ESG in Private Markets

Posted by | Nilesh Sharma

From ‘good to have’ to ‘value creation’

In recent years, the global financial landscape has shifted toward ESG (Environmental, Social, and Governance) investments, with private markets following suit. This trend has driven growth in sustainable investments, particularly in private equity. ESG principles now play a central role in value creation, impacting investment strategies, deal sourcing, and due diligence. The direct ownership advantage in private markets has made ESG integration more seamless. Collaborative efforts are accelerating the adoption of responsible investing, but challenges remain, particularly for smaller firms, related to ESG data, talent, regulation, and value creation.

In this article we explore the impact of ESG on investment strategies, deal sourcing, due diligence, and the challenges faced by both larger and smaller firms in embracing responsible investing.

The Rise of ethical investing in Public and Private Markets

One of the emerging trends in the global financial markets – in both public and private investment – in the last decade has been the increasing demand for, and mainstreaming of, ethical and sustainable investment. Much of this demand has been driven by large asset allocators including pension funds, who historically (and rightly so), have focused their responsible and sustainable investment activities on public equity and fixed income asset classes. Public investment is highly scrutinized and requires tighter regulation, so the successful integration of ESG principles of responsible and sustainable investing into investment firms’ public portfolios has enabled them to extend these into their private investment portfolios.

Private Equity’s evolution: From nascent to dominant in sustainable investments

Consequently, the private investment market has witnessed significant growth in sustainable investments. The private equity industry in particular has come a long way since the majority of the industry’s efforts in this area were branded “nascent and superficial” by the Institutional Investor magazine in 2020. Since then, and arguably earlier, sustainable investing has built significant scale across Asia, Europe and North America. Indeed, this structural reboot in investing has resulted in European funds with explicit ESG investment mandates now accounting for a large portion of the industry’s assets, and could potentially cross EUR1 trillion in asset under management (AUM) by 2025, according to top tier consulting firm PwC.

ESG funds surge: A $7 trillion market and growing

According to , assets managed by the 14,500 ESG funds in 2023 were nearly US$7 trillion. This is likely to grow further as both performance and regulation promote sustainable investments in the public and private markets. Global consulting firm McKinsey & Co., in its Global Private Markets Review 2023 report highlighted that the past year was arguably the best for ESG-focused funds, with US$200 billion in sustainability-related deals in the first half of 2022.

ESG integration: A game-changer in Private Market Investment strategies

The slow and gradual realization that sustainability and ESG principles can be used to both create and unlock value has made it increasingly clear to private market money managers that they need to include them at the core of their investment, risk management and value creation activities. As investment teams come to recognize ESG as one of the pillars for value creation, the way deals are sourced and the due diligence activities involved in making investment decisions have also altered, creating a multiplier effect as teams scout for investment opportunities that meet ESG standards across sectors and geographies to build deal pipelines.

Overcoming challenges: ESG integration in the Private Equity landscape

Private market players have found it relatively easy to integrate ESG into their decision-making due to the advantage of direct ownership compared to traditional asset classes. Growing collaboration and a healthy degree of competition within the industry has also helped increase the pace of ESG integration. Despite being such a competitive industry, initiatives such as the Initiative Climat International (iCI), a global, practitioner-led community of private equity firms and investors that seek to better understand and manage the risks associated with climate change, and supported by the UN Principles of Responsible Investments (PRI) and the ESG Data Convergence Project, are examples of growing collaboration within the industry to put this into the mainstream.

However, challenges persist for a widespread integration of these practices, particularly with smaller firms. Indicatively, these include:

  • Appropriate ESG data and reporting
  • ESG skilled talent and resources
  • Regulatory compliance and clarity
  • Tangible value creation for stakeholders

The global financial landscape has undergone a profound transformation in recent years, with a prominent shift towards ESG investments. This shift has not only influenced the strategies and practices of investment firms but also fueled a substantial growth in sustainable investments, especially within the private equity sector. ESG principles now play a central role in value creation, influencing every aspect of investment, from deal sourcing to due diligence. The unique advantages of direct ownership in private markets have also made ESG integration a more seamless process, whilst collaborative initiatives, exemplified by the likes of the Initiative Climat International and the ESG Data Convergence Project, have played a pivotal role in accelerating the adoption of responsible investing within the industry.

However, despite the progress made, challenges persist, particularly for smaller firms. These challenges encompass various facets, including the need for appropriate ESG data and reporting, the acquisition of ESG-skilled talent and resources, regulatory compliance and clarity, and the concrete creation of value for stakeholders. As the global investment landscape continues to evolve, one thing remains clear: ESG principles will remain at the forefront, guiding the industry towards a more sustainable and responsible future.

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