If you thought that ESG was already top of the private equity agenda, think again. Things are only just getting started. We’ve already seen the tide turn here at Palico in the last year or so, with sustainability strategies and diverse teams becoming a more common sight, especially among European fund managers that list on our marketplace. Investors are also seeking these products out more and more.
Europe is leading the way on these issues, with a forcible regulatory push in motion. The EU’s Sustainable Finance Disclosure Regulation (SFDR), which came into play earlier this year, has been a major catalyst in the asset management industry. But our view has been, and continues to be, that this is only the beginning of a megatrend that spells a vast opportunity for private equity.
Last week we came across some research that not only confirms this, but tells us that the industry may well be underestimating where things are headed. By PwC’s estimate, ESG private capital assets under management (AUM) in Europe will grow from circa €250bn today to more than €775bn by 2025, at a bare minimum. In its best-case scenario, PwC puts this figure at €1.2trn.
To be clear, that is across all private market strategies, including private equity, infrastructure, real estate and private debt. But it’s an astronomical figure, accounting for more than 42% of forecast AUM in only four years’ time. This is quickly looking like a make or break situation.
ESG has often been viewed as a box-ticking exercise, asset managers cowing to regulators. SFDR is the latest requirement but it doesn’t actually oblige PE fund managers to take any action other than transparently report to their investors on the social and environmental impacts portfolio companies are having. There’s nothing stopping them from buying coal plants or gambling business if they wish to do so.
But it is becoming increasingly evident that ESG is about more than appeasing authorities and is in fact a means of creating improved risk-adjusted returns. There is various evidence in the public markets that ESG enhances returns and lowers risks, and for a number of reasons ranging from the lower cost of capital these companies benefit from to revenue and profit growth as their business models align with societal expectations.
PwC finds that investors are seeing this outperformance as a major a reason for seeking out ESG-minded PE funds, too. Their research shows that 35% of LPs see compelling risk-adjusted returns as the main motivation for committing capital to these funds.
We see further confirmation of this from the GP side of the partnership in another report on the state of ESG in the industry, also released this month. Half of the PE fund managers surveyed in this instance say that their ESG approach has already had a net positive impact on returns, including 20% who say the effect has been highly positive. One in ten concede that it it’s too early to tell and a further 10% say the effect has been negative, leaving 30% who are neutral.
Even those who are not seeing a step up in their funds’ TVPIs or IRRs may simply have to wait a while longer before their ESG strategies deliver. Like anything worth doing in life, these fundamental adjustments will take time and effort before they yield results.
GPs may need to establish an ESG team or recruit a sustainability champion to push this agenda and lay down first principles to follow. Firms will also need to embed or improve existing data analytics capabilities to make their vision a reality. There will be a J-curve but, as a long-term, illiquid asset class, the private equity industry is more than accustomed to exercising patience.
GPs should start planting the seeds today by developing sound sustainability strategies. Not only will this be essential for raising funds as ESG AUM rapidly swell, it will also help to deliver alpha, which is ultimately what GPs and their LPs want. It’s an obvious win-win. And first-movers will see the biggest rewards.