ESG: a competitive differentiator and driver of returns for private markets

Environmental, social, and governance (ESG) factors have emerged as an increasingly important global trend in recent years. Private markets haven’t been immune from this agenda; in fact, ESG standards now need to be considered across all stages of the investment lifecycle. 

Not only are ESG investments promoting sustainability and managing risk, but they’re also creating long-term returns for investors. McKinsey’s Global Private Markets Review 2023 states, “the evidence supporting a positive correlation between ESG and financial performance continues to mount, as long as the underlying company is healthy.” Perhaps it’s no surprise then that ESG assets under management (AUM) exceeded $100 billion in 2022, for the first time. 

Based on the potential returns and with more emphasis being placed on the importance of ESG influences, investors are increasingly incorporating ESG metrics into their capital allocation, and financial institutions are having to respond. 

Sustainable investing becomes mainstream

The importance of us living in a more sustainable world is reflected in how capital is being deployed across private markets. This is perhaps most visible in the growing popularity of impact-related funds and investments into sustainability-driven projects. 

Typically, impact funds include an explicit ESG agenda as part of their investment strategy. Despite tough economic conditions, capital continues to be deployed to these vehicles at record levels as more investors place a growing importance on the E of ESG.

Even outside these funds, approximately 40% of total investment into global climate technology was deployed through venture capital strategies, highlighting the importance of private investing in the development of new technologies that will support positive environmental change.

Gender and ethnic diversity

More importance is also being placed on diversity, equity and inclusion (DEI) within the industry. In 2020 and 2021, 50% of firms reported internal diversity statistics during the fundraising process for the first time.

This is predominantly due to an increase in demand for such insights from LPs. McKinsey states that they have a “willingness to allocate twice as much capital to a gender-diverse deal team, and nearly three times more capital to an ethnically or racially diverse deal team, all else being equal.”

Although diversity across the private markets landscape is undoubtedly improving, a lot of work remains to be done in this area. For example, significant gaps remain in representation for women and ethnic and racial minorities across private equity and other alternative investing firms. As the McKinsey report highlights, “only time will tell if LP pressure on GPs will be enough of a catalyst to change the face of private markets.”

ESG isn’t limited to deal activity

It’s important to note that investors don’t just give consideration to ESG within fundraising and deal activity, but throughout the entire investment lifecycle. From fundraising and asset selection, to value creation and exit planning, ESG remains on the minds of investors.

McKinsey explains that a recent survey indicated that nearly three-quarters of LPs would potentially remove a manager from consideration if it was unable to provide acceptable standards of ESG-related disclosures. 

McKinsey highlights five key areas areas in which GPs can improve their ESG activities:

1. Top-line growth: Attract B2B and B2C customers with more sustainable products and achieve better access to resources through stronger community and government relations.
2. Cost reduction: Lower energy consumption and reduce water intake.
3. Regulatory and legal interventions: Achieve greater strategic freedom through deregulation and earn subsidies and government support.
4. Productivity uplift: Boost employee motivation, and attract talent through greater social credibility.
5. Investment and asset optimisation: Enhance investment returns by better allocating capital for the long term, and avoid investments that may not pay off because of longer-term environmental issues.

ESG as a competitive differentiator for firms

With more investors taking ESG into account when deploying capital, offering access to investment opportunities with a strong impact or sustainability theme is becoming an increasingly important driver of competitive advantage among financial institutions. 

In addition to this, firms also need to demonstrate their own commitment to operating in a responsible and ethical manner. The momentum behind ESG shows no signs of abating and is evidently near the top of the agenda for investors. Financial institutions that don’t take this attitudinal shift seriously, risk being perceived as behind the times and, even more importantly, behind their competition.