Capitalism & Conservation: A future without economic growth would be a tragedy. Venture capital can help to drive sustainable growth

Contrary to what some activists advocate, a future with zero economic growth is not only impossible, but also undesirable. Citizens in emerging markets need and deserve a better future for their children. Private equity’s focus on efficiency is good for the planet, as it benefits from sustainable approaches to economic activity. 

Apocalyptic views of economic growth are old news, and they are wrong

In 1798, Thomas R Malthus[1] predicted that population growth was exponential and the Earth’s resources would run out in less than a century, causing untold suffering. Two hundred years later, the world population has grown to almost eight billion people, and never in history has a higher proportion of humanity been lifted from extreme poverty[2]. Malthus was a good historian but a lousy forecaster.

In the late 1960’s, Stanford professor Paul Ehrlich predicted a Population boom[3] that would cause hundreds of millions of deaths from famine in the following decades. His views, a modern version of Malthus’, saw resource utilisation as a constant per unit of wealth, with attendant catastrophic damage to the planet as populations grow.

Fifty years on, available data proves Ehrlich wrong . Since the 1970s - the time when Ehrlich started waving the flag of planetary collapse - the world’s population has fared better than ever across almost all metrics of human development[4] . Capitalism has delivered growth at scale despite huge population growth. The famines he foretold have shrunk to historical lows (this is particularly true if you exclude famines in non-capitalist countries – caused by failures of collectivist state economic planning, which make up the majority of famine deaths in the 20th century).

Luckily, many intelligent scholars have questioned neo-Malthusian views, compared them to available data, and found them lacking. One of my favourite amongst these scholars is Andy MacAffee[4], who happily provides abundant data to support his claim: the essence of Capitalism is to do more for less. Capitalism has proven Malthusian projections wrong so far. We are creating wealth while using less resources in many parts of the world. The US does not use less resources in manufacturing because it has outsourced manufacturing to areas like China (as Malthusians argue). It has outsourced production indeed, but its domestic industrial output has also grown during the last decades, while consuming less resources. The case is even more obvious when looking at agricultural production. The US (and Europe) are producing more agricultural output than ever, with much less land, using less water and inputs. If you have not come across this inspiring MIT professor, I recommend you read his articles, or listen to some of his lectures[5].

 Like MacAffee, I share the angst that possesses many environmental activists. I definitely worry about climate change. I worry about the potential destruction (or at least degradation) of some of my most beloved ecosystems: Botswana's Okavango delta, the Serengeti-MasaiMara ecosystem which spans Kenya and Tanzania and hosts the world’s largest mammal migration, the Laikipia plateau at the foot of Mt. Kenya, where my children have grown up, or the Luangwa valley in Zambia, where we are involved in a wildlife ranch that is pretty close to what I hope Heaven looks like. Above all, I certainly believe we can do more to help the planet. Unlike neo-Malthusians, I believe the only way we can help save these ecosystems is by helping poorer nations grow and develop. Poor people are too busy surviving to care about the planet. Help them become wealthier, and you will see the change. And example: since 1990, China has added over 500,000 Km2 of forest area - an area almost the size of Spain and larger than the whole state of California.

Efficiency as a source of Return on Capital. The reason why capitalism is good for the environment

The fundamental error of the enemies of economic growth is their lack of understanding of capitalism and investment. Just as economics is not about money, but rather about ‘utility’ (an abstract word one can translate for ‘happiness’, or ‘satisfaction’), capitalism is not about maximising sales, or volumes of production, but rather about maximising return on capital invested. This distinction is key to explain why venture capital and private equity are a force of good for the planet.

At our firm, we link the discipline of investment with a desire to maximise impact on climate, conservation and rural livelihoods. We believe that those are not just virtuous "feel good" ideas, but a key driver of long term competitive advantage. However, we never forget that impact cannot be sustainable if a business is not viable as a profitable going concern. Financial discipline is key. This approach can generate both higher returns and higher impact (not in all companies, and not in all industries, but luckily we can choose!).

