Access: The Imperfect Nature of Impact Investing
“What gets measured gets improved." - Peter Drucker
Hello reader,
Welcome to the 26th edition of Access - the most clicked link from last week’s newsletter was this gem from 2007, titled ‘An introduction to the fundamentals of an expanding, global industry’.
To our newest subscribers, welcome! It’s great to have you here. Access is a free newsletter, covering news, views, and opinions on private markets. Plus the occasional Tiktok.
If you’re looking to catch up on some of our recent newsletters, why not try The Democratisation of Private Assets, SVB’s Meltdown, or Art as an Alternative Asset 👇
Anyway, on to this week’s edition. It was Earth Day last weekend, which is our tenuous link to this week’s piece on the important - but imperfect - nature of impact investing.
Until next time -
Liz & Melissa
In case you missed it…
Last week’s edition featured 87 of the very best private equity resources, including:
FEATURING:
In Brief: The Latest ESG & Impact Investing Resources
7 Steps to ESG, from Danielle Pepin, Head of Product at Dynamo Software
Climate Change Hub on PRI, from Peter Dunbar, Head of Private Equity at PRI
Investing in the Energy Transition, from Erika Karp, Chief Impact Officer at Pathstone
In Depth: The Imperfect Nature of Impact Investing
IN BRIEF
Below, you’ll find a selection of the latest ESG & impact investing resources. All have been shared this week from people in our private markets network.
7 Steps To ESG
What are the fundamentals of an ESG program for fund managers? Dynamo Software released a webinar this week that explains best practice for setting up an ESG program.
“Our message here is very much, try to get the fundamentals into shape; don’t build a really fancy escalator to nowhere”
- Dynamo Head of Product, PMV Danielle Pepin
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Climate Change Resources for Private Markets
The Principles for Responsible Investment private markets climate change resource hub, provides private markets investors access to important climate tools, guides, and insights to support their actions towards achieving net-zero and building more resilient companies and assets.
The hub now features a new guide from the PE track of The Sustainable Markets Initiative (PESMIT). This is a group of the largest global GPs.
Of those large global GPs:
100% reported LP pressure to decarbonise portfolio companies and portfolios.
70% have a high or very high expectation for an exit multiple premium for decarbonisation
- Peter Dunbar, Head of Private Equity at PRI
Access PRI's resources on climate change for private markets
***
In The Transition to Clean Energy, How Should We Think About Fossil Fuels?
Pathstone is hosting a live webinar on May 10th, focused on investing in the energy transition.
Erika Karp, Chief Impact Officer at Pathstone, will be joined by Mark S. Brownstein, Senior Vice President (Energy Transition), at the nonprofit organization Environmental Defense Fund, Geoff Eisenberg, Partner at the Ecosystem Integrity Fund, and Brooks Preston, Managing Director at Macquarie Infrastructure and Real Assets.
“Their collective expertise will allow for a great discussion on THE most critical global economic issue of our time.”
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IN DEPTH
“ESG is typically about how a company operates. Impact is what it does to make a profit” - Megan Starr, Global Head of Impact at Carlyle
We could have titled this piece ‘The Indeterminable Nature of Impact Investing’. There is no universal agreement on what constitutes an impact investment, and confusingly, ESG & impact investing are often used interchangeably.
Let’s start by untangling some of the definitions. As Erika Karp, Chief Impact Officer at Pathstone points out, “ESG is not an asset class, it’s not a style, it’s not a strategy.” Erika goes on to explain that “ESG is an analytical lens… once you do ESG analysis you can do any kind of investing you want.”
Environmental, Social, and Governance - known as ESG - are non-financial factors that investors apply to their analysis to identify risks and opportunities, according to the CFA Institute.
When people criticise ESG, they’re often criticising the way ESG data has been used to make a decision they disagree with. One of the key concerns of critics, particularly in the US, is that ESG data is used to screen potential investment targets, cutting off some companies - or entire industries - from vital funds.
“Woke Capitalism” & The Curious Case of Tesla
In recent months, US media has been awash with criticism of ESG or impact investments. Tucker Carlson complains of “a destructive force pressuring governments to sabotage their own economies”. (Carlson was exited from Fox News this week, after Fox reportedly settled a defamation lawsuit connected to their reporting of the US presidential election in 2020).
Last year, Elon Musk called ESG a “scam” after Tesla was booted off the annual S&P 500 ESG Index.
In their rebuttal, S&P asked the question that was on everyone’s minds - “But, how can a company whose self-declared mission is to “accelerate the world’s transition to sustainable energy” not make the cut in an ESG index?”.
“While Tesla may be playing its part in taking fuel-powered cars off the road, it has fallen behind its peers when examined through a wider ESG lens.”
The answer was it lacked a low carbon strategy & business codes of conduct, plus “claims of racial discrimination and poor working conditions at Tesla’s Fremont factory”.
In other words, it’s possible that a business can have a clear impact goal, but still score poorly on ESG factors.
The Growth of Impact Investing
Because there’s so much difference in definitions, it’s also quite difficult to ascertain the size or scale of impact investing.
“In fact, many veterans of the impact investing space define ‘impact’ differently. Executives at the same organisation may even disagree on whether it is an impact investor.”
