The Exchanges

Q How did you determine what the mandate would be for that pool of capital?

A At the time, we had no external clients, and it was very easy just to spend time with my colleagues and understand what was in their personal portfolios and what sorts of opportunities they were looking for to complement that. And it's no surprise if you talk to the partners at a private equity firm, even though Bank Capital had a variety of different businesses at the time, the overwhelming exposure that dominated So many of our personal portfolios back then is equity risk. So whether it was via private equity co-investments, whether it was some of our other business units, many of which sort of lean on or have equity risk factor as part of the exposures you have, or whether it's just sheer ownership and future income from the firm. We were all heavily, heavily exposed to equity risk, so it was no surprise that a lot of what we were craving was investments that are diversifying from equity risk, so strategies that are more in the absolute return and uncorrelated buckets, so either explicitly uncorrelated investments or things that were just less correlated and somewhat orthogonal to equity risk, so It could be fixed income investments. It could be real estate investments, things that were just different than what we did internally at Bain Capital, which tended to be very focused on equity oriented things.

AI assessment note: “spend time with my colleagues and understand what was in their personal portfolios”

Q You alluded earlier to compliance markets and voluntary markets. What are these environmental markets?

A I know there's a lot of, a lot of buzzwords and a lot of confusion. So let's break it down into these two pieces, compliance markets and voluntary markets. And while we talk about environmental markets broadly, most often we're talking about some sort of carbon market. And by carbon, we mean CO two carbon dioxide, a greenhouse gas, which is in the atmosphere. And we all know the story from there. Let's talk about compliance markets first. Compliance markets are created by a government with the policy objective of reducing emissions, and what the government does is they create some sort of cap on the number of emissions that they're going to allow in a given period of time, so say in a year, and the government caps how many permits they are going to issue Which is a proxy for how many tons of carbon dioxide gas they're going to allow for a given year. And the government then requires every emitter of a certain size to buy one of these permits in order to emit that ton of carbon dioxide. And the emitters must comply. So that's why we're calling it a compliance market. The term cap and trade is often used for this type of market. Where the government is capping the number of tons of carbon dioxide that can be emitted, and where the underlying permits can be traded between the emitters, investors, and anybody who wants to participate in those markets. So some examples of compliance…

AI assessment note: “Compliance markets are created by a government with the policy objective of reducing emissions”

Q So let's turn to the voluntary markets. So what are the voluntary markets, and how do they work?

A So voluntary markets are the second side of environmental markets, and per their name, these are markets where the people who are buying the underlying instruments are doing so completely of their own volition. So there's no government requirement that they buy Um, the underlying instrument. So what is the underlying instrument in, in voluntary carbon? There's a lot of vocabulary. People may have heard things like a carbon credit or a carbon offset or a voluntary carbon credit. Let's just use the term a carbon offset. And when someone is participating in the voluntary market, they are basically saying, I want to buy something to offset the impact, the carbon emissions that I have had on the world. So I've already done some activity. Let's say I took a plane ride on a jet and that used up some fuel and some share of that is due to me. I want to offset that behavior by buying some sort of instrument. So it's something I'm doing totally voluntarily. No government says that I have to do it. And these offsets need to be created by somebody who is undertaking an action in order to have that offset impact. And there's really two types of voluntary carbon offsets. There's offsets where you undertake a specific task. In order to remove carbon out of the air. So an example of that might be planting a tree. If you plant a tree, the tree will grow. It will absorb carbon dioxide out of the …

AI assessment note: “these are markets where the people who are buying the underlying instruments are doing so”

Q What type of resources do you need to deploy internally on your team to first get up to speed and then stay on top of all these developments in this space?