How does this work? A mini case study

While Okavango's typical investments are a bit more 'hardcore' on the conservation front, please indulge this more conventional example. Imagine we look at acquiring an African company in the Food security sector. This is a growing sector. Africa’s need for agricultural production growth is critical. The UN Food and Agriculture Organisation (FAO) estimates that over 500,000 km2 of African savanna forest, an area the size of France (or Kenya) will be converted to commercial agriculture between 2010 and 2030[7]. In the meanwhile, Africa’s agriculture is fragmented, lacks mechanisation, has poor use of sustainable fertilisers, insufficient water conservation, and is labour intensive. To top this, Africa’s yields are dismal: Kenya’s yield per hectare of Wheat, for example is one fifth that of the Netherlands[8].

The high demand for agricultural products in Africa, the need for exporting of commodities, and the fertility of the land in many areas make investment in agricultural production an attractive investment sector, but there are different approaches to investing in agriculture.

According to Malthusian beliefs, investment in agriculture in Africa will inevitably translate into wholesale land use change, with attendant deforestation, soil damage, reduction in water security, biodiversity loss and increase in vulnerability of rural populations to the devastating effects of climate change. Right? Not necessarily.

Let us examine a hypothetical investment in a wheat producing company in Kenya. Let us put aside the fact that most investment firms, such as Okavango Capital are born out of a desire to create positive impact via our investment activity. Let us just assume we are interested in two things only: maximising Internal Rate of Return (IRR)[9], which is the measure of return on capital used by private equity firms, while reducing risks.

The firm (FarmCo)

FarmCo is a typical Kenyan mid-scale agricultural firm: it owns and cultivates (directly and through out-grower partnerships) 10,000 hectares of land. It produces the average yield per hectare, at the average cost per hectare. The private equity firm buys the company and wants to create a good return to its investors. In order to achieve this goal, it must sell the firm for a substantial capital gain, after a typical holding period of five years. Private equity firms tend to make and sell investments in companies based on multiples of profitability. The most common one is Enterprise Value to EBITDA (EV/EBITDA). We will compare 2 scenarios, (1) a Malthusian approach where the company grows by using resources at a constant rate, and (2) a typical private equity approach where the focus is on maximising return on capital via efficiency.

Scenario 1: Pure growth, no change (Malthusian view)

The private equity investor will deploy capital to acquire and grow the business. Business is seen as a permanent relationship between capital, labour and resources, delivering similar yields on a per-hectare basis throughout the time of the investment. 

In this hypothetical case, we allow for economies of scale linked to area expansion leading to a lower cost per hectare. Land (a limited resource) will be converted to increase production, with attendant pressure on the environment (and perhaps indigenous communities who may be displaced). Profit will be increased.

In the case of FarmCo, let’s assume the following happens:

a)     To increase sales we will double the land size to 20,000 hectares (acquiring 50% of the new land and renting the rest). This doubles the revenue.

b)     To finance the increase land we make a $2.5m investment. Using a below-market price per Ha for the area. For the purpose of simplicity we ignore costs of land-clearing or preparation for cultivation.

c)     We maintain Kenya's average yield/ha in tons during the life of the investment (which is what Malthusians believe), but the larger land size allows for a reduction of Cost/Ha, and an increase of EBITDA [10]margins of 50%.

d)     If we are successful with our investment, we double the size under cultivation, and the revenue but triple our EBITDA.

Scenario 2: A more typical private equity approach

In our experience, the main focus of private equity investors is on solving inefficiencies. This is particularly true in two cases:

A.     industries with relatively low margins. When you make 10% profit, you can double your profits by either (a) doubling your sales, or (b) reducing your costs by 11%. Try doing the calculations.

B.     Industries with high capital expenditure. Remember what matters in the end is the return on capital invested. If you can increase the amount of dollar revenue per dollar of capital invested, all other things being equal, you can double your profit, even if your costs per hectare increase.

In the case of FarmCo, let’s assume the following happens:

a)     To increase sales we invest heavily in technology, soil health, sustainable water systems and crop varieties.

b)      We do not acquire or lease more land, but focus instead in getting our yield/hectare closer to that of advanced economies (in our case-study we get up to 40% the average of the Netherlands - this is a conservative estimate based on actual yields in SubSaharan Africa).

c)     Given its increase in yield, FarmCo shares some of the improvements with clients and reduces prices by $5/ton

d)     As a result of this investment, our cost per hectare goes up by 70% to $537/Ha which would make it substantially higher than the average cost in Germany ($470/Ha x year) - again this is an estimate, well above average costs even for highly productive farms in the region.

e)      In addition, we assume we have to spend $1.5m in technological improvements to achieve higher yields.

f)      If we are successful with this investment the area under cultivation stays the same, but revenue grows by almost 90%. More importantly, due to not needing to manage a larger farm, our EBITDA margin grows substantially to 19%, which using a larger revenue base, translates into substantially higher profits. In addition we limit ESG risks and attendant costs linked to land expansion.

In summary, both Scenarios achieve somewhat similar levels of revenue and operating profit. However, Scenario 1 uses many more capital and natural resources, and while it achieves a lower cost per Ha, it also delivers lower yields.

Investment Returns

We assume in both cases we acquire and exit the firm at the same multiple: 7x EV/EBITDA, and we use no leverage. Because we invest less capital, and we achieve higher yield, Scenario 2 can outperform the economies of scale of Scenario 1.

In Scenario 1, investors get an IRR of 14% and 1.5x their money. In Scenario 2, the IRR goes up to 26% and the investors receive 2.2x money. A much better return with lower use of land, and attendant ESG risk linked to land use change, displacement of communities and negative impact.

Why does this happen?

It is simple: efficiency. If you achieve more for less, your return on investment grows faster.

Of course, the world is not perfect, and markets are often inefficient. There are firms that invest in the wrong sectors of the economy, or do not seek the most efficient strategies. While this example illustrates the right approach to sustainable investment, there are examples where efficiencies are low, or fail altogether.

But the principle remains: if you focus on the incentives (to maximise return on capital invested), you will see that private equity investors will work hard to create efficiency. And no other system has achieved a reversal of Malthusian laws as successfully as capitalism.

Efficiency is based on reducing resources used per unit of wealth created, which is good for the planet.

Next time someone tells you that to save the planet we need to stop growth, consider weather the wealthiest 2 billion of the world's citizens (of which you are likely one) would be willing to see their wealth (and education, and health services) reduced by 75%, so the ‘other’ 5.7 billion people in less developed countries can catch up to their standard of living. Citizens in emerging markets want to (have the right to) a more affluent future for their children. But there is no need for this zero-sum re-distribution vision of the world. Sustainable investment can deliver growth in emerging markets, and it can do so while improving the planet. It is possible, and having been part of it for over a decade I can tell you that it is beautiful to witness.

While some alarmists continue to find a problem for every solution, we will continue working hard to try to help the right companies achieve their potential. And in doing so, we hope to leave the planet a little better than we found it.

____________________

Josep Oriol is founder and managing partner at Okavango Capital Partners, an investment firm focusing on climate, nature conservation and rural livelihoods.

[email protected]

[Disclaimer: FarmCo is a hypothetical example to illustrate the thinking around maximising IRR by venture capital and private equity practitioners. It does not represent any real firm nor any investment made by Okavango Capital.]

References:

[1] https://oll.libertyfund.org/titles/malthus-an-essay-on-the-principle-of-population-1798-1st-ed

[2] https://en.wikipedia.org/wiki/Factfulness:_Ten_Reasons_We%27re_Wrong_About_the_World_%E2%80%93_and_Why_Things_Are_Better_Than_You_Think

[3] https://en.wikipedia.org/wiki/The_Population_Bomb

[4] https://data.worldbank.org/

[5] https://mitsloan.mit.edu/ideas-made-to-matter/why-economic-growth-hasnt-ruined-planet

[6] https://hbr.org/podcast/2019/09/dematerialization-and-what-it-means-for-the-economy-and-climate-change

[7] FAO- World agriculture towards 2030/2050-ESA working paper no. 12-03 -June 2012

[8] https://ourworldindata.org/grapher/cereal-yield?tab=chart&country=KEN+NLD+TZA+USA

[9] https://www.investopedia.com/terms/i/irr.asp

[10] Private equity firms prefer to use EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation) as a proxy of operating profit for firms in order to value them. This is because EBITDA allows us to eliminate the distortive effects of debt, and of buy vs lease operating strategies. https://corporatefinanceinstitute.com/resources/knowledge/valuation/ev-ebitda/