LPs are becoming increasingly ambitious on their ESG priorities, with all of those not currently invested in ESG funds looking to invest within the next 24 months according to recent figures…
LPs are becoming increasingly ambitious on their ESG priorities, with all of those not currently invested in ESG funds looking to invest within the next 24 months according to recent figures…
European ESG assets will rise to as high as EUR1.2 trillion by 2025, according to PwC, with private equity responsible for almost a third of this and appetite from investors still growing.
When asked about their principal motivations for investing in ESG-linked assets, LPs cited risk management (41 per cent), corporate values (41 per cent) and risk adjusted returns (35 per cent) as their main reasons for doing so.
European mandate-led institutions, particularly Nordic and Dutch pension funds, have generally led on zero carbon goals and ESG policy, but the goal pool of ESG-minded LPs is expanding rapidly.
According to a recent survey by the Official Monetary and Financial Institutions Forum, pension funds are leading on ESG and deploying the greatest variety of strategies at scale.
“It’s fair to say European investors, both LPs and GPs, have been ahead of US and Asian investors in terms of integrating ESG,” says Joshua Featherby, managing director at investment firm Cambridge Associates. “European GPs have been better at discussing ESG than their US counterparts.”
This may be changing, however. UK law firm Dechert says that 49 per cent of GPs expect a ‘significant increase’ in EMEA LPs’ ‘ESG scrutiny’ and reporting, but 60 per cent of GPs expect the same from North American LPs.
Foundation for change
Jay Ripley, co-head of investments, Global Endowment Management (GEM) cites US foundations, including Ford Foundation, Heron Foundation, MacArthur Foundation, and Kellog Foundation, as all leading in the ESG space.
“I’ve spoken to other endowments and foundations in the space, and even the ones who I thought would be the furthest away from discussing or integrating ESG are approaching GEM for advice on how to bring in new policies to accommodate it,” he says.
While European LPs can be more focused on climate, North American LPs often have their own ESG agenda to implement.
“In the US however, endowments and foundations tend to focus on racial and social justice,” says Ripley. “At GEM, for example, our private investment team went to the Race Equity Institute course to identify and reduce our inherent biases when making decisions on who we work with.”
US-based TPG Rise Climate, one of the largest impact funds in the market currently with a hard cap target of USD7 billion, includes some of the world’s largest institutional investors: AXA, Ontario Teachers’ Pension Plan Board, Silk Road Fund, State of Michigan Retirement System and Washington State Investment Board. But it also holds an investor base of the world’s leading multinational companies too – Apple, Nike, FedEx, Dow, Boeing and General Motors.
This was made possible, in part, by the appointment of former US Treasury Secretary Hank Paulson as executive chairman of the fund. In an interview with Fortune magazine last year, Paulson said: “Every one of these began with a call from me and [TPG co-founder] Jim Coulter to the CEO.”
Net carbon zero targets are now a priority among institutional investors globally.
Ground zero
Not surprisingly given its mission, the UK’s National Trust endowment has a publicly stated 2030 net-zero commitment. Cambridge University Endowment Fund was also described as “very progressive, almost to the point of concessionary” by Stan Miranda, founder and chairman of advisory firm Partners Capital, due to the endowment’s 2030 net-zero commitment.
A 2022 survey from ILPA-Bain reveals that 31 per cent of LPs have set net-zero commitments, and more than half of those LPs are based in Europe have already done so.
Net-zero in 2050 is a more common commitment for LPs, as 2030 is often too soon. Featherby says that “it’s hard to overstate how ambitious the net-zero 2030 goal is”.
What sets the National Trust apart from most others, however, is the fact that they’ve set themselves the challenge of not using carbon offsets to achieve this. Instead, they’re using their ability to be long-term investors to finance carbon capture opportunities, including more proven strategies, such as regenerative forestry, as well as more novel technologies, accessed through their venture capital portfolio. The focus is on being truly additive, not just refinancing existing or more preventative measures, Featherby says.
There is also a noticeable move among some of the more progressive LPs to drive their GPs to begin investing in ESG or increase these investments, and in some cases, refusing to work with GPs who don’t meet their standards.
GPs are responding to this: 94 per cent of GPs have an established ESG approach, up by 16 per cent in 2020 according to PineBridge Investments.
However, this “approach” bears many interpretations and has not always been consistent, with only 46 per cent of GPs tracking diversity for their portfolio companies’ board of directors, for example.
63 per cent of LPs plan on increasing their allocation to ESG funds in the next 24 months, with 55.9 per cent of LPs planning on increasing their allocation between 10 and 20 per cent: a significant increase.
“Today, the pressure on LPs and GPs to think about ESG is coming from all angles,” says Featherby. “Before, it used to only come from a relatively small pool of loud critics or student bodies. But today, even corporate pension funds are being pressured by their employees, by their parent company, by their peer and wider stakeholders – it’s a cacophony of noise which can no longer be ignored.”
Morgan Stanley’s annual ‘Sustainable Signals’ report shows that 57 per cent of asset owners also foresee a time when they will only allocate to managers with a formal ESG approach.
ESG has been in the background of portfolios for the past ten years, but has often been an optional investment choice rather than a requirement. Now, however, it’s at the forefront of countless LPs’ investment intentions and commitments and has become a necessity rather than a choice.
The initial push for PE firms to sign up to UNPRI (United Nations Principles for Responsible Investment) came from LPs asking whether their managers were signatories, and now LPs are asking for more.
As a point of progress for GPs, Manuela Fumarola, ESG manager, private markets, Aberdeen Standard Investments recommends that “GPs start considering technology tools for SFDR and also begin considering climate modelling.” (‘How Limited Partners Are Mitigating the ESG Data Gap’, SS&C Intralinks, 2021).
“It’s great to see that lots of GPs are starting on their ESG journey, but to receive the highest ESG rating from Mercer, you need to have established ESG processes which have been in place for a while and are measurable in terms of progress,” notes Rhonda Ryan, Mercer’s head of European private equity.
Though ESG has been a topic of conversation for many years, many feel that it is only now that there is a real momentum and sense of change, as increasing regulation looms.
“For pension funds, in particular, regulation in the UK has also helped to force them to address ESG,” says Featherby. “Five years ago, there were many LPs and GPs who were delaying or even avoiding the conversation altogether, but now it’s one of the first discussion points on the agenda. It has to be.”
New legislation and guidance, including the introduction of the first LP and GP partnership to standardise ESG reporting led by Carlyle and CalPERS and the first net zero guide for PE for GPs and LPs launched by IIGCC and based on the Paris Aligned Investment Initiative, is contributing to this shift.
“It has got to the point where fund managers that don’t start incorporating ESG into their investment processes are facing ‘existential risk’,” says Featherby. “Not only will they likely struggle to raise capital from LPs, but their performance is also likely to suffer in the meantime.”
Read the rest of the Private Equity Wire Insight Report: Creating Values: Behind the ESG Revolution in Private Equity
