustainability disclosures have shifted. As the headof responsible investing at a large global pensionfund remarked, “The early days of sustainableinvesting were values based: How can our investinglive up to our values? Now, it is value based: Howdoes sustainability add value to our investments?”From our interviews and survey results, it isapparent that investors want companies to providemore sustainability disclosures that are materialto financial performance. According to a seniorsustainable-investing officer at one top 20 assetmanager, “Corporations do not provide systematicdata on one-third of the sustainability factors[that we consider] material.” This could changeas more companies issue reports in line withthe sector-specific standards that SASB createdin consultation with industry experts and investors.Government authorities and civil-societyorganizations also appear to be coming aroundto investors’ views about the material connectionbetween a company’s handling of sustainabilityfactors and its financial performance. The EuropeanUnion’s 2014 directive on nonfinancial reportingand the Financial Stability Board’s creation of theTask Force on Climate-related Financial Disclosuresin 2015 are two signals that financial regulatorsrealize sustainability-related activities can materiallyaffect the financial standing of companies andshould be reported accordingly.ConsistencyWith so many reporting frameworks and guidelinesto choose from and so many potential stakeholderinterests to address, companies rarely makesustainability disclosures that can be comparedas n
Welcome to the fifth volume of McKinsey on Investing, developed to share the best of our recent research and thinking relevant to investors. Colleagues from around the world and across many disciplines— including asset management, infrastructure, institutional investing, and private equity—collaborated to develop these insights.
By necessity, The McKinsey Waywas more descriptive than prescriptive. With The McKinsey Mind, we take the opposite tack. Whereas The McKinsey Way dealt with what McKinsey does, The McKinsey Mindshows you how to apply McKinsey techniques in your career and organization. To accomplish this, we build on the
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