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Where ESG meets private equity
As private markets are gaining more investor appeal, CGWM’s Patrick Thomas looks at
the pros and cons versus public markets
Fomo, the fear of missing out, is probably the fund investor’s worst enemy. If there is a bandwagon, investors will jump on it – frontier markets, cryptocurrency, Chinese consumer tech, the metaverse, AI – even ESG – there is always a new trend in markets that investors feel they are missing out on.
Today perhaps, we can add ‘private markets’ to that list. Investors can see the amount of money that was being made pre-IPO when they look at the ‘magnificent seven’ and other tech giants, and they now want in on the action. Even though this strategy went a bit awry when inflation ticked up, interest rates along with it and the cost-of-living crisis hit us all – the cost of borrowing soared, which hit private companies hard. This pushed a few companies to go public, but a lot of IPOs didn’t work out and companies fell below their IPO price.
As inflation drops and interest rates too, private markets are beginning to look more attractive again. But one problem is that not a lot of companies want to go public these days. They are happy to stay in private markets for longer – take Space X – Elon Musk is in no rush to float the company. For investors this is a conundrum – the options to access these companies is limited and can only be done through specialist funds or investment trusts, which have access to private assets, or to participate through illiquid specialist private asset structures.
Making an impact
For investors, the question is, how do you play ESG in private markets? It’s not straightforward. Can you make the biggest ESG impact through public or
private investing?
A lot of ESG investors want to make an impact – they want their money to positively impact climate change or society, so they want to give money to the companies that are making a difference. And you can do that directly when the company is privately owned – buy the sustainability equivalent of Space X and the company gets the money, so you’ve made a difference to a problem you care about.
As soon as they are listed, you are buying shares from another investor – you aren’t giving money to the company directly. You aren’t really ‘changing the world’ through your investments – you are just aligning your portfolio to your values. Of course, companies can and often do raise capital on public markets and investors can choose to participate in this capital raises to fund new projects etc.
Investors can also engage and vote with their feet when investing in public companies. You can attend AGMs and speak directly with the board. For example, Canaccord often engages with the direct equities it owns for clients and through third-party fund managers to ensure they’re focused on fiduciary duties and voting/engaging appropriately in line with our expectations.
ESG investing in private markets – what’s the catch?
There are quite a few. For a start, many of the best companies focused on sustainability orientated products and services tend to be publicly listed (water management companies, utilities, healthcare etc), so there is a more limited accessible choice. Secondly, sustainability themes tend to require a lot of long-term investment – think hydrogen power, AI, oncology drugs – the private market now has a very different funding environment and borrowing costs have risen sharply in recent years.
Another issue is private markets are by their nature private. Transparency requirements are less onerous than in public markets. It’s difficult to look under the bonnet to see what they are really doing, and this can cause problems for investors looking for sustainability focused data.
This can be problematic when you’re trying to figure out how well, or badly, a company is doing from a performance or a sustainability perspective. The ‘haystack theory’ applies when investing in private markets – for every Space X (successful, high growth) you invest in, there will be 10 or 20 that fail. The lack of transparency means that if a company is approaching IPO, you don’t have as much scrutiny over how strong either the investment or sustainability case is – and if you do have an inkling it won’t end well, there is only a small, illiquid market to offload your shares.
Private – in and out of favour
Of course, risks like this tend to materialise quickly and investors got a brutal awakening a few years ago when it became apparent lots of private companies were going to struggle. The narrative rapidly changed to ‘just buy the S&P’. Some sustainability funds with private company exposure were hit badly.
We think there are less extreme ways for investors to make a sustainable impact through their fund choices than only investing in private markets. Here are some points to consider:
- ESG in the public markets. You can achieve your sustainability goals by buying public market stocks. Ultimately if everyone demands ‘impactful company’ stocks, these companies should see a lower cost of capital. That does have a small impact on their investment choices. So traditional impact products in public markets are still very relevant.
- Don’t ignore the bond markets if you want to make an impact. Lending money to companies or governments to fund impactful projects is theoretically a direct transmission mechanism. Investors should use it.
- Renewable infrastructure. Finally, we have areas like renewable infrastructure accessible via listed investment trusts. These trusts finance initiatives that help alleviate sustainability problems. Investors can support these when they come to the market for capital.
