Future Returns: Private Funds Focused on ESG are Facing Transparency Push

This focus on ESG factors is making it necessary for private-market managers to provide non-financial information such as greenhouse gas emissions or board diversity so investors feel they understand “the full depth and breadth of an investment when making a decision,” Bouchard says. 

Preqin published a report late last month titled “ESG in Alternatives 2022: The Transparency Tipping Point,” which found that ESG is growing as an investment strategy, as is the push for transparency. According to the report, 42% of private market assets under management are in funds with an active ESG policy. 

Penta recently spoke with Bouchard and Andrea Ramirez, Preqin’s head of ESG client strategy, about the report and efforts by investors and regulators to better understand exactly what these funds invest in. 

ESG’s Growing Share 

A survey conducted by Preqin last November found that 72% of investors believe fund managers adopt ESG policies because investors demand it, more so than because of regulatory requirements, moral imperatives, or fiduciary duties, among other factors. 

As a result, assets in funds with ESG policies are on the rise. As of last fall, 42% of assets under management, or US$4.37 trillion, were in private market funds “committed to ESG investing,” Preqin said. A year earlier, the firm estimated 36% or US$3.1 trillion was committed to ESG through private markets. 

The greatest share of these assets today (US$2.26 trillion) are in private-equity and venture-capital funds, but given the size of these sectors, ESG-oriented vehicles represent only 34% of these funds. ESG-oriented vehicles, however, represent 64% of assets in private infrastructure funds, or US$610 billion, and 59% of assets in private-debt funds, or US$730 billion.

While on the rise, ESG is still relatively new to private markets compared to public markets, and fund managers are still developing expertise and figuring out how to assess environmental, social, and governance data. It can be particularly complex with private companies that in some cases are very small (how can employee diversity be assessed when there are only two employees, for instance?) or when a private fund only owns a small share of that company. 

“It’s a learning curve,” Ramirez says. Firms that have been exposed to ESG reporting requirements and standards in the public markets have a leg up, while others are just in the initial stages of learning. Especially for smaller funds, getting up to speed can be a big investment. “They are double-hatting and probably learning along the way as we even define what is ESG in these markets,” Bouchard says. 

A Range of Impact

The biggest category of ESG funds currently are impact funds, with 129 in North America that have raised and targeted US$26.5 billion, Preqin said in its report. Europe has 82 impact funds with US$19.5 billion in capital raised and targeted, Preqin said. 

Europe also has 44 ESG funds, with US$21.4 billion in capital, and 25 funds targeted to what is known as “article 8” of the European Union’s Sustainability Financial Disclosure Regulation, or SFDR, which is designed to boost transparency. Article 8 refers to funds that promote ESG characteristics.

For managers of these funds, the issue is determining what key performance indicators to follow to meet an ever evolving set of standards. But getting this step right is essential. “Unless there are clear and well-defined standards and definitions, assessing the quality and integrity of ESG commitments will remain a challenge,” the Preqin report said. 

Grassroots Efforts and Regulation

Industry groups are helping private funds navigate what is a new world for some. A corporate reporting reference group formed through the Principles for Responsible Investment network of the United Nations, for instance, is setting global and regional standards and interpreting disclosure requirements in the U.S., EU, and globally, via the International Sustainability Standards Board of the London-based IFRS Foundation. 

Also, the U.S.-based Institutional Limited Partners Association, or ILPA, a trade association for investors in private funds, has come up with a grassroots framework of ESG reporting metrics that Preqin said is specific to private markets. In its initial stages, the project has focused on six performance indicators that they can all agree on related to greenhouse gas emissions, renewable energy, board diversity, work-related injustices, net new hires, and employee engagement, the report said. 

Preqin calls this effort “quality over quantity.”

In the U.S., the SEC has proposed climate-related disclosures that all public companies would need to provide. Private companies that supply goods and services to public companies would also need to disclose their emissions for the benefits of these customers. 

This past spring, the SEC has proposed a rule requiring both public and private funds to label their ESG strategies more clearly and to disclose how they are meeting them, rules with a similar purpose to the EU’s sustainability financial disclosures. 

Funds that consider ESG as factors in their investment decisions can be considered “ESG integrated,” while funds using ESG as a main driver in selecting investments are considered “ESG focused,” Ramirez says. Funds that aim to create a specific positive environmental or social impact are considered “impact funds.” 

The rules also will require funds that suggest a specific focus to invest 80% of assets according to that strategy. 

Such standardization, if approved, could help ESG investing evolve in both the public and private markets.