How ESG and impact investing are affecting LP and fund manager strategies
“ESG has now become central to private markets – 2020 and 2021 are the years that the dam broke. Every LP and GP is talking about this and people are expecting more.” So says Reji Vettaseri, Lead Portfolio Manager of Private Markets at DECALIA Asset Management. It’s certainly clear that ESG and impact investing have risen in importance for investors, but where are private markets on the path towards sustainability?
Many non-impact funds started incorporating ESG into their investment decisions and processes a few years back, but more recently, and in particular since the pandemic, these efforts have intensified. “A couple of years ago, many private markets firms were offering a vision,” says Vettaseri. “They were stating principles and you could say there was some greenwashing going on. Yet now I think we’re in the second stage of development, where firms are using ESG as a real screening tool. They won’t invest in companies where they can’t trust management to implement policies that are responsible across multiple dimensions.”
In private debt, for example, the past year has seen some firms offer sustainability-linked loans that provide more favourable economics to borrowers that hit pre-defined ESG targets. “What’s really exciting is that we’re seeing non-impact investors start to define deals with a reference to ESG,” says Vettaseri. “They are putting in ESG covenants and ratchets where if you were invested in, say, a waste management business, there would be financial benefits for the company to meet clean-up targets.”
Many LPs believe we are at an inflexion point for sustainable investing. “Half of our clients now have sustainable and impact investments in their portfolios,” says Annachiara Marcandalli, European Head of Sustainable and Impact Investing at Cambridge Associates. “And they are mostly very satisfied – cleantech companies, for example, have outperformed the whole universe of venture capital and private equity over the past three years.”
This trend is evident in the growth of impact funds. Pre-pandemic, the number of these funds was rising steadily, in particular as blue chip names such as TPG, Bain Capital and KKR built impact strategies. Yet the post-pandemic period has seen a wave of new impact funds launched by both newer and existing managers – indeed, the market has deepened enough for impact funds of funds to become a viable proposition. Golding Capital Partners recently launched a €300m impact fund of funds, while earlier this year, Neuberger Berman reached a final US$280m close on a vehicle targeting direct and fund investments in the private equity impact space.
Even so, there remain a lot of concerns around the potential for greenwashing by fund managers. The most recent survey of impact investors by The Global Impact Investing Network in 2020 found that the biggest challenge for the market over the next five years was impact-washing, cited by 66% of respondents. “There is plenty of greenwashing going on in the market,” says a Senior Portfolio Manager at a UK pension fund. “And even where there are impactful initiatives taking place at portfolio companies that make good business sense and are good for the planet, the reporting is not well set out, so it’s difficult for us as an LP to judge.”
“Managers need to be able to demonstrate how they are managing ESG factors,” says Imogen Richards, Partner at Pantheon Ventures. “But there is still a difference between those who really walk the walk and those for whom this is still just a box-ticking exercise.”
Part of the issue is the difficulty many have of getting their arms around ESG and impact performance. Despite the various initiatives to create guidelines, principles and frameworks, a lack of standardisation in reporting causes headaches. There are also distinct regional differences. “ESG means different things in different markets,” says Richard Hope, Head of EMEA at Hamilton Lane. “In North America, DE&I are more important, while in Europe, there is a greater emphasis on climate. The issues are getting data in the first place and then reporting in a way that suits everyone. Over the past 18 months, the world has started caring more about ESG – it has accelerated in a way none of us could have anticipated. That’s a good thing, but how do you harmonise different approaches in different parts of the world?”
Over the past 18 months, the world has started caring more about ESG – it has accelerated in a way none of us could have anticipated
Even where there regulations are in place in an attempt to stamp out greenwashing and false claims, issues can arise. In Europe, for example, the Sustainable Finance Disclosure Regulation imposes mandatory ESG disclosure obligations for asset managers. It seeks to classify funds and their investments according to their level of sustainability - Article 6 funds, for instance, do not integrate any kind of sustainability, while Article 8 funds promote the management of environmental and social factors. Article 9 funds, meanwhile, promote sustainable investments as an objective. “We are already hearing of some GPs saying that they are not going to try and conform with Article 8 or 9 even though they are pursuing sustainable strategies,” says Hope. “That’s because the data just isn’t available to comply.”
“It’s a wild west of reporting,” adds Christopher Bone, Head of Private Debt, Europe, at Partners Group, which invests directly in companies. “Each of our portfolio companies reports in a different way and we need to try and homogenise that, but each of our LPs has a different format for reporting, so it’s very time-consuming to aggregate and distribute information. The SFDR is adding complexity to this.”
Yet there are many who believe that the variety of reporting methods – and therefore the potential for greenwashing – will settle over the coming years. “Standardisation and getting towards the same definitions of what we’re measuring will be a big first step,” says Carmela Mondino, Head of ESG and Sustainability in direct investments at Partners Group. “But actually, what we need to do is treat ESG data like financial data. If investors are going to make decisions based on ESG KPIs, they need to start getting assurance on these numbers. If you put ESG in your documentation, you need processes that you can audit. Until now, everyone has had a clear pass, but we are starting to see some pressure to demonstrate you have done what you said you were going to do.”
And that pressure is coming not just from regulators, but increasingly from LPs, many of whom have targets set for their own institutions. The Net Zero Asset Managers Initiative, which commits investors to supporting net zero greenhouse gas emissions by 2050 or sooner, is one expression of this – it already has 128 signatories and represents US$43trn of assets under management despite only being launched in December 2020.
“LPs have the power to influence the way managers approach investments and companies do business,” says Mondino. “If we or our fund managers own the majority of a business, we can transform it both by using ESG as a proper risk management tool or by taking advantage of the move towards sustainability.”
Indeed, many believe that private markets have a unique role to play in transitioning economies to operate on a more sustainable footing. “ESG can be a real differentiator for private markets,” says Vettasseri. “You can invest in ESG strategies in public markets, but the ownership is so dispersed, it’s much harder to have any impact. If private markets can move to a model where ESG is not just a risk management tool, but a catalyst for creating genuine impact, it will attract even more of the growing amount of institutional capital that cares about sustainability.”
If GPs can step up to the plate, the next few years could be a very interesting time indeed for private markets.
If private markets can move to a model where ESG is not just a risk management tool, but a catalyst for creating genuine impact, it will attract even more of the growing amount of institutional capital that cares about sustainability