As awareness of ESG and the drive to sustainability and net zero grows, there
is no doubt that private markets will be a necessary part of the response to the challenge – environmental and social factors should attract investor demand
for private assets. So in reality, there should be space for both public and private ESG assets in portfolios.
Patrick Thomas
Head of ESG investing, Canaccord Genuity Wealth Management
‘
Transparency requirements are less onerous in private markets. It’s difficult to
look under
the bonnet,
and this can cause problems for investors looking for sustainability focused data’
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cover story
Private enterprise
Private markets are
particularly well suited for sustainable investments but before public market clients
dive in, writes Michael Nelson, they should be aware this area requires a specific skillset
The private investment market has steadily grown over the past 10 years, with investors chasing diversified returns and hedges against an increasingly volatile public market. This has been all the more apparent recently, with the global economy still reeling from the Covid-19 pandemic, increased geopolitical tensions across the globe and interest rates spiralling upward.
As a result, sustainable funds typically underperformed traditional counterparts due to their lack of exposure to fossil fuel energy, at a time when so many worried about energy security, and flows have also suffered.
However, the sustainable investment landscape adapts and evolves at a fast pace. Additionally, private markets are particularly well-suited to sustainable investing, as fund managers have direct ownership and control over the assets they hold. This provides abundant opportunities for engagement. Further, the long-term nature of the types of assets typically featured in the private markets are ripe for decarbonisation, such as within infrastructure where there are airports, toll roads and seaports, notes Maria Nazarova-Doyle, global head of sustainable investment at IFM Investors.
“The ability to take a long-term view, coupled with direct control over assets, makes private markets an investment of choice for asset owners focusing on sustainable and impact investing as it allows them to directly influence sustainability outcomes compared with public markets. This approach has particularly been effective in sectors critical to the energy transition and addressing climate change, such as renewable energy and green infrastructure,” she explains.
A distinct skillset
However, investing in private markets requires a distinct set of skills and expertise compared with public markets. This includes a deep understanding of specific asset classes (eg infrastructure, real estate, private equity) and the ability to assess the long-term potential of these assets in generating risk-adjusted returns.
For Nazarova-Doyle, the key sustainable investment competencies for those working in private assets include conducting thorough assessments of environmental impacts, social implications and governance structures, utilising
risk assessment frameworks to identify and mitigate social and environmental
risks, including the regulatory environment the asset operates in, and keen negotiation skills, especially for structuring deals such as power purchase agreements for renewable energy, which require specialised knowledge of
financial and technical aspects.
Tycho Sneyers, managing director at LGT Capital Partners, goes further. For him,
an intrinsic knowledge of cashflow measurement and the metrics involved are important aspects of being successful in the private market space but, perhaps more importantly, forming relationships with the best managers is the key.
“In the private equity space, success comes through people getting to know who
the best managers are and forming a relationship with them because the very
best managers – those that have no difficulty raising capital from existing investors – tend to be oversubscribed most of the time.
“If you’re a new kid on the block and you want to invest with these managers, you need to hire people who already know who those people are and, ideally, have already formed a relationship with them. That’s a really big challenge.”
‘
The ability
to take a
long-term view, coupled with direct control over assets, makes private markets an investment
of choice for asset owners focusing on sustainability and impact’
Maria Nazarova-Doyle, global
head of sustainable investment,
IFM Investors
Investors need to bear this in mind when choosing which private markets solutions to allocate to, and Emily Pollock, co-founder of private asset solutions at Schroders Capital, agrees. She says to start in the world of private market investing, investment managers should work with an adviser or experienced professional. Although you can upskill to a point, “part of the beauty of private markets is that it’s fragmented” and “it’s not like you can go online and look at a database”.
“What I love the most is it’s a person-to-person type of business. At the end of the day, you place your trust in someone doing what they say they’re going to do. A limited partnership agreement, for example, is literally a pledge to provide a certain amount of money to someone to spend however they see fit.
“That important trust element though means meeting the universe of managers is important to identify who else is out there and who’s competing, getting to know them, getting to understand what they’ve done in the past and also what they’re going to do in the future.
“I’d suggest, in the case of switching from public to private, an investor would first need to start with carving out part of their allocation and building a portfolio, working with a manager who can help design a portfolio that has proper diversification and a plan of action to avoid severe concentration risks.”
