Private markets funds: Putting their money where ESG is
ESG has become a mainstay of private markets, evolving from being just a risk mitigation tool to a major driver of value. Market participants see further room for its integration to grow.
A decade ago, environmental, social, and governance (ESG) principles were a secondary consideration for most private fund managers. General partners (GPs) and limited partners (LPs) typically viewed ESG as a risk mitigation tool. Today, many overwhelmingly believe a focus on ESG is a strategic imperative to unlock new growth opportunities and enhance returns.
In a 2023 survey by PwC, over 80% of private equity executives said ESG had been a primary driver of value creation in at least one of their recent deals. A third (32%) said it had driven value in the majority of their deals. (See Figure 1.)
According to the Global Sustainable Investment Alliance’s latest report, global sustainable investment has now topped USD30 trillion, a surge of 20% since 2020, thanks to investor demand for responsible investment options, regulatory pressures, and the realization that ESG factors can really affect a company's performance and risk profile.
Influential investors and development finance institutions (DFIs) are helping to drive the change.
“ESG is a very important topic for DFIs like ADB, and we are typically at the forefront of pushing the boundaries for GPs to actually adopt such policies,” said Yee Hean Teo, Principal Investment Specialist at the Asian Development Bank, speaking at a Private Markets Webinar Series organized by CFA Institute.
ADB requires any private funds it invests in to follow its ESG policies and incorporate the relevant requirements into their investment strategy and processes. After an investment is made, the fund manager will also have to provide regular reports on its ESG performance, including how its portfolio companies are adhering to ESG standards and the monitoring mechanisms it has in place to assess and improve compliance.
If some deficiencies are identified, then ADB and the GP will work together on correcting them and help either the fund or the portfolio company to have more robust ESG standards, said Teo.
While the commitment to ESG is clear, its adoption in private markets is far from a straight line.
“ESG is definitely a theme that is here to stay,” said Angela Lai, Vice President, Head of Asia Pacific and Valuations, Research Insights at Preqin. “Investors who are committed to ESG will likely stay committed, but in the past two years, we also sometimes see investors who might not prioritize ESG as much when markets are soft. There’s probably more chatter around prioritizing financial gains, so the support for ESG to financially outperform other investments has been a bit mixed,” she told the webinar.
Making an impact through private credit
In the private debt segment, too, ESG is fast making inroads, amid recognition that sustainable investment practices can drive long-term returns – all while addressing critical environmental and societal challenges. New regulations, such as the European Union’s Sustainable Finance Disclosure Regulation, are also pushing for greater transparency and accountability.
Some private credit managers have started raising impact-focused credit funds. Research by the Global Impact Investing Network shows the market size of impact investing at the end of 2021 was USD1.16 trillion, having more than doubled in three years.
Among the major deals in 2024 were global asset manager Nuveen raising USD170 million for an impact credit fund in October, aimed at providing investors with access to investment grade corporates and other credit sectors designed to deliver alpha and returns – all with an environmental and social lens.
Similarly, in September, Allianz Global Investors announced the first close of its impact private credit strategy with EUR560 million in commitments – more than half of its target size. The fund will focus on three key themes: climate change, planetary boundaries and inclusive capitalism.
But raising impact funds through private credit is far more challenging than raising it through private equity, creating an imbalance in ESG progress in these two asset classes. (See Figure 2.)
Kerrine Koh, Managing Director, Client Solutions, Country Head for Singapore at Hamilton Lane, points out that private credit providers have less influence on their portfolio companies after a transaction is underwritten.
“Is the company going to stay true to net zero? Would it continue to get away from certain air pollutant industries? As a debt provider, and not as majority control shareholders, there are limitations on helping companies to stay the course,” she said.
If private credit providers are serious about their ESG commitments, they need to find tools to mitigate some of these challenges.
According to Andrew Tan, Chief Executive Officer, Asia Pacific, Muzinich & Co, it’s important to have a baseline when scoring transactions for possible investments. This means looking not just at environmental metrics but also digging deeper into the borrower’s governance standards and social impact.
“What we say to borrowers is that if you’re able to meet certain ESG measures and milestones going forward, we will give you a reduction in the price of the debt as an incentive to get them to move towards a better ESG outcome,” said Tan on the webinar.
While this is helpful to prod borrowers on their ESG journey, a wider mindset change will go a longer way.
The challenge in Asia, says Tan, is that ESG is typically not front of mind for a lot of borrowers, making data gathering and ESG measurement a challenge.
“Over the last three years or so, we’ve made quite good progress on making borrowers a lot more aware about ESG and factoring it into their corporate plans,” said Tan. “There’s also a lot of emphasis on ESG from investors in private credit funds, especially from Europe, so if you have those investors in your fund, you have no choice but to focus on having an ESG standard and framework in place.”
Greening real estate investments
There is one other bright light: the real estate industry, where ESG is more measurable.
Alan Lok, Director, Curriculum Development at the CFA Institute, reckons real estate is an industry “that has the least greenwashing” as its long history has led to robust and stringent ESG standards.
“It’s not just a checklist when developers need to put the facilities in, but these are tangible add-ons that people can just walk in, look at and see the immediate effects,” he added.
This is important, given the role of the real estate sector when it comes to energy consumption.
According to the Global Alliance for Buildings and Construction, buildings are responsible for 34% of global energy demand and 37% of carbon dioxide emissions. To increase energy efficiency of a building and boost its green credentials, developers are using more renewable energy, metering, installing LED lights, upgrading heating and ventilation systems and offering window glazing and shading.
Investors, meanwhile, are using a variety of approaches to ensure greenwashing risks are tackled effectively.
Annora Ng, Managing Director, Capital Markets, at real estate private equity fund manager GAW Capital, said her firm set up a dedicated ESG team two years ago to improve its green practices, amid a big push for ESG among its investors, including pension funds and sovereign wealth funds.
But given how disparate Asia’s real estate markets are, a more tailored approach is needed. Christine Li, Head of Research, Asia Pacific, Knight Frank pointed out that the main markets attracting investors are Australia, followed by Japan and Singapore.
In some markets, green buildings now fetch a high premium. For example, green-certified Grade A office buildings are commanding rental premiums of over 10% more than non-certified buildings in some parts of Asia, and over 20% in Hong Kong, according to research by JLL.
“In terms of green premium, it is really because the occupiers are going for the best and most premium buildings,” said Li. “Hong Kong is very unique because the occupancy demand is quite muted, but there is huge supply of buildings and office space available.”
While the green premium has swung higher, Ng believes it is not yet fully accounted for in property sales.
“A lot of time the buyers and sellers are still not willing to price in that cost of that green premium,” she said. “We’re at the stage where on the rental side, people do pay attention to ESG, but we still need to transfer that line of thought into the sales transaction side.”
Explore related articles
How the democratization of private equity is changing the investment landscape
How the interest rate environment is set to reshape private markets
Considering a private markets career? The experts share their tips
How private market funds are integrating ESG in investments
You may also be interested in
02 Dec 2024
Africa’s wealth management opportunity
Want to learn more about ESG Investing?
Choose your own learning path through our sustainability certificates: the foundational Certificate in ESG Investing and the advanced Climate Risk, Valuation, and Investing Certificate.
