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Finding value in ESG – An APAC perspective

ESG investing continues to gain momentum and prominence among global institutional investors as they increasingly look to benchmark not only the performance of funds in their portfolios but the impact they have on the world.

Mutual funds and ETFs with a focus on sustainability attracted USD20.6 billion in net inflows in 2019, four times higher than the USD5.5 billion raised in 2018, according to Morningstar. Within private markets, however, there is still a way to go with only an estimated one third of private equity firms signed up to the UN’s Principles of Responsible Investment.

A recent survey conducted by Aberdeen Standard Investments found that North America continues to lag behind Europe and Asia Pacific, with Merrick McKay, head of European private equity at ASI, quoted as saying: “The general trend suggests that private equity firms are regarding ESG as increasingly important, with firms based in Europe leading the way.” He added: “We are optimistic looking at results from firms based in Asia Pacific, with a number of respondents having implemented initiatives in the last year to improve ESG performance.”

With BlackRock’s CEO, Larry Fink, suggesting that climate change has become a ‘defining factor in companies’ long-term prospects’, it is likely that ESG investing could become a mega trend in private markets over the next decade, as private market participants embrace ESG metrics into their investment strategies.

There are three key reasons to explain this ESG growth trend.

1. Investor expectations

Allocators are becoming more demanding and want to see evidence of ESG policies and how they are being implemented. Having a policy in place should not be viewed by managers as a simple check the box exercise; investors want to understand how they are incorporating ESG metrics into evaluating portfolio company performance, the level of engagement they have with management teams on ESG issues and so on.

Managers who can demonstrate a commitment to ESG are beginning to be seen in a more favourable light by investors, and this is helping to improve their fundraising profile on the global stage.

But as the ASI survey alludes to above, there remain regional differences in respect to manager adoption.

“I would argue the UK and Europe is perhaps a bit ahead of the curve in terms of asset managers adopting ESG factors into their investment strategies, compared to here in Asia,” comments Seamus Fox, Commercial Director, TMF Group (Hong Kong).

“However, increasingly Asia Pacific-based managers are taking ESG issues on board because there is increased allocator pressure, especially from investors who are more socially aware and involved in the activist space..”

East Asia, he says, is probably a bit on the slow side when it comes to ESG adoption, “but when you look at Hong Kong and China, some of the larger asset managers are setting in place their own KPIs and running more specific ESG strategies. A number of large Chinese asset managers have become UN PRI signatories.”

More than half of the top 10 Chinese mutual fund managers have become PRI signatories and interest has recently spread to private equity and the asset management arms of banks, according to the UN PRI’s website.

In September 2019, Chinese insurer China Ping An became the first asset-owner signatory, which the UN PRI hailed as a “significant shift in the ESG landscape in China and beyond”. It went on to explain that until that point, much of the demand for ESG integration in China had come from international investors, “coupled with China’s politically mandated push towards green and high-quality sustainable development”.

“I was speaking recently to a large allocator and they are putting measures in place to ensure that a percentage of their overall portfolio allocation goes into impact investments,” explains Fox. “The reason being is they have their own end investors, and if they are pushing the agenda on social activism and sustainable finance, they have to respond in kind in terms of the types of investments they allocate to. Investors want to know exactly how their money is being managed.

“For Asia fund managers, the value of getting this right is that it opens more doors for fundraising, compared to those who don’t have ESG as part of their strategy.  Those managers that have a proven track record in strong corporate governance are well perceived in the market.”

There is still work to be done with respect to how Asia managers can think about implementing best practices from their peers in Europe. It is more of a guidance issue than anything else.

“As TMF Group has a large global footprint, we can guide clients not just on what developments we see in Asia but also what we see in North America and Europe. In certain jurisdictions where there isn’t much guidance at all, we try and share with clients what their peers are doing in other parts of the world,” says Fox. He confirms that noticeably more ESG-dedicated funds are starting to be launched by managers in the region, as well as managers tailoring existing fund products to improve their ESG credentials.

“The only way you can actually fully be seen to be promoting ESG issues is by running ESG-specific fund products. Some managers are setting up impact investing funds and it is certainly something we are seeing a lot more of, especially for those Asia managers wishing to expand into Europe,” confirms Fox.