Additionally, Pollock notes a rise in the need for specialisation. Gone are the days, she continues, where someone could perform the role of a generalist – specialising in either a region or sector, or the type of deal, with operational know-how is crucial.
The shift in hiring practices, as a result, has been noticeable, says Nazarova-Doyle, with firms seeking individuals that combine deep expertise in private markets with experience in sustainable and responsible investing. This includes professionals with a strong background in infrastructure, private equity and real estate, who can bring valuable insights into managing assets with a long-term, sustainable focus.
“In particular, this trend is starting to take on in Defined Contribution (DC) pension funds as they grow their holdings across the world and become very large and sophisticated investors. More and more DC pension money is invested in private markets and these funds need to have internal expertise to be able to either select the right asset managers, build the right strategies or even manage private assets directly,” says Pollock.
Private climate funds concentrated in high-emitting sectors
Asset-weighted sector exposure %
Source: MSCI, data as of 30 September 2023
Data requirements and transparency
There are also marked differences in terms of data and reporting. Private markets have often had a bad reputation for the lack of transparency of information, typically involving less regulatory oversight and public scrutiny compared with public markets. This means there is often greater flexibility in how information is disclosed and reported, explains Nazarova-Doyle.
However, Pollock asserts the information on an investor’s private investments is very good – it’s just not made publicly available. This places a greater responsibility on investors to ensure robust reporting practices are in place, especially when it comes to sustainable investment outcomes – and they can access them.
“In private investing, you own and operate the companies or the assets you have. There is better access to data than you would have on the public side, because you own and know what to collect and how to collect it.
“On the public side it is systematised and standardised data, which means they’ve been able to get up to speed faster on portfolios. On the private side, because of the fragmentation by industry, by manager, by geography list or by any of the various criteria, it’s been tougher.
“But at the same time, because you’re owning and operating these assets, the ability to be more sustainable and more impactful over the longer term is another one of the big benefits of the private investing universe.”
That hasn’t prevented the regulatory environment for private assets evolving quickly and demanding more disclosure, particularly when it comes to sustainable investment. Sophisticated private market investors are developing comprehensive reporting frameworks that capture the impact of their investments on environmental and social factors, as well as governance practices.
The result of this is the ESG Data Convergence Initiative (EDCI), founded in 2021 by a group of limited and general partners frustrated at the lack of performance-based data from private companies. The goal is to “create a critical mass of meaningful, performance-based ESG data from private companies by converging on a standardised set of ESG metrics for private markets,” allowing general partners and portfolio companies to benchmark their current position and generate progress toward ESG improvements, while enabling greater transparency and more comparable portfolio information for limited partners and investment managers.
In July 2024, EDCI said it had gathered over 120,000 data points from 6,300 portfolio companies spanning 75 different countries and 76 industries aligned with the Sustainable Accounting Standards Board.
A more mature market
As to whether the private market space will continue to see growth, Pollock says she “drank the Kool-Aid a long time ago” and can only see continued expansion
from here.
“Private markets used to be classed as ‘alternatives’, but what we’ve seen over the past 10 years is a maturity of the market and it has become so embedded within the largest portfolios and with the largest investors – there’s only one direction to go from here.”
Those seeking to pivot to private from public market investing successfully should ensure they have the right talent and capabilities in place to effectively manage their investments. The message from private market investors seems clear: underestimate the differences at your peril.
‘
It’s a person-
to-person type of business.
At the end of
the day, you place your trust in someone doing what they say they’re going to do’
Emily Pollock, co-founder of private asset solutions, Schroders Capital
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interview
The shape of things to come
Maria Teresa Zappia, head
of sustainability and impact,
tells Natalie Kenway how
Schroders Capital is shaping the
future of sustainable finance
through private markets
Although Schroders Capital was only officially formed in 2021, some of the teams that make up the business – which has grown organically and through acquisition – have operated for more than 70 years, Schroders Capital’s Maria Teresa Zappia tells PA Future. It would be fair to say they have the expertise of investing in private markets where, she says, investing in sustainability and impact truly began.
“It’s clear there are huge opportunities in private markets overall, but due to the extended investment horizon and ability to shape the investment process, this is really where impact and sustainability investment started,” the head of impact and sustainability notes.
