Sustainable forestry represents a major portion of conservation finance’s investable landscape. According to a 2016 Forest Trends report, “State of Private Investment in Conservation 2016,” sustainable timberland investments accounted for approximately 34 percent of all private conservation investments from 2004 to 2015.
Also, according to a 2017 report by Credit Suisse AG and McKinsey Center for Business and Environment, “Conservation Finance from Niche to Mainstream: The Building of an Institutional Asset Class,” sustainable forestry is among the most well-developed conservation finance markets. With the maturity and scale needed to attract higher volumes of private capital, it resembles a mainstream investment product.
However, according to speakers at the 2018 RISI Forest Investment Conference, timberland has matured as an asset class. Financial returns have fallen dramatically, particularly since the mid-2000s, making timberland investments less attractive. As a result, timberland investment managers will feel pressure to differentiate their products and increase returns.
This may lead managers to adopt innovative models such as well-managed conservation strategies. Because such strategies can increase returns through creating additional revenue streams such as the sale of carbon credits, they will likely become more common in timberland investing. Thus, the maturation of the timberland asset class could prove to be a catalyst for the growth of conservation finance.
A Mature Asset Class
The timberland asset class has matured and grown more efficient since the mid-2000s. Investment returns have fallen substantially, said Mike Clutter, vice president and director of United States investments and operations at Forest Investment Associates, during his presentation at the 2018 RISI Forest Investment Conference, which took place in New York City on May 1-2.
Clutter said TIMOs emerged in the United States in the early 1980s. Timberland represented an attractive, newly discovered asset class that arose as vertically integrated forest products companies began to sell off their timberlands, largely due to pressure from investors. It offered investors high returns with relatively low risk and positive correlation to inflation. It also showed low or negative correlation to other asset classes such as stocks or bonds – and a low correlation to the overall market. Timberland was touted as a highly profitable safety net that would perform well in a recession environment and withstand high inflation.
Over the next 25 years, over 50 million acres of timberlands would transfer from industrial to institutional ownership. Most of the transferred land was managed by TIMOs. However, as the asset class attracted a growing group of investors, exceptional opportunities dried up and returns plummeted.
According to New Forests’ “2017 Timberland Investment Outlook” report, the global timberland market has grown substantially in the past decade. The assets under management by TIMOs nearly doubled from about $24 billion in 2006 to $44 billion in 2016.
The United States continues to account for over half of the entire timberland investable universe. However, returns in United States timberland have dropped dramatically. According to Clutter’s RISI presentation, returns peaked at over 35 percent in the late 1980s and early 1990s. Since 2015, they have fallen under 5 percent.
Timberland is no longer as compelling an investment as it once was. In addition to lower returns, there are reasons to doubt the diversifying power of timberland investments. At the 2017 RISI Forest Investment Conference, Jim Hourdequin, CEO of The Lyme Timber Company, said timberland showed higher correlation with other asset classes in the decade since 2006 than in the previous decade. In other words, in recent years timberland returns have moved more closely to the overall market, reducing their strength as a safety net.
A Set of Future Structural Changes
With timberland’s maturation, structural changes will reshape the industry. TIMOs currently rely predominantly on commingled closed-end funds which pool capital from multiple investors to be invested and managed over a discrete period (typically about 10 years). This structure requires that timberlands be sold at the end of a fund’s life. This can result in inefficient sales, when it may be in an investor’s interest to hold onto high quality assets for longer periods of time.
According to Peter Stein, managing director at The Lyme Timber Company, “In the near term, there will be new forms of investment vehicles designed for longer-duration ownership of timberland assets or structures similar to holding companies in order to slow down the churning (such as relatively frequent TIMO-to-TIMO sales).”
“As a mature real asset, [TIMOs will have an] increased focus on annualized operating revenues as well as a need to reduce fees and increase the alignment between investors and investees,” Stein said. Because cheap, high-quality assets are no longer easy to come by, TIMOs cannot count on good deals that will guarantee high returns. They must focus on the day-to-day management of timberland assets and improving operational efficiency to increase profits. Also, TIMOs have not escaped the pressure to reduce fees that has arisen throughout the investment management industry in the past several years.
An Increased Focus on Conservation Finance
At the 2018 RISI Forest Investment Conference, it was evident that themes such as impact investing, conservation finance, and ESG (environmental, social and governance) criteria are garnering increased attention.
Four of the conference’s 24 sessions – around 17 percent – specifically focused on impact investing and/or conservation. Many other speakers mentioned these themes as part of their presentations. It was evident that conventional TIMOs are becoming more interested in conservation finance due to the growing prominence of sustainable investing.
Some industry leaders predict that conservation finance and environmental markets will redefine timberland investments. David Brand, CEO of New Forests, said he foresees an industry re-segmentation process. This will lead to a new management regime that breaks down forestry assets into different elements such as timber production, carbon sequestration, and water regulation.
As a result, investors will reap higher profits while addressing climate change. According to Brand, “Forests are going to become a type of natural infrastructure. All forests will be managed for their climate change benefits. All forest products are going to be part of the global imperative to deal with climate change – and that will become valuable.”
Others hold somewhat more conservative outlooks. According to Stein, “Greater focus on long-term forest management, third-party certification, and conservation-NGO partnerships will continue to increase as this asset class further stabilizes.”
Stein’s view predicts an increasing importance of conservation finance strategies, but not necessarily the total market restructuring Brand described.
A Contrast between Old and New Conservation Strategies
As the industry has matured, TIMOs will need to adopt new strategies to stand out and compete for capital. Some TIMOs have been able to increase investor returns through conservation-oriented strategies. These include the sale of conservation easements and carbon credits and the use of the New Markets Tax Credit Program. It is likely that these tried-and-tested conservation strategies will become more common as TIMOs seek to differentiate themselves.
New conservation strategies, such as incorporating water or biodiversity markets into investments, will also likely emerge. At the 2018 RISI Forest Investment Conference, Erin Robert, executive director of sustainable finance at JPMorgan Chase & Co., said a new tax incentive may spur conservation finance in timberland investments.
Established in the 2017 Tax Cuts and Jobs Act, Opportunity Zones allow investors to transfer unrealized capital gains into Opportunity Funds to be invested into designated low-income communities. In turn, investors receive a temporary tax deferral and other tax benefits. Opportunity Zones may create the economic conditions needed to allow for new sustainable timberland investments in certain low-income rural areas.
The Prospects for Conservation Finance and Timberland Investing
The timberland investment industry has clearly passed its growth phase of the 1990s and early 2000s. As it continues to mature and stabilize, some industry insiders foresee consolidation and fewer TIMOs in ten years than there are today.
Such conditions may lead to a surge of alternative strategies as TIMOs attempt to differentiate themselves. Conservation finance will become increasingly important. The question is whether it will remain a niche strategy utilized by specialized firms or become a dominant factor that redefines the timberland investment industry.
Note: Peter Stein is on Conservation Finance Network's advisory board. Credit Suisse has collaborated with and donated to Conservation Finance Network.