ESG investing is showing growth and promises resilience in a challenging macroenvironment
ESG has become a major consideration in PE worldwide. Beyond dedicated funds and deals, its influence can be seen across the investment lifecycle, from fundraising and asset selection to value creation and exit. Most funds now consider ESG risk factors in due diligence, and increasingly, ESG is seen as a competitive differentiator and driver of returns.
ESG investing is transforming the industrial sector as investors look to align their investments with their values and place their bets on companies with potential for long-term sustainability and profitability. PE and VC investors are especially well positioned to address ESG concerns within industrial companies, which are under intense scrutiny for their environmental and social impact.
In 2022, about 89% of investors globally factored ESG into their investment approach. ESG fund assets reached about $2.5 trillion at the end of 2022, rising nearly 12% in a single quarter – almost double the growth of the broader global fund market. European investors are leading the way.
Companies with strong ESG records are considered essential to portfolio resilience. Evidence suggests they perform better over the long term, and some LPs consider impact a “safe-haven” attribute: On one hand, sustainability gives portfolio companies a competitive advantage, and on the other, such business are future-proofed in terms of regulation and consumer demand.
"We are at the beginning of an ESG 2.0 phase. Correlations between ESG scores and shareholder value reveal mixed results, and the unbridled rush to net zero has contributed to geopolitical instability and overcommitments to unsustainable technology long-term. We are seeing more sober, pragmatic deals around green technologies – many of them in clean innovations related to legacy energy – and a flight to quality over press releases on people and governance."
Stratospheric growth in climate investing is set to continue, especially in industrials
The global volume of private market transactions in energy transition and other climate-related assets rose sharply between 2019 and 2022, from $75 billion to $196 billion, according to PitchBook data. In 2021, investment shot up nearly 90% from 2020. The focus is on the industrial sector: Power is the top recipient, followed by transportation.
Climate-related private investment far surpassed the broader market in 2022 by deal activity, deployed capital, and