Zappia herself joined the company through acquisition and is also chief impact and blended finance officer and deputy CEO at BlueOrchard Finance, a company specialising in impact investing in emerging markets, which Schroders acquired in 2019 in an expansion into private markets offerings for its clients.
This was followed up with the purchase of 75% of the shareholding of Greencoat, a European renewable energy investor, in 2021 before the businesses were combined to create Schroders Capital.
Today, the company has some $100bn (£74.7bn) in assets under management allocated across investments within private equity, debt, real estate and infrastructure, indicating the level of growth in this asset class but also the firm’s commitment to impact investing.
“There is immense potential to shape strategies that address both environmental and social challenges [in private markets],” Zappia explains. She points to examples of BlueOrchard’s focus on financial inclusion and Greencoat’s investments in solar and wind energy, while Schroders’ UK Real Estate Impact fund, which prioritises social housing in deprived UK regions, also makes a positive difference through private investments, she says.
Watch the video interview with Zappia for more on the establishment
of Schroders Capital and embracing sustainability.
‘
There is immense potential
to shape strategies that address both environmental and social challenges
in private markets’
Maria Teresa Zappia, head
of sustainability and impact,
Schroders Capital
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Demand has prompted acquisitions
Appetite for private markets has increased exponentially in recent years.
Private assets constitute a much larger market than public assets and offer potentially higher yields, diversification, and in cases such as real estate, a hedge against inflation, making them popular in a post-Covid market with heightened geopolitical tensions.
Asset managers have taken note and have either acquired established businesses in this area, like Schroders, or sought to establish teams and products organically.
But Schroders’ early acquisitions meant the group was in the unique position of launching the first Long-Term Asset Fund (LTAF) in 2021. These are regulated open-ended investment vehicles introduced by the Financial Conduct Authority to enable a broader range of investors, with longer-term horizons, to invest efficiently in illiquid and private assets.
Schroders now has two LTAFs – Climate+ and Renewables+ – and has plans to launch a UK venture and growth LTAF investing in UK science and tech companies after being awarded £300m by the British Business Bank and Phoenix Group.
“The democratisation of private assets is a big thematic area for Schroders Capital. We have moved from the typical investors in private markets, that are generally institutional investors with long investment horizons, to family offices or alternative types of investors, and potentially retail investors.”
With LTAFs, she adds, the firm has been able to create these “semi-liquid strategies” that are 80% invested in private markets and 20% in listed equity, which has “really opened up the floor” in terms of the investor audience.
In turn, access to the sustainable and impact opportunities are opening up, and Zappia adds private markets is an area where investment firms can really have a high impact through their investments. She points to the firm’s UK Real Estate Impact fund, which focuses on tier two UK cities and social housing in deprived areas. “We’ve received the Sustainability Impact label [under the new Sustainability Disclosure Requirements fund labelling rules] for this strategy, which underscores our commitment to addressing social housing needs while maintaining rigorous impact KPIs.”
Growing and competitive space
Despite the rich history at Schroders Capital, Zappia also explains how
private markets impact and sustainable investing is in its relatively early stages
with the investment universe being “quite narrow”. However, she adds, it is “absolutely growing”.
“The challenge is if you are really embedding sustainability and impact into your investment process you may find yourself with a sometimes-restricted investment universe. However, you have a highly impactful portfolio, and that isn’t really comparable to market trends.”
In an increasingly competitive space, the firms that dedicate investment in this area will be the ones to thrive.
Schroders Capital seems to be one step ahead. It has the teams’ history and experience, impact tools such as SustainEx and Context – which Schroders Capital developed to analyse hard-to-measure impact metrics – and continues to dedicate investment into this area. For example, Zappia also comments on the firm’s development of artificial intelligence analysis for due diligence and administration.
Schroders Capital is well positioned to remain a key player in shaping the future of sustainable finance in private markets.
Maria Teresa Zappia is the head of sustainability and impact at Schroders Capital. She has led BlueOrchard’s impact team since 2018 and having been part of the BlueOrchard management team since 2008. At Schroders Capital, Maria Teresa leads all sustainability and impact-related activities across private asset themes and asset classes. At BlueOrchard, she is responsible for the Public Private Partnership funds under the firm’s management and impact practice.
Prior to joining Schroders, she held positions at the European Bank for Reconstruction and Development, and the Asian Development Bank.
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