ESG Is a Force That Continues To Shape Private Equity
The drive by sponsors to incorporate ESG criteria into investment strategies was inevitable. In recent years, consumers have increasingly championed sustainability expectations, and limited partners have increasingly demanded opportunities to make their commitments to funds with ESG and impact objectives. The Financial Times recently reported that, on average, about 100 ESG-oriented funds were launched annually between 2020 and 2022, and that in addition to launches, more than 120 other funds were repurposed or introduced ESG criteria in their strategies between 2018 and late 2023.[1]
The rate of change is striking. According to industry association Invest Europe, only 9% of private equity-backed companies in its European sample had net zero targets at the end of 2021. However, by 2022, research from Bain & Company and the Institutional Limited Partners Association showed that 93% of limited partners would walk away from an investment opportunity if it posed an ESG concern. This push by limited partners goes beyond optics: 50% cited better investment performance as a key reason to incorporate ESG criteria in investment objectives.
By contrast, in 2023, the growth that ESG funds enjoyed in the preceding years slowed down: 55 funds citing ESG objectives were launched in the first half of the year and only 6 in the second half. Data from Calastone shows that ESG funds also suffered £2.39 billion of outflows, making 2023 the first year of net selling since 2019.html [2] This must, however, be viewed against the wider 2023 backdrop, which saw global fundraising fall by around 11.5% to levels not seen since 2017. In Europe at least, 2023 is likely to represent a bump in the road for the growth of ESG and impact investment.
Continuously evolving regulatory landscape
Regulators have reacted to the high level of interest by sponsors in ESG. The European Commission is undertaking a review of its Sustainable Finance Disclosure Regulations, to assess potential shortcomings. The focus of the review is on providing legal certainty to investors and sponsors, ensuring that the myriad of regulation is useable, and that the framework give the Commission the power to play its part in tackling the mislabeling of ESG and impact funds, known as “greenwashing”.html [3] The public consultation closed late last year, and the final outcomes are awaited. In due course, the review may lead to the adoption of a more precise categorisation regime to replace the use of Articles 8 and 9 as “de facto product labels”.[4] Meanwhile, the UK’s Financial Conduct Authority has floated the creation of three labels under its parallel Sustainable Disclosure Requirements – sustainable focus, sustainable improvers, and sustainable impact – effectively acknowledging investor demand for funds that have explicit ESG aims.
Frameworks are also being put in place by working groups to help guide the industry’s efforts towards net zero. In May last year, the Institutional Investors Group on Climate Change (IIGCC) published its new net zero private equity guidance to standardise target setting, engagement and reporting between LPs, GPs and portfolio companies and support progress to net zero at scale.
Tying financial compensation to ESG performance
The global focus on ESG is also changing the way in which GP compensation is administered. Many impact funds are now exploring options for linking GP renumeration to specific impact targets. While the idea of impact linked carry dates back more than a decade - London-based Aureos Capital established a 15% base rate of carry for its 2009 Africa health fund with an increased rate for achieving impact targets – finding the right model remains challenging. Adopters include a number of leading impact sponsors, who tie carried interest to the fulfillment of an impact fund’s mission.
Sustainability-linked bonds
ESG criteria are increasingly being included in portfolio companies’ financing too. Green, social and sustainable loans and bonds are a growing focus for corporates. The sustainability linked bond market in Europe is home to two thirds of SLB issuance from corporates. The structure of these bonds is such that the debt carries a coupon linked to sustainability-based KPIs (key performance indicators), with the issuer paying less interest on the debt if it hits the KPIs but more if it doesn’t. For example, Italy’s ENEL, one of the leading utilities groups in Europe, raised €1.5bn at the beginning of last year by issuing bonds tied to KPIs on the EU Taxonomy and UN Sustainable Development Goals, building on its past issuance of “green” bonds.
Is the trend changing?
As discussed above, last year saw a reversal of the growth that ESG-focused funds had enjoyed for the prior four years, but in the context of a dislocated and malfunctioning market. The Times recently reported that between 2019 and 2022 a net £24.6 billion was invested, while 2023 was the first year where outflows exceeded inflows.[5] Around £4.38 billion was moved from ESG funds into investments perceived to be lower risk such as money market funds, these funds representing more withdrawals than in the previous eight years combined.[6] Again, however, this shift can well be seen as a reflection of investors’ outlook on markets generally, rather than a cooling of interest in ESG.
Beyond the state of the global economy, there are other factors at play. Outflows have primarily come from US investors, while European flows into ESG have held steady. In the US, particularly in “red states” where many large fund managers are based, anti-ESG sentiment and a political backlash has impacted appetite for ESG exposure. Indeed, by the end of 2023, 18 states had introduced some form of legislation banning or limiting the consideration of ESG as an investment criteria.[7] This led Larry Fink, CEO of BlackRock, the world’s largest fund manager, to decide to restrict use of the term ESG as it has become “weaponsied”.[8] Other asset managers such as Abrdn, Morgan Stanley and UBS are dropping “ESG” and “sustainability” labels from some fund names. As a result of the evolving ESG regulations, UBS disclosed that they had renamed two US sustainable money market funds.[9]
Looking beyond the turbulence of 2023, more than $30 trillion (£23.6 trillion) of the world’s long-term savings are reported to be invested with ESG objectives.[10] The overall momentum towards investment in the ESG and impact asset class remains very strong, especially in Europe. In the past five years private investors have become more attuned to investing with ESG considerations, and the increasing global focus on the importance of sustainability means that investment with ESG and impact objectives is likely to maintain its momentum through economic and political cycles.
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Mike Preston is a Partner Cleary Gottlieb in London
Christy O’Connell is Counsel at Cleary Gottlieb in London
Sources:
- [1] https://www.ft.com/content/6656d077-7e9f-4f5a-b753-3c91379194d8
- [2] https://www.thetimes.co.uk/article/investors-pull-2bn-from-green-and-social-funds-5ht6jjcw2
- [3] https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/13961-Report-on-the-Sustainable-Finance-Disclosure-Regulation/public-consultation_en
- [4] https://citywire.com/selector/news/european-commission-weighs-up-future-of-article-8-and-9/a2425986
- [5] https://www.thetimes.co.uk/article/can-esg-adapt-to-a-changing-business-environment-zbcfb70cd
- [6] https://www.thetimes.co.uk/article/investors-pull-2bn-from-green-and-social-funds-5ht6jjcw2
- [7] https://www.ft.com/content/a76c7feb-7fa5-43d6-8e20-b4e4967991e7
- [8] https://www.thetimes.co.uk/article/blackrocks-larry-fink-stops-using-weaponised-term-esg-dkjtppc9r
- [9] https://www.ft.com/content/6656d077-7e9f-4f5a-b753-3c91379194d8
- [10] https://www.thetimes.co.uk/article/can-esg-adapt-to-a-changing-business-environment-zbcfb70cd
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