A For us specifically, we wanted to understand these markets granularly. So even when we were thinking about using external parties to be our agents and investing in these markets, We wanted to understand them ourselves. So we deployed our investment team. I think everyone on our 13 person investment team touches these investments in some way. About half of us are spending a good chunk of our time looking at these markets. So we have six or seven people focused on underwriting in the first place. That takes a process of two to four months, depending on the complexity of the market, where again, we'll go and hire a consultant or an advisor to help us who is Very well versed in that market, if not involved in the sort of architecture of that market. So research is an important part of what we do, and not only doing that up front, but over time, having enough bandwidth to be able to monitor what's going on in those markets over time. These aren't stocks where there's necessarily, like, could be major news in any given quarter. There are news developments, and there is price action you need to monitor, but for the most part, we're only getting involved where we feel like, The situation is relatively stable where there's unlikely to be stroke of the pen risk and meaningful regulatory change that would sort of fundamentally change the rules of the game and or where the supply demand si…

AI assessment note: “everyone on our 13 person investment team touches these investments in some way.”

Q Why don't you take me back to what brought you to the seat at Bain?

A Absolutely. Absolutely. First, thanks for having me on the podcast. And, uh, I've been a listener for many years and really enjoyed a lot of episodes. So glad to be with you today. So my background back in my old college days, I was studying to be an attorney and was a politics major and got the very wise sage advice from my parents to do anything, but go to law school. So, uh, ended up exploring a couple of different job opportunities and got some really unique offers, including an opportunity to go into the business world, doing sort of a strategy role at the Walt Disney company. So join them straight out of college. In their corporate strategic planning group out in Los Angeles. And that really kind of opened my eyes to the business world, which isn't an area I had necessarily thought that I was going to move into really enjoyed that experience and really was a good exposure to sort of the strategy side of business. After that role, I wanted to compliment that with something more on the finance side. So, so looked around for other Pre-business school opportunities, and the first one I came across was Bain Capital. So this was back in the year 2000, and Bain had the customary pre-business school associate program, and it was a really good fit with what I was looking to do at the time, which is to bone up on finance and learn about investing. So it was a really interesting fit…

AI assessment note: “looked around for other Pre-business school opportunities, and the first one I came across was Bain Capital.”

Q What kind of volatility do you have to withstand in the short term to get to what you're playing for over time?

A If you look statistically at the annualized volatility of some of these instruments, I would think of it as, you know, while these are commodities, it's something like a modestly volatile single stock equity. So you're looking at annualized vol that could be in the thirties, something like that. Perhaps some of the markets more volatile than say an equity market index, but it really depends on the market for a long time. The California market had very low volatility because for most of the last decade, the price was at the regulatory price floor where it basically the auction prices couldn't go down. The futures were trading right around this price floor. So you saw it really as almost a flattish price. Gradually escalating with the minimum price escalation, which is five percent plus CPI per year with relatively low volatility. It's increased somewhat as prices come up off the floor in California, but still relatively modest by commodity standards. And I think if you're using the time horizon that we do, we think the volatility is modest in light of what we think the return potential is. So the sort of implied sharp and or sortino one might be thinking about as you think about, even though it's just a single instrument in a given market, If you thought about it sort of as its own strategy, it's something that we think is quite attractive and stacks up relatively well to other …

AI assessment note: “annualized vol that could be in the thirties, something like that.”

Q I think that's a terrific context to dive into where we're going to head with this, which is these environmental markets. And maybe the place to start is how did you come across these markets as an investment opportunity?

A We've been investing in commodities oriented strategies, whether it's longer term private equity style investments or, uh, commodities trading strategies for over 10 years. So have gotten to know a lot of different firms in that ecosystem. The merchant commodity trading firms, uh, most of which are private, a small number of hedge funds that, that tend to focus in, in, in those sorts of commodities trading strategies, especially. And it was just in conversations with that network over a period of years that we started to hear people talk about some of these markets, both, um, there's sort of two types of environmental markets as compliance markets and voluntary markets. But it was just an ordinary conversations about what's going on in different markets that we started to hear some of our friends and partners talk about, um, exploring these markets, and that sort of piqued our interest and presented us the thread on which to pull to kind of learn more about them over time.

