ESG as a key driver of private markets investments

There’s no denying the rapid rise and exponential growth of ESG-related investments across private markets. The sector has even outpaced private equity deal activity, with 16% growth per annum versus 12%. Yet, as outlined in McKinsey’s Global Private Markets Review 2022, the ongoing evolution of impact investments in private markets will require a strong commitment to formalising ESG principles.

Taking ESG seriously – the rise of metrics and reporting

In past years, ESG has been criticised for the lack of consistent metrics and performance indicators that can demonstrate tangible positive outputs. In our latest impact investing roundtable, this sentiment was also reiterated, with the general consensus being that “you can only define yourself as an impact investor if you have some form of measurement to support your decisions.” 

Although members of the roundtable agreed that measuring how investors’ capital links to positive change may not always be possible, participants agreed this was not a sustainable long-term perspective and there would soon come a time when investors would start to insist on measurable outputs as an essential requirement.

The launch of the ESG Data Convergence Project indicates that this time is now fast approaching, as GPs and LPs unite with the goal of standardising ESG metrics and reporting. The benefits of having such metrics in place are clear; McKinsey’s research highlighted that:

• funds with explicit ESG metrics doubled in the last five years alone;
• the average fund size of firms with explicit ESG policies is $1.1 billion compared to $0.3 billion for those without 

This growing commitment to formalising ESG principles is also reflected in the new regulatory requirements introduced in Europe, and the introduction of UN-supported principles around responsible investment.

The five stages of a firm’s ESG evolution

According to McKinsey, financial institutions progress through five key stages when actioning ESG. 

• Acknowledging that ESG matters

This step follows from ‘step 0’, where no attention is given to ESG. At this stage, most firms recognise that ESG is important and they provide a public declaration of adherence, such as signing the PRI (Principles for Responsible Investment).

• Tracking ESG

Firms track, measure and report on ESG factors in their portfolio companies and potential target companies that reflect their goals.

• Setting targets

ESG targets for portfolios are established and firms develop a plan of action to meet these.

• Investing on an ESG basis

ESG is integrated into a firm’s investment process and decision making. The process enables firms to make better investment decisions, capture value-creation opportunities and control risk.

• Transforming companies

Investors can influence and help companies to improve on ESG for capturing value-creation opportunities. Emerging data suggests there is a positive correlation between a company’s ESG performance and shareholder returns.

Unfortunately, the ESG journey is a slow process. As highlighted by McKinsey, only a small proportion of firms go beyond Stage 4 and only 15% have their own investment policies which take ESG into consideration. 

Gareth Lewis, chief executive of Delio, said that changing investor preferences are forcing institutions to adapt the way they position themselves in the market:

“We are seeing an increased amount of investors actively investigating and researching a company’s ESG footprint as part of their investment decision making process. As well as deploying their capital more actively to opportunities with clear impact principles, they are also reviewing how their personal values align with those of the financial institutions that manage their wealth.”

The ‘S’ in ESG begins to come into sharper focus

Alongside the increased demand for environmental reporting and metrics, we are beginning to see greater demand for diversity metrics. As the ‘s’ in ESG comes into sharper focus, a large number of institutional investors are beginning to view diversity metrics in GP portfolios as ‘table stakes’ before committing capital. 

The report outlines the progress that private markets firms are making, but highlights there is still work to be done. It is anticipated that the demand for diversity metrics will only continue to rise, with millennials and Gen Z expected to form 75% of the workforce in the next five years. This generation’s interest in ESG means that they will prefer to associate with, purchase from and invest in brands that are socially responsible and attuned to issues such as diversity, equality and inclusion.

With the current climate crisis and social inequalities causing investors to look for solutions, there is no doubt that ESG investing is now an integral element of the private markets landscape. The timely introduction of more consistent frameworks that tangibly measure the impact of these investments means that financial institutions will need to adapt and position themselves accordingly. However, if they can do this successfully, the sector only looks set to go from strength to strength.