More and more, ESG considerations are recognised as critical in valuing assets. Recent growth in investment volumes reflects this trend. While fund raising in private markets broadly lost momentum in the second half of 2022 as macroeconomic conditions changed, 2022 was the most successful year yet for private markets ESG investing.
ESG assets under management (AUM) in the segment have grown by 35% per year over the last decade, taking volumes to above US 100 billion for the first time in 2022 underscoring strong interest from private market investors. In parallel, asset managers have increasingly committed to integrating ESG as can be seen from the number of new PRI signatories in 2022.
A growing trend with great disparities
Despite these positive trends, data provider Preqin finds that only 42% of the AUM across private capital is managed by funds that have an active ESG policy. In our view, this indicates that there is still plenty of scope for improvement.
The data shows a vast variety across the different private asset classes: 32% for private equity and venture capital and 64% for infrastructure. Within each of these, the granularity ranges from light-touch ESG strategies to sophisticated approaches.
In part, this reflects a dichotomy within private assets: in some areas, access to ESG data is extremely limited. Elsewhere, strategies with a tangible impact can be found.
Multifaceted asset classes such as private assets require flexibility and expertise to integrate ESG considerations given the wide array of realities they cover. The ESG integration levers at an investor’s disposal depend on the specificities of each asset class and can be examined from various angles:
Controlling versus non-controlling stakes
A majority stake in a private company can give investors privileged access to management, the possibility to access specific data and put in place post-investment action plans. In addition, private equity funds can implement interest alignment mechanisms such as carried interest linked to extra-financial considerations. However, this does not apply to all private assets. Many cases involve minority stakes or debt which does not come with the same benefits. This does not mean that nothing can be done ESG-wise. For instance, when Investing in debt which is held for an extended period, careful due diligence is necessary to identify extra-financial risks and opportunities. Potential post-investment risks can be mitigated by including ESG considerations in the deal documentation in the form of sustainability-linked ratchets, access to ESG indicators and so on.
Direct versus indirect investments
Indirect investments can take various forms such as funds, funds of funds or collateralised loan obligations. To ensure that ESG considerations are properly integrated, it is, for example, possible to assess the policies, methods and expertise of the fund managers selected, as well as their capacity to monitor and engage with portfolio companies and report on them. Extra-financial aspects can be integrated in side-letters requiring managers to exclude certain activities, respect certain norms or provide access to specific indicators or even a dedicated follow-up.
Investing in private assets often means holding assets for longer than listed assets. This demands more rigorous selection criteria, but also creates the opportunity to engage with investees and support them over time. This can also be true for indirect investments where long-term engagement can help improve company practices.
Access to data
Accessing data is a thorny issue for private markets, particularly compared to listed markets where data is plentiful and made available by numerous providers. Private markets data is harder to come by, often confidential and sometimes even non-existent.
There is no common basic ESG data set. At regional level, however, regulatory frameworks can be expected to help in the longer term as is the case in the European Union with the Corporate Sustainability Reporting Directive. This is an ambitious reporting framework under which listed and unlisted companies exceeding certain thresholds have to report extra-financial information.
In many cases, the only way to access data is through ESG questionnaires. They can encourage companies to report along specific lines negotiated in covenants. However, as of now, it is fair to say that not all companies can or are willing to report such data. Alternative approaches may be needed:
- Using estimates based on company/project activities and industry benchmarks. Although they will not replace reported data, they can help investors navigate limited visibility.
- Innovative solutions can provide access to data. For instance, we have invested in a start-up that uses artificial intelligence to analyse satellite imagery. This allows investors to quantify, for example, emissions by companies or the biomass and carbon sequestration of natural assets. Another example is our investment in a solution which uses AI to flag past controversies by trawling the web and social media for information.
Potential for impact
Private asset investments can be used to directly affect the real economy and contribute to solving pressing challenges such as climate change . We believe private equity and private debt, real assets or natural capital can be promising candidates for impact strategies.
Private equity investments can occur at various stages of a company’s development: from early-stage venture capital to big buyouts. Through private equity, an investor can help shape practices as the company scales up including its mission, products and operations, governance or the composition of management.
Although companies are increasingly taking a more rigorous approach towards better practices, the expectations of regulators, civil society and end-consumers are evolving. Investors should participate. This is why we have developed a strong expertise to handle this mosaic of asset classes. As the sustainable investor for a changing world, we are tracking its evolution closely.
Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
Environmental, social and governance (ESG) investment risk: The lack of common or harmonised definitions and labels integrating ESG and sustainability criteria at EU level may result in different approaches by managers when setting ESG objectives. This also means that it may be difficult to compare strategies integrating ESG and sustainability criteria to the extent that the selection and weightings applied to select investments may be based on metrics that may share the same name but have different underlying meanings. In evaluating a security based on the ESG and sustainability criteria, the Investment Manager may also use data sources provided by external ESG research providers. Given the evolving nature of ESG, these data sources may for the time being be incomplete, inaccurate or unavailable. Applying responsible business conduct standards in the investment process may lead to the exclusion of securities of certain issuers. Consequently, (the Sub-Fund’s) performance may at times be better or worse than the performance of relatable funds that do not apply such standards.