The financial world will be watching the COP26 meeting in Scotland later this month as global institutional investors continue to struggle to pinpoint which alternative investments provide the greatest impact when it comes to ESG.
Patrick Ghali, co-founder of global alternative investment advisory firm Sussex Partners, has been closely reviewing managers and strategies as both GPs and LPs are left grappling for ways to show ESG compliance in a world where standards are completely lacking.
“We find those strategies most compelling where the managers can succinctly and clearly demonstrate to us the impact that they are achieving and how they measure this,” Ghali said in a recent interview. “We prefer managers that focus on a specific niche, and where there is real and demonstrable expertise with regard to this niche, including a strong advisory board of industry experts and perhaps even academics.”
Earlier this month, PwC Luxembourg issued a report predicting that European private market ESG assets will soar in the coming years accounting for 27.2% to 42.4% of the entire private capital industry’s asset base. The market in ESG assets in the region is expected to exceed €1.2 trillion ($1.4 trillion) by the end of 2025, officials predict. PwC surveyed 200 general partners and 200 limited partners representing €46 trillion in global AUM.
Consulting firm Verus in its recent research found that private equity funds have always focused on governance risk, but increasingly are growing aware that environmental, social and governance issues are highly interrelated and that the biggest benefits over time are to companies that balance efforts between all three.
Despite the pandemic, ESG‐committed fundraising remains strong, led by private credit and buyout strategies, according to Verus. A key driver in this trend has been firmwide ESG commitments by the largest alternatives managers.
“There is a massive amount of money earmarked by both governmental and private investors that go into ESG and SDG investments, and this is clearly a new mega trend,” said Ghali. “It is therefore clear that this will open up significant opportunities for years to come, but investors have to make sure that the managers they pick are really able to deliver on the promised impact, and really understand the challenges and opportunities this entails.”
Still, many limited partners are still left wondering if the ESG label is meaningful. In Ghali’s view, the measurement of ESG impact needs to be transparent on the part of the manager and not superficial. A clear focus and demonstrable expertise are crucial.
Within private equity, for instance, he finds that a team of investors with a “deep” industry network and the ability to create a network of like-minded investors are most likely to attract assets. Often such investments relate to new technologies, such as new alternative energy sources.
He used the example of funds focused on hydrogen where the partners have an industry background and an understanding of the issues faced by end users and in turn have been able to attract investors looking for similar solutions.
Another strategy is focused on carbon credits. With fewer players than in this space, there is a clear growth trajectory, according to Ghali, and a potentially strong alternative return stream.
And while solutions related to hydrogen or carbon credits seem to be easy to label as ESG-friendly, there is much more work to be done as investors still are not able to rely on basic screening tools or indices for benchmarking purposes. Ghali suggested that investors ask managers for an impact report that includes the basis on which impact assessments have been made and measured.
“Some investment managers are now offering to make their compensation partially subject to their hitting specific impact goals,” he added. “Of course, it is important to understand how these goals will be measured but this is another great way to ensure alignment and avoid greenwashing.”
Investors would be wise to solicit advisors, in Ghali’s opinion. While such firms are not able to source investment ideas, they can make sure the measurement and reporting sides are robust and that any unintended effects and consequences are properly assessed.
