Professional Pensions: Private companies prove attractive to ESG investors

Private equity asset managers committed to ESG investing now manage c$3.1trn, or 36% of the value of total global private market assets, according to a Preqin report published in October 2021.

This is a result of more and more institutional investors, particularly pension funds, focussing their private market allocation to more ESG-oriented investments than they have in the past.

There are some large institutional investors who over the last two years have shifted their entire private markets investment approach into a sustainable strategy, resulting in a greater need for ESG-focussed private markets managers and investment themes.

This typically encompasses investing in private companies along a spectrum from integrating ESG for risk mitigation and performance enhancement through to fully fledged impact investment with specific goals of having a measurable environmental or social impact.

This is particularly fruitful when investing in small- and medium-sized companies who are at the forefront of innovation in the ESG sector and have been some of strongest performing private investments in the last couple of years. Institutional investors have developed significantly more support and credibility with their ESG investments as growing valuations are becoming increasingly compelling compared with less ESG focused investments.

A major attraction of private companies is the high level of access to the individual management teams and the increased governance, influence and control private investors can achieve. This will allow end investors, in conjunction with their private equity partners, to make sure they are partnering with the right company, management team, stakeholder and shareholder base from the very beginning to ensure alignment around the ESG themes that they care about. It is critical to be certain from the outset that there's consistency, because it is much harder to revamp the strategy and approach of a business after an investment has been made.

The private equity manager will also have a presence on the board which they can use to remind the leadership of the company of the core ESG principles in their investment approach and ensure these principles are visible to institutional investors in the company's reporting. Sometimes there are situations where there is an economic decision about leaning into some of those principles, but it's worth remembering that value creation can be achieved by thinking more sustainably and efficiently in conjunction with a clear sight of the bottom line.

Overall, sustainability will be the biggest investment theme over the next decade. According to a report published by McKinsey in January 2022, capital spending on physical assets for energy and land-use systems to reach net zero between 2021 and 2050 will reach $275trn, or $9.2trn per year on average, an annual increase of as much as $3.5trn from today.

So it's not surprising that environmental investments have been in greatest demand because of the ready availability of hard metrics to measure, track and justify the investment, especially with regard to CO₂ emissions reductions. But we still see a lot of interest in the social side, although this component tends to be more attractive to investors with a requirement for investing in specific geographies which are most relevant to them.

Some investors may also have a goal to find private equity managers who offer a compelling diversity perspective but are hindered by a low capital base. They may be willing to take on more relative risk in order to seek out those managers and support their growth.

With ESG investing in private companies still in its infancy, there is rightly a need for the impact of these companies to be benchmarked. The United Nations' sustainable development goals (SDGs) go a long way in achieving this objective, but ultimately fall short in terms of tracking impact and measurement. It is important to have a regulatory body to set standards, because it helps to create a uniform lexicon around tracking, metrics measurement and categorisation of peer groups. We think it is also important for every investment strategy to either work within an industry wide measurement platform or build out those metrics and reporting systems in house that are most relevant to their specific strategy and set of goals.

As improved and standardised data reporting comes to market, the increased allocation of pension fund investments into private companies with a strong ESG track records looks set to continue.