­­Mark Canavan is senior portfolio manager at the New Mexico Educational Retirement Board where he manages the pension funds’ $1.7 billion in real estate and real assets allocations. During his time at the Retirement Board, Canavan has expanded the scope and definition of what it means to invest in the real assets space to achieve stellar returns, all while battling through some of the toughest market conditions in recent history and a near fatal bout with cancer.

Mr. Canavan was recently named on Trusted Insight’s Top 30 LPs Investing In Real Estate & Real Assets, and he graciously spoke with us on November 4. Our conversation will be broken into three parts: first, Canavan’s implementation of mitigation banking to revitalize distressed areas of nature and generate a double-digit IRR; second, Canavan’s first-hand account of stumbling onto the impending financial calamity known as the Great Recession and derisking the New Mexico Treasury’s portfolio (his previous employer) before the collapse; and finally, Canavan’s outlook on the current market climate and its implications on real estate and real assets.  
 

Trusted Insight: You studied physics in college. I know it's been a few years since then, but how did that background factor into your current position? Do you see those teachings crop up in your thinking when it comes to the markets?

Mark Canavan: I have a fascination with analyzing things. I like taking apart a thesis and putting it back together. I am an acute analytical, but that is not a result of having a love of physics. It's more just the result of whatever in me that makes me like science and physics and analysis. I question everything.
 

Trusted Insight: You seem to be a pioneer when it comes to taking a unique direction, take your implementation of mitigation banking for example.

Mark Canavan: Whenever the data supports it, yeah. I'm not going to go out and do something just because it's new. It's got to be fully supported, and I've got to be able to see the trend.

I've got to be able to take apart the investment thesis and put it back together. Kind of like a young kid when they get a present, they start bashing it against the table for no other reason than trying to break it, because kids don't know whether things will break or not. I try to break things basically. I guess you could call me negative in that way. I try to take a thesis and break it.

I tried it with mitigation banking. I put that to every test I can think of to try and break the investment thesis. I looked for examples of environmental regulations being waived due to economic environments. I looked for examples of environmental impacts that are being allowed en masse, and I watched the mitigation banking industry develop over a series of years.

I've always had people pitch environmental investments to me, but they lead with the environmental foot, right? In other words, they lead with the social or environmental good of it.

But it's my fiduciary duty to make sure something is a sound investment. It's not just somebody else’s social or political agenda.

In that sense, my education did develop in me that ability, per se, to tear apart a subject and beat up on it and see whether it held water or not, to use a bunch of euphemisms.

I found mitigation banking compelling. When I first ran into mitigation banking, I found it environmentally pragmatic. At the time I decided to do mitigation banking, most of the environmental deals I'd ever seen--clean energy, green energy, clean this, green that--really had bad underlying fundamentals, had bad underlying political regimes, had bad underlying regulatory regimes, and frequently had a subsidy that could be taken away.

When I ran across mitigation banking, there's no subsidy there. It's just, here's the Clean Water Act of '72 and the Endangered Species Act of '73. Here's the rules and regulations of how you're supposed to mitigate for your own environmental damage. It's not a subsidy where you go buy a solar panel, we'll give you $10,000. It's just here's the rules. Let the market decide how it's going to solve the problem. It’s a free market solution to the restoration needs of a lot of areas in the country, and that seems really pragmatic.
 

Trusted Insight: So how does mitigation banking work?

Mark Canavan: Under the '72 Clean Water Act and '73 Endangered Species Act, you have to remediate damage to certain environments, mainly water based. What that wound up leading to was a lot of rules and regulations that ended up leading to a bunch of unintended consequences.

One of which is the following: You're driving down the road and see an empty lot or what used to be an empty lot. They're developing a shopping center. They're developing a little community. There's an offset required to their hydrological impact on the area.

To remediate their damage, they would put a huge pond in the area and wrap a fence around it and call it a protected wetland. What they ended up doing was creating a health hazard, an eyesore, a mosquito farm. It wasn't the intended outcome of the rules and regulations promulgated under the 1972-73 acts. But, those types of outcomes happened.

Over time, what wound up developing was a program where the Army Corps of Engineers, which regulates all this, would allow and approve of somebody restoring say a thousand acres, and in turn that group was granted a thousand credits which they in turn could sell to developers impacting the same watershed. That's not always what the math is, but the point is they are much larger environmental restoration projects. The government agency in charge of issuing credits says, “We will grant you credits, and then you can turn around and sell to the people in the same watershed that are impacting the environment. The end buyers then post the credits to the agency in fulfillment of their requirement to offset their impacts on the environment.”

Follow me? Now you've got a project that's a thousand acres instead of a pond behind Wal-Mart. When you get to doing restoration at scale or remediation at scale, you actually wind up having a valid ecological uplift.
 

Trusted Insight: Do you have a real-life example?

Mark Canavan: Sure, New York City. A lot of people don't know this, but for the longest time 90 percent of New York City’s drinking water has been unfiltered. The city’s water comes straight from upstream waters through the aqueduct system right into your tap.

Then, in 1989, the EPA issued the Surface Water Treatment Rule requiring cities to either provide filtration or meet the EPA’s drinking water standards in some other way. In essence, the EPA walked in one day and said to New York City, "Your water is below EPA standards. You're going to have to build a filtration system to get your water back to EPA standards."

So, New York City investigated the cost of filtration and discovered it would cost between $6-$10 billion. They were pretty tight on money at the time, as New York normally is, so they looked for alternatives.

One of the alternatives was to restore and preserve the watersheds from which New York City gets its water; to negotiate with farmers to use different farming practices; to buy out some homeowners and the landowners building developments impacting the hydrology of the area; and to take out various roads, because asphalt has tannin in it, and when it rains the tannins get into the watershed.

To make a long story short, they did this $2 billion remediation project and voila, their water went back to being pristine again and at or below EPA standards. That's an example of how a large-scale project has a meaningful impact to hydrology, water quality and habitat -- a lot of ecological uplift, while saving NYC billions of dollars.

When I looked at it, I went, "Wow. That just makes a ton of sense." There's no regulator that takes their pen and can strike out a subsidy. As an investor, I've seen that happen before. It wasn't necessarily a subsidy, but a regulator in Europe decided to change the tax rules of infrastructure investment almost killing the investment.

For that matter, let's go back to something that was most certainly a subsidy: solar in Spain. They changed the subsidy structure of Spain. Wiped out the industry overnight. I don't know. It might have recovered since then, but they used to be the example for the rest of the world to follow. And then one stroke of a regulator's pen, and voila, it was gone. As an investor, I don’t like that kind of uncertainty.

That's the nice thing about mitigation banking: there's no such regulator's pen to use because the '72 and '73 Clean Water and Endangered Species Act are so deeply ingrained in the statutory and regulatory environment of the United States. They're not going to be overturned anytime.
 

Trusted Insight: Where does someone like you come into that?

Mark Canavan: The New York example, that was an example of when I was underwriting the mitigation banking space in general, scouring the landscape for examples that this is a viable alternative to other economic activity.

How that all plays into how we wound up investing is because of my interest, we went and underwrote a couple mitigation banks in Florida. At the end of the day we didn't go forward with that investment.

But during that whole process, I realized I wanted to meet people who could manage a fund of mitigation banks to do this for us. There were very few people, as you can imagine, who did it, but then I met a guy who started a firm called Capital Resources Partners. His name is Fred Danforth.

Fred had his own investment bank he created, a merchant bank. He wanted to do an early retirement, so he sells his company. He was a fly fisherman and a conservationist. People that he knew from the conservation industry approached him about buying out a ranch in Montana that they needed to buy and restore to be able to restore the Blackfoot River.

I don't know if you have ever heard of the book or the movie, The River Runs Through It. All the fishing in the book and movie was supposed to take place in the Blackfoot River. Well, by the time they made the movie, there were no fish in the Blackfoot River, because it had been so degraded by mining impacts and by ranching impacts of cattle.

So, Fred was approached by some of his friends. "Please buy this ranch. We need it to finish this restoration of the Blackfoot River." Fred buys the place and starts restoring it on his own dime.

He winds up getting up to his eyeballs, in deep with his own money, when he realizes he can generate revenue from this project in the form of these mitigation banking credits, and he can use that to offset some of his expense.

At the end of the day, he wound up being pivotal in the largest river restoration in the United States. Here's a guy who has an investment banking background, a business background. He'd already raised private equity funds before. He was pivotal in this one restoration.

Based on that one restoration, he then turned around and created three mitigation banks and financed the team himself to do a proof of concept, off of which he could then launch an investment fund. That's about the time I met him. It was perfect timing.

I had looked at other groups. There weren't many. I think there was four, and most of them had only some little part of restoration. It would be a timber fund that did some restoration, or it would be a land fund that would do some restoration here and there. Well, two of the groups don't exist anymore. One of them I wouldn't invest with because it was a conflicted platform. Then there was another group that was charging insane fees, because they were using an environmental pitch to raise money off unsuspecting investors who didn't understand they were paying too much.




…if I’m looking at growing my portfolio, that's where I'd prefer looking -- payment for ecosystem services markets. They are deeply ingrained in the American psyche. They're not going to go away. There's impetus to go down that road.

Anyway, that's how we got involved in mitigation banking. My boss encourages innovation and allows us to do things other people haven’t done. But, doing mitigation banking was a pretty long evolution for me. I don't just jump into something new like that. From inception of the concept to doing the deal I think was two years.
 

Trusted Insight: What kind of returns does an investment like this produce?

Mark Canavan: I really like mitigation banking, returns are really high. If you look at cash flows off this investment and net asset value on this investment, we're getting just a little bit over 16% IRR net with no leverage. Where are you going to find that return unlevered other than maybe in distressed debt?

Now, over time, don't get me wrong, as that fund matures that high return on the front end will be 13%-ish, somewhere in there, net of all fees. Still, that's unleveraged, so that's great. That's a really big gross margin.

In mitigation banking, there's a broader term for these types of investments called payment for ecosystem services. Those markets provide good returns. All the lemmings haven't gone off the cliff yet so the returns haven't compressed. I'm focusing there.

I'm not putting all my effort there, but if I’m looking at growing my portfolio, that's where I'd prefer looking -- payment for ecosystem services markets. They are deeply ingrained in the American psyche. They're not going to go away. There's impetus to go down that road.

 

Trusted Insight: How big is the market and how quickly will it become saturated?

Mark Canavan: That's a great question. It's pretty big. I don't have the exact numbers, but it's in the multi-billions of dollars annually. That's enough to keep us happy for the time being, but also that's multi-billions of dollars just within the current mitigation banking regulatory regime.

In addition, the whole concept is being broadened to cover more things. There's lots of stuff to be mitigated at a reasonable rate of return for the foreseeable future. Literally, NMERB was the first pension plan in the United States investing in mitigation banking before others piggybacked on our due diligence. Then a premier university endowment  came in, followed by two exceptionally large family offices and other high net worth investors. Then, eventually, two large European pensions invested.

Then on the second fund raise, another marque university endowment came in, a couple more European pensions, and all the founding investors increased the size of their commitments. So state pension plans haven't even shown up to the show yet, except for NMERB. The momentum hasn't really built yet.

KKR just bought one of the environmental engineering services firms that does mitigation banking. I'm guessing that KKR is stepping into the space pretty soon with a KKR branded fund. That's just my guess.

After that point, in say five, six years maybe, returns will trade in. It will still be a viable market, but returns will not be 13 or 14 percent unlevered, net of all fees.

This will give you an idea about the scale of it.

Pay for Success is another structure for mitigation banking. Basically, a federal, state, or local government lacking the resources to execute a project puts the project out to bid. The investor/contractor must hit given outcomes stated for the project, and when those outcomes are met they receive their capital back with a stated rate of return. If they outperform the expected results, the investor/developer earns additional returns on their investment. It’s more or less a form of public-private partnership. Basically, a government entity says, "Okay, we don’t have the resources to fund this project on our own, and the private sector may very well be able to do this restoration in a more timely and cost effective way than we can, so let’s put this out to bid.”

The deals we are doing in the mitigation funds range from $7 to $30 million, with the majority being in the teens. Our first fund is running at a 16 IRR net unlevered. But that kind of return, that's for the first movers. It will get diluted over time.

These Pay for Success deals can be $250 million at a pop. These more moderate, lower yielding, fixed income type investments, the Pay for Success, that's a pretty huge market. I don't know how long it will take to dilute that, because there’s virtually nobody there yet.

Then there's other markets where other environmental values are being considered as worthy of generating credits that you can sell to other people. And these credits, by the way, are posted once to fulfill your regulatory requirements, they are not trading schemes like carbon credits.

For example, air quality, there are certain habitats that the Army Corps of Engineers, the Bureau of Reclamation and the Environmental Protection Agency want restored or preserved, and they're willing to issue mitigation banking type instruments to accomplish their goals. There's all kinds of ways of slicing and dicing the mitigation banking pie. Currently, it’s all based on rivers, marshes, watersheds and lakes. But, you can extend the concept out from there.
 

Please check back for Part II and Part III of Mark Canavan's exclusive interview with Trusted Insight.

To learn more about Real Estate & Real Assets investing, click here to view the complete list of Top 30 LPs Investing In Real Estate & Real Assets.