Amid the raging Covid-19 pandemic, 2020 marked the first year that investment in environmental, social and governance (ESG) oriented funds topped US$1 trillion. And this boom in ESG investing, accelerated by public consciousness and investor preference for a longer-term, more sustainable investment strategy, is unlikely to be a temporary trend. The implication for companies everywhere is clear: improve your ESG credentials or risk being overlooked by fund and asset managers.
Limited partners (LPs), i.e. investors, putting their money into private equity funds are also fast realising that ESG investing and achieving excellent financial returns are by no means mutually exclusive. Indeed, the Financial Times reported in June 2020 that the majority of ESG funds outperformed the wider market over a 10-year period.
Their attractive returns, taken together with the fact that they’re best suited to evolving regulations and emerging sustainability frameworks, mean that investors are increasingly choosing ESG-focused funds and investments over and above non-ESG-compliant assets.
In this article, I take a look at the importance of ESG criteria from the investor’s perspective, be they institutional or private, and assess the impact of growing investor interest in ESG on the alternative assets sector as a whole.
All types of investor heeding the ESG siren call
According to the latest Callan ESG Survey of institutional investors, released in October 2020, over 30% of respondents not yet incorporating ESG factors into their investment decisions are now considering it. This is the highest rate in the survey’s history and nearly three times the 2019 result. Moreover, in Q3 2020 alone, 262 firms – including 43 asset owners – signed up to the UN’s Principles for Responsible Investment (PRI), taking the PRI’s signatory base to 3,300 firms worldwide.
Private Equity International’s LP Perspectives 2021 study, meanwhile, shows that ESG factors are gaining greater weight in LPs’ due diligence processes, with 88% of investors taking a manager’s consideration of ESG factors into account while conducting due diligence – up from 80% a year ago.
As for family office and (ultra-)high-net-worth individual investors, IQ-EQ’s recent white paper examining the so-called ‘great global wealth transfer’ highlighted the fact that this seismic transition of family wealth between generations is placing the spotlight firmly on ESG. Indeed, as the more socially and eco conscious millennial generation takes the reins of family businesses and fortunes, they are driving ESG discussions, striving for good governance and positive social/environmental impact in relation to the power of their capital.
This trend is reflected in the key findings of the 2020 UBS Global Family Office Report, which reveal that almost two thirds (62%) of families now regard sustainable investing as important for their legacies and 39% of family offices intend to allocate most of their portfolios sustainably over the next five years.
Further, according to Capgemini’s World Wealth Report 2020, while 27% of high-net-worth investors said they were interested in sustainable products, this percentage balloons to 40% among those in the ultra-high-net-worth bracket. Moreover, these wealthy investors said that they intended to allocate 41% of their portfolios to ESG-focused businesses by the end of 2020. And to our earlier point, while giving back to society was ranked highly as a priority, the number one driver behind this commitment was the expectation of higher returns.
Investor demands driving regulatory developments
In private equity, transparency has become the watchword: everyone wants more granular data, more often. In 2020, these demands became significantly more focused on sustainability metrics, with increasing amounts of pressure being placed on managers and companies to provide greater transparency around ESG metrics and ESG-related risks such as greenwashing.
One significant hurdle is that there isn’t yet a global regulatory body monitoring ESG, nor a single established framework to follow, meaning that ESG has so far been almost entirely open to interpretation for private markets – especially given the lack of public information available. But given the growing investor focus on ESG, this looks set to change as a number of significant regulatory developments emerge worldwide.
Looking globally, the World Economic Forum released its ESG disclosure framework in September 2020, developed in collaboration with the ‘Big Four’ accounting firms and aligned with the UN’s Sustainable Development Goals. This represents a key milestone in setting up a universal benchmark for reporting sustainable value creation and, of the options currently available, it holds the best chances of becoming the standard in private marks for ESG reporting. Key regional regulations are also being introduced, such as the EU’s Sustainable Finance Disclosure Regulation (SFDR) that comes into effect in March 2021, which focuses specifically on enhancing the transparency around ESG considerations in investment decision-making.
Social pillar of ESG coming into the spotlight
While the ‘E’ and ‘G’ pillars of ESG have always been well understood, a 2019 Global ESG Survey by BNP Paribas revealed that 46% of the 347 institutional investors surveyed found the ‘Social’ aspect to be the most difficult to analyse and embed in investment strategies.
In today’s Covid-19 environment, however, the social pillar has been propelled to the fore. Given the acute sense of local, national and global social responsibility to stop the spread, the ‘S’ is set to attract significantly greater attention from investors than it has to date. It will also garner significant scrutiny from regulators, governments, customers and employees.
While there was a disparate focus on (and reporting of) social criteria in the past, it will now be a crucial element of the corporate story and a prominent pillar of a company’s ESG credentials, with focus shifting firmly to the health and safety of employees and their communities. Investors will expect to see clear communication of society-related activity and progress moving forward.
Driving a permanent shift in the alternative assets space
In the alternative asset investment sphere, 61% of the 400 LPs polled by Preqin in 2020 believe that ESG will become an integral part of the industry over the next three years. Already, at an empirical level, large ESG bond volumes (both in the UK and globally) are reflecting the fact that asset managers and pensions funds have large mandates to purchase ESG-focused assets. And looking at the global picture, as Asia becomes increasingly committed to ESG investing and with the Biden administration set to direct the USA back onto a ‘greener’ path, a clear ESG framework for the alternative assets sector will no longer be a nice-to-have but a must-have for investors the world over.
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- ESG: Searching for substance behind the acronym
In this white paper, co-authored by Charles Russell Speechlys and IQ-EQ, we strive to better understand the various components of ESG and set out what ESG might mean for our clients in terms of the operations and output of their businesses, the relationships they have with their stakeholders, and the impact that their businesses or investments have.