2. Regulation

On 10 March 2021, asset managers will need to comply with the EU’s Disclosures Regulation, which is part of Europe’s long-term commitment to meet its climate change targets, and encourage the growth of sustainable finance. The purpose of the Disclosures Regulation is to bring greater transparency on how European asset managers integrate sustainability risks into their investment processes and convey those risks to their end investors.

The UK is expected to adopt these new disclosure requirements even though the transition period is due to end in December 2020 and the UK will no longer be wedded to EU rules. It too is making a commitment to improve ESG transparency and reporting, having last year introduced the Green Finance Strategy, which expects all listed companies and large asset owners to disclose in line with the recommendations of the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) by 2022.

In Asia, Hong Kong has itself taken a proactive stance. Its financial regulator, the Hong Kong Exchange (HKEX), has moved quickly to tighten ESG regulations and is set to introduce new mandatory disclosure requirements with effect from 1 July 2020.

Under these new rules, companies will need to provide a board statement setting out its consideration of ESG matters; disclosure of significant climate-related issues which have impacted and may impact the issuer; disclosure obligation to comply or explain key ESG performance indicators, and published ESG reports within five months of the financial year-end.

“Hong Kong is seeking to align itself with global ESG requirements. The HKEX has changed its rules and made them much more stringent and it is also encouraging boards of directors to take on the reporting responsibility as well. The guidance being offered to Hong Kong managers is broadly in alignment with the Principles of Responsible Investment and that is what people are looking to follow more closely,” says Fox.

For global private market participants, this shifting regulatory environment is pushing them to think about ESG factors more closely than ever before.

3. Performance

A third key driver for the growth in ESG adoption among private market fund managers is the value associated with performance. Increasingly, there is evidence that sustainable investing in companies with high ESG credentials not only allows managers to demonstrate their commitment to making a positive impact, it also leads to better financial returns. Investors don’t want to allocate capital and not enjoy a good return; they want it in tandem with real impact that can be monitored, benchmarked and quantified by the manager.

According to Global Impact Investing Network’s Annual Impact Investor Survey 2018, total assets under management in social impact investing (SII) funds was USD228.1 billion, 56 per cent of which was allocated to emerging markets.

Morningstar’s latest report, ‘How does European sustainable funds’ performance measure up?’ says that a growing body of research shows sustainable investing has a positive effect on investment performance.

That is fine within public markets, but measuring the performance of sustainable fund products remains challenging in private markets because data is fragmented and there is still no standardised reporting framework for asset owners to avail of.

As such, performance analysis remains challenging for investors who are keen to guard against investing with managers who fall foul of ‘greenwashing’, marketing their funds in a way that champions ESG, in principal, but does precious little tom improve ESG at the individual asset level.

Interestingly, the whole debate around performance has been brought into sharp focus in recent months in response to the global pandemic caused by Covid-19.

According to data from Refinitiv, companies in the FTSE UK 100 ESG Select index – which comprises the top 100 UK-listed companies with strong ESG practices – outperformed the FTSE 100, since market sell-off began on 21 February.

“In Asia I would say it is still very much an alpha-driven industry,” says Fox. “Performance has always been at the top of people’s minds and if they can access good performing funds with a clear ESG component to the strategy, that is a win/win situation for them. There are impact funds that are less alpha-driven and will sacrifice alpha in order to achieve their ESG goals – but for the bigger fund managers, alpha generation is still a crucial factor.”

By investing in high-growth industries such as food processing and recycling, or renewable energy, private fund managers are able to build long-term and improve valuation multiples. This is about delivering a strong IRR, at the Fund level, as opposed to doing so for altruistic purposes.

Looking ahead, it is likely that the impact COVID-19 has had on how we think about the environment – in terms of international travel and lowering carbon emissions – will accelerate ESG investing even faster than before.

“Covid-19 could impact infrastructure investing and accelerate the push toward electric cars and electric highways, which in turn will reduce carbon emissions and improve air quality in Asian cities. People don’t realise how bad the problem is until it goes away – and that’s something that people have noticed in recent months,” concludes Fox.

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