- Penney Frohling, Partner at EY
In EY’s 2022 report on the UK impact investment market, impact was defined as ‘Investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return.’ They conservatively estimated that a minimum of £58bn is flowing to impact investing in the UK, with 39% managed by fund or investment managers, 16% by insurance companies, and 14% by private equity or venture firms. The report notes that ‘more than half (55%) of this capital is going to private companies, with 35% in private debt and 20% in private equity.’
From a private equity standpoint, there are clear synergies between impact investing goals and general PE investment strategies, like the longer hold periods and active management approach.
This piece from Franklin Templeton lists five factors that make private equity well-suited to impact investing:
Deep engagement: GPs engage with portfolio companies at board level, allowing them to influence key decision-makers to adopt and strengthen impact practices.
Long-term relationship: The longer-term nature of private equity investments allows an investment’s climate impact to be measured more effectively.
Contractual enforcement: Private equity firms can embed impact best practices into transaction documents and company charters as a precondition for investment.
More granular data: PE firms often benefit from better and more detailed information transparency than public market investors.
Iterative process: The process of driving positive impact is inherently iterative, following a nonlinear “theory of change.” Private equity benefits from a close relationship with investee firms to build better impact practices through a regular, long-term feedback loop.
“We have seen a massive acceleration in the integration of sustainability issues in investment. Participants have come to see the decisive role that incorporating ESG criteria can play in creating and protecting value.”
- Candice Brenet, Head of Sustainability at Ardian
So, with responsible investing hitting the mainstream, what’s incentivising private equity firms to act?
Firstly, there’s regulation - the need to comply with commitments made by countries, governments, industries, and communities. Then, comes value creation; the GP’s fiduciary responsibilities to investors and portfolio companies.
“The emergence of a new wave of customers (particularly among the millennial generation) who believe their buying choices should align with their personal values, and as such are keen to support ‘profit with purpose’ businesses – creating a sizeable market opportunity.”
- BVCA
The third reason that private equity firms are exploring impact investing is reputation - to meet LP expectations and protect investor reputations.
And finally, purpose - the opportunity to actively engage as a responsible investor.
“Impact investors seek to do good while doing well — to deploy their wealth in a way that benefits society and also generates a profit.”
- Patrick Temple-West, writing in the FT
That this comes last on our list doesn’t necessarily mean it’s a lower priority, but arguably while investors are looking for proof of wider benefits, they still expect to see a financial return.
Beyond Divestment: Harnessing ESG Data For Greater Impact
Despite the challenges associated with ESG and impact investment, there is general consensus that investors & fund managers have the power to influence behaviour. Yet there’s debate about whether this influence should be used for good, or for profit, or both. Critics on both sides will tell you that not enough is being done, or that too much influence is being wielded, depending on their perspective.
And it’s not limited to private markets. In a piece for the FT this week, Camilla Palladino writes:
“The shareholder registers of oil companies these days resemble a pack of gerbils fighting under a blanket. There are those who want the companies to cut oil and gas production targets and to do it yesterday, those who want to make as much money as possible right now, and everything in between.”
Navigating the issues in a nuanced way, particularly the thornier questions around climate change or the clean energy transition for example, can be difficult.
Tobias Hartz, Partner at Simon-Kucher believes that “Climate change may represent just one element of the ESG equation, but it’s arguably the biggest global challenge.” Hartz goes on to say that, “Often the greatest potential can be found in investing in companies that are not yet green by definition, but where there is a clear path to delivering genuine climate impact.”
“If you want to decarbonise the global economy, you have to go where the carbon is.”
- Megan Starr, Global Head of Impact at Carlyle
Historically, ESG & impact investing were seen as separate disciplines. And where an ESG program was in place, a poor ESG score would act as a deterrent to investors.
“Many private equity investors avoid ‘grey’ or high-emitting assets in an attempt to decarbonize their portfolios,” says Greg Fischer, a partner and director at BCG. “This is a missed opportunity. We cannot divest our way to global Net Zero.”
Carlyle’s Global Head of Impact, Megan Starr, agrees. “[What] we're seeing now is that the kind of next phase, of saying - actually, how can you invest in companies that maybe don't have great environmental or social dimensions, improve those and that's actually the kind of activism thesis of improving those companies into the higher multiples."
ESG data can play an active role, helping firms identify opportunities for decarbonisation. This also helps avoid situations where divestment might improve the ESG rating of a company or portfolio, but risks creating an overall negative impact for the planet.
“So a well-intentioned corporate actor spins off a coal-producing subsidiary to reduce its carbon footprint and meet the climate related portfolio goals of its board and shareholders, thereby creating an independent business more likely to expand coal production aggressively precisely because it has been freed from a corporate parent publicly opposed to such initiatives.” - Jason Thomas, Head of Global Research at Carlyle.
A Sustainable Future?
There is no doubt that ESG and impact investing will continue to divide opinion. Perhaps we shouldn’t be surprised, given what’s at stake.
David Correll, Ph.D. is a research scientist at the MIT Center for Transportation and Logistics. He admits that critics may have a point about the '“vexing ambiguity of ESG”.
“But in the end, all of us share the same plight: stuck on this imperilled planet, hoping that both our ecosystems and our retirement plans suffice for the rest of our mortal lives.”
A sobering thought indeed, and perhaps just enough of a shared incentive for people on both sides of the debate to find a path forward to achieving long-term sustainability.
And finally… #earthday2023
We were going to sign off with an uplifting video from the recent Earth Day celebrations, but of course, it’s Tiktok, so instead we found this 🙈
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