How Private Market Funds are Integrating ESG in Investments

It’s a common misconception that private market investors do not care about environmental, social and governance (ESG) factors because they do not have to answer to public opinion. While it’s true that they face different pressures than public market investors, private funds have also been rapidly integrating ESG into investments in recent years. According to data provider Preqin, private market ESG funds raised USD92 billion in 2022, more than three times the USD29 billion raised by these strategies in 2020.

This trend is driven by rising investor awareness of ESG generally, pressure from institutional clients, tightening regulations, and the expectation that assets with better ESG performance will likely be more resilient and provide better long-term returns.

Here we will explore these drivers in more detail and outline the challenges and opportunities arising from this trend for private market managers.

ESG-focused investing first took hold in public equity markets, where the buying of listed stocks is scrutinised and regulated more heavily than private market investment. But private market assets under management have soared in recent years, roughly doubling to USD11.7 trillion in the past five years alone (see Figure 1). This has brought the focus on responsible investing across from the public markets. Accordingly, institutional investors like pension plans, sovereign wealth funds and insurers increasingly expect – or indeed require – private market firms to incorporate ESG factors into their investing practices.

Most European limited partners (LPs) and general partners (GPs) – respectively, the entities that invest in and manage private funds – feel ESG-related regulation, such as climate disclosure rules and the EU’s green taxonomy, will have a positive impact, found a PwC survey published in May 2023. 

Nearly nine in 10 (87.5%) LPs surveyed plan to increase their private market ESG investments over the coming two years, and 86.5% of asset managers say they will expand their ESG private market offering over the same period, PwC found.

There are also other commercial drivers for private market firms, such as that portfolio companies can get potentially cheaper loans if they hit certain ESG targets, most notably around carbon intensity.

Private market managers are acknowledging that new sustainability reporting regulations – despite largely targeting listed companies and their investors – will have an effect on their business. This is true even for venture capital firms, which have typically  faced less scrutiny than investors in public markets.

Ultimately, private market investors are also recognizing that strong performance on ESG measures in investee companies tends to indicate lower risks and potentially better returns in the long term – in other words, that ESG risk is material in both public and private markets.

For example, a recent study of private shareholder engagement with listed companies found that engagement on material ESG issues is more likely to succeed and corresponds with outperformance in target companies.

Reflecting the direction of travel, in December 2021 US private equity giant KKR launched its Sustainability Expert Advisory Council, a six-member independent panel to provide external insights on sustainability topics and advice on ESG strategy and initiatives.

Asset managers are increasingly applying sustainability criteria to investments in private markets – yet that is easier said than done, for a number of reasons.

For one thing, private companies do not face the same disclosure requirements as their public counterparts, so data is harder to come by (see Figure 2). To manage their private assets, investment managers use proprietary metrics and methods, third-party frameworks (such as the ESG assessment tool provided by Environmental Resources Management, a unit of the UN Global Compact) or a combination of both.

This is an even more acute issue for venture capital (VC) investors, given that start-up businesses are likely to have limited resources to dedicate to an ESG agenda or provide relevant disclosures. Adding to the challenge, methodologies and standards for navigating ESG in VC are at a nascent stage.

Difficult though this data may be to obtain, however, the reality is that if you don’t ask, you don’t get. That is clear from the experience of property investors.

Dutch pension fund manager APG Asset Management reported going direct to property users to request energy usage data for buildings in its portfolio. And industry initiatives like GRESB (formerly the Global Real Estate Sustainability Benchmark) and the Carbon Risk Real Estate Monitor (CRREM) are making more such information available. GRESB now receives data from 2,084 real estate entities representing gross asset value of over USD7 trillion.

Private market managers are seen as very well placed to integrate ESG into their investment strategies and drive positive impact.

Private asset funds, for example, generally have deep involvement in – and so wield strong influence over – the businesses or other assets they invest in. They are far more likely to be able to encourage companies to put good ESG practices in place than a minority shareholder in a listed firm. PE-owned companies also operate on a longer time horizon than their publicly traded counterparts do, further supporting a focus on ESG.

Integrating ESG considerations at an early stage of business growth may also help drive more value in the long-term. VC investors are therefore in a position to build sustainability into corporate culture from the get-go, with the goal of improving their ability to make a successful exit from their investment.

Private equity and VC funds are catching up with ESG practices in the public investment industry. As private markets investing continues to grow, the sector’s approach to ESG can be expected to come under closer scrutiny. But these changes are also driven by a growing belief that sustainability improves the risk-reward equation. As the world steps up its focus on key sustainability issues, investment professionals are finding it harder to ignore the implications of ESG factors on long-term performance.

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