AI assessment note: “in conversations with that network over a period of years that we started to hear”

Q What does the price action look like in terms of sort of volatility and correlation with things like equities fixed income and commodity oil markets?

A It's different market by market, but I would say as a general theme, we think about the price action in really two different time horizons. The first is on a shorter term basis, we do think some of these markets will have some correlation to Equity markets, especially for the exchange traded instruments where you're just seeing involvement in markets where there are financial market participants in other instruments. So we think inherently there is some modest connection there while these markets are driven by their own fundamentals in the short term, there could be some moments of, of positive correlation. But I think the more important time horizon that we use is focusing on the medium and long-term of what will drive prices in these markets, and that's the fundamentals of each of these individual markets, the supply, the demand, the regulatory changes that are occurring, and we believe the price action that comes out of those fundamentals is uncorrelated with the equity markets, with the macro economy, and there's such a unstoppable secular trend, it seems, of These markets being penetrated by investment capital and more and more regulatory changes that are bullish on price in these markets that we think that happens and is likely to, to continue regardless of what's going on in the broader market. So that's the time horizon that we think about for thinking about price actio…

AI assessment note: “we think about the price action in really two different time horizons.”

Q How do you think about the return and risk characteristics in the voluntary markets?

A It's a great question. There's a wider band of both return potential and risk in the voluntary side of things compared to many of the compliance markets. There's just a broad menu that one could pick from. You could buy offsets that have already been issued. So that's relatively low risk. They've already been produced. They've been verified by a third party. You can figure out roughly the prices where those trade, and there's also much earlier stage opportunities where you could work with a project developer who is undertaking a project where they have a 20 year plan in order to, let's say, reforest a certain section of the Amazon, and where by virtue of undertaking that project A greenfield development project. That project will issue these offsets starting, say in five years from now, once enough trees grow that you can validate how much carbon has been removed from the atmosphere. So it's really quite a broad menu of different investment opportunities available. There's been a lot of news and press recently around the validity of different voluntary carbon offsets and their legitimateness and actually having impact. We're finely attuned to that in what we look at, and we think it's very important for allocators to really think about that as they look at this space, and end users ultimately are very focused on this, so if you're effectively trying to develop and create produc…

AI assessment note: “There's a wider band of both return potential and risk in the voluntary side”

Q How did you take some of the deep research driven DNA that you learned from the decade being on the direct side and employ that particularly in those earlier years when you were looking at LP relationships and outside managers?

A It's interesting. When I moved over from stock picking to allocating, it ended up being quite a bit more similar than I thought, in the sense of, at the end of the day, you're interviewing teams about what they do in their day job, and then conducting research to try and build conviction and belief around what they're going to be able to do in the future. And how they're going to be able to perform and either lead their fund or lead their company. Um, so for a good 10 years, I had had training and, and sitting down with, you know, the management teams of public companies or companies going public and really understanding how they operated, how they did what they did, how they competed against others, and doing the necessary research to understand the industry they were in, what was unique about that particular company, what was going to differentiate them, and where their return stream was, you know, what are earnings going to be over time. And then supporting that over to the early days of what we did and what we now call our partnership strategies group, it was similar. It's interviewing portfolio managers, interviewing the analysts on those team to understand what do they do and how are they different from their peers? What are examples of their work and really trying to tease out who's going to be able to compete well in their respective industry? The context is different. …

AI assessment note: “porting that over... It's interviewing portfolio managers, interviewing the analysts on those team”

Q When you've done your research on both of these markets and you decide you want to participate, how have you thought about whether to do this directly or partnering with managers who are focusing on it?

A That's a great question, and I think speaks to the flexibility we use within our group, where we're open to different models. When it makes sense, we will express investments and bets directly, but we're also willing to partner and JV with external parties, whether they're fund managers or developers, as the case may be. We've utilized both approaches and particularly early on, you know, we often look for river guides to be our partners as we explore these markets. And I'd say we've, at this point, think we've developed enough knowledge in many of these markets to be able to express bets directly. In some of these markets, in some investments, we're more likely to use a third party in what we do, particularly on the voluntary carbon side of things, where even if we sort of vertically integrate and go way up the supply chain, we're not going to have a team doing the development project in Indonesia ourselves. We're going to be partnering with a local developer. So very much like one in sort of allocator parlance, one might partner with a local operating partner in order to actually go and implement a real estate strategy or a permanent agricultural strategy. Plantation strategy. We will be partnering with developers on, on the voluntary side of thing in some cases. And, you know, we'll take it case by case and, and look at different markets. In some markets, it'll be so transpar…

AI assessment note: “When it makes sense, we will express investments and bets directly, but we're also willing to partner”

Q What was the most challenging moment in your career?

A Early in my career, when you're young and still figuring it out, um, having your first big, big Deeply research stock call go against you and go wrong leaves a mark and, and sort of makes you never want to feel that again. In the mid noughts, there was a particular company that I had done significant research on and ultimately didn't end up working out. And there were a couple of key moments, you know, earnings calls where things didn't work out, changes in management that were unexpected. And it really made me question, like, how well do I know this? And luckily that turned out to be Less frequent than things that I did that ended up working out well, but that certainly left an indelible mark of really never wanting to feel that again and motivating me to, you know, really try and have thorough understandings for different investments that we look at.

AI assessment note: “having your first big, big Deeply research stock call go against you”

Q I want to ask you a couple of basic questions about how these permits work to just put it in some perspective. So I guess the first is how precise are these measurements of the emissions that companies are putting into the atmosphere?

A They are precise enough for the purposes of what this program is trying to do. So each of the different jurisdictions has a certain set of rules around what the entities must do In order to both measure their emissions in the first place to figure out whether or not they're large enough in order to be covered by these sorts of programs. And then on an ongoing basis, measure their emissions to basically make sure that those entities are purchasing enough allowances in order to offset the activity that they have as emitters in those markets and the precise rules in terms of how frequently and the process vary from jurisdiction to jurisdiction. But I would say that's not a particularly controversial area of these sorts of markets. Once the programs are implemented, it's generally a multi-year process of both rulemaking and socialization amongst all the constituencies in a market. Trade associations on behalf of the emitters come in and weigh in, and they, along with the technical staff at the relevant regulatory jurisdiction, decide how that's all going to be handled. So we don't see a lot of controversy in those precise measurements. At the end of the day, We see more and more of the emitters actually buying into these programs. And while there was resistance, 10 and 15 and 20 years ago, you know, where you would see oil companies lobbying against these sorts of programs, what yo…

AI assessment note: “They are precise enough for the purposes of what this program is trying to do.”

Q What happens to an emitter if they surpass the permitted allowance they have from their purchase of the permit?

A This is starting to get into the micro, and it's going to vary market by market, but in one example, let's take California, because that's the biggest one here in the US. So what an emitter will need to do is to buy a number of allowances. In California, it's a rolling three-year compliance window, and essentially the Emitter needs to buy enough allowances to cover their emissions over that three-year window, and there's a certain schedule associated with when they need to buy those. If they don't buy enough, then they are going to be significantly penalized by the jurisdiction. In the program's History to date, there has been a hundred percent compliance as far as we know with this program, and that in part has been not that big of a, of a lift for the emitters because the prices have been low, relatively low historically. In California, they've been in the neighborhood of 10 to 20 dollars per ton from the time from 20 12 to roughly 20 20. In the last year or two, you started to see the price creep up to be in the mid to high twenties, but still relatively low, and this is the cost per ton of CO₂. For these permits. Right now, there is this existing surplus for emitters to be able to buy them, so there's no issue with the emitters being able to buy them, but at some point, there will be a shortage, and what will happen then is the price will go up significantly. And in the Cal…

AI assessment note: “If they don't buy enough, then they are going to be significantly penalized”