Can private markets move the dial?

Private markets’ concentrated and active forms of ownership make them particularly well suited to impact strategies. It is therefore unsurprising that institutional investors that set aside at least some capital to achieve impact objectives deploy large proportions of this into private markets. Of the $1.6trn of impact assets under management reported by the Global Impact Investing Network (GIIN), private equity accounts for 43%, real assets for 16% and private debt for 14%. Impact investing is also on the rise – GIIN estimates that impact investing assets under management increased at a compound annual growth rate of 21% between 2019 and 2024, with climate and energy transition-related investments among the biggest contributors to this growth.

So how is thinking around impact strategies developing? And how are private markets capturing the opportunity?

The only way to move the trillions of dollars needed towards climate is to demonstrate market returns.

Yalin Karadogan, Partner at LeapFrog Investments

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Funds must demonstrate market returns for impact strategies to grow further

Impact investing may have its roots in concessionary and philanthropy capital, but expectations have changed as the market has expanded and as institutional investors have entered the fray. “The real prize is market returns,” says Yalin Karadogan, Partner at LeapFrog Investments. “There is a need in some areas that are more difficult or niche for concessionary capital, but the only way to move the trillions of dollars needed towards climate is to demonstrate market returns.”

“Capital allocation can have a huge impact, and it will always be driven by a profit motive,” says Vishesh Srivastava, Co-Managing Partner of Future Business Partnership. “But if you prove that you can make money by doing good, then everybody follows. And that’s when we have a real impact as an industry.”

Yet while there is plenty of belief that impact strategies can generate returns at least in line with broader private markets, they are not yet proven. “There is no data yet because there haven’t been impact funds with dedicated teams for the past 10 to 20 years,” says Jan Ståhlberg, Founder & Managing Partner at Trill Impact. “So investors today have to take a leap of faith - there is no endorsement from the advisors because they don’t yet have conclusive evidence that it works.”

And there are some concerns that too much capital has concentrated in a few areas, which could create future headaches. “I see a lot of AUM being raised on very narrow impact criteria, often by firms without impact specialists,” says Srivastava. “In Europe, there is an enormous amount of capital chasing assets with a unit-for-unit correlation with carbon savings and so people are overpaying for them – that’s the easiest way to lose money. It will be heartbreaking if, in five years’ time, there is a generation of impact funds that have lost money because of this. They won’t admit to overpaying or making poor investment choices and so investors could well just draw the conclusion that sustainable investing is bad.”

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New business models are emerging…

Fortunately, much has changed since the cleantech 1.0 boom in the 2000s, when many investors did lose money. Back then, many investments were predicated on subsidies and there was a lack of infrastructure to support the growth of these businesses. Chuck Templeton, Managing Partner of S2G Investments, likens the situation to what happened with the internet. “There used to be a need to invest heavily in engineers, servers and other hardware infrastructure to make this work,” he says. “Then along came Amazon Web Services and the cloud and it became much cheaper to set up an internet-related business. Solar didn’t used to be bankable, but now the infrastructure is there in a lot of instances. Similarly in food and agriculture, a few years ago, it wasn’t clear that you could make the casein needed to produce the melting and stretching qualities in cheese without a cow. Or that you could grow meat. Now it can be done and what you’re seeing is service companies develop to work with industries to develop these products – an entrepreneur doesn’t have to raise $80m to build a factory, they can just work with one of these companies to reverse engineer their products using existing equipment.”

Solar didn’t used to be bankable, but now the infrastructure is there.

Chuck Templeton, S2G Investments

3 …and these are helping to create a green discount

As new impact-related products and services develop and become commercially viable, investors need to find new business models and ways of making them more affordable, according to Karadogan. “If you want to scale up impact, you have to focus on achieving a green discount,” he says. “Today, many products with more sustainable credentials charge a green premium. The wealthy may be able to pay that, but you can’t just expect less wealthy consumers to pay more for the products and services they need. We have to reach a point where consumers are choosing products or services not because they care about climate, but because they are better and cheaper.”

He adds: “The just transition is very important – it’s not fair to say that, as consumers in emerging markets move from poverty to middle class, they can’t buy air conditioning. There has to be a green leap towards climate-friendly products that are also cheaper.” He points to a portfolio company in India, Battery Smart, which is a battery-swapping business for two and three-wheeled vehicles. “The company saves consumers money because they don’t have to buy the battery,” explains Karadogan. “It removes the charging time and charging anxiety and it allows the riders to spend more time earning money through deliveries and so on. Meanwhile, it’s improving the air quality in cities like Delhi. It’s win-win-win.”

4 Climate-related strategies will need to broaden and scale up

While much of the energy transition and climate tech capital has traditionally focused on infrastructure and venture capital, respectively, there remain gaps in other company phases and sectors, such as growth equity, buyout and businesses across sectors seeking to decarbonise using brown to green-type strategies. “Venture capital remains prominent and will always be there, but there is a need for scale-up financing to later stages requiring larger investment tickets,” says Thierry Wolff, Head of Unit at the European Investment Fund (EIF). “Currently, the average supported fund size in the EIF portfolio is around €150m. To fund more mature companies and to bring currently generalist businesses to a more sustainable footing, you need two or three times that amount. If we want to meet the Paris Agreement targets, we need to invest in these businesses and transform them to be more climate-aligned.”

Yet fund sizes that are too large can also be an impediment to attracting LP capital, as Richard Benson-Armer, Global Head of Advisory at CREO Syndicate, explains. “Family offices are often seeking to make catalytic investments and they want to see other investors follow them,” he says. “But the fund size can be a barrier for many institutional investors. There is a need for mid-sized funds of $300m to $600m to target the growth space.”

“Fund sizing is a big part of our due diligence,” adds Richard Moon, Head of Private Markets at Railpen. “How quickly capital can be deployed and how much you reserve in a fund structure is an important consideration for LPs. We want to understand how much flexibility the GP has for maximising existing portfolio assets’ value versus investing in new opportunities. The other point is that there can be an issue with track record and expertise in climate-related investments. What we try to do is look at whether there are transferrable skills and knowledge from other industries into climate – conventional energy experience, for example, gives knowledge of the energy system that is highly relevant in clean energy.”

These transferrable skills and experience in more generalist situations may hold the key to future climate action fund formation. “We don’t see climate as a sector per se,” says a European LP. “We recently shifted away from looking at this through a private markets stage lens to examining opportunities according to themes such as tech, life sciences, and so on. Our questionnaires therefore changed and what we’ve found is that there are a lot of generalist funds that are already supporting the transition of their portfolio companies, but they haven’t been communicating it. We’ve found that there is often already a track record of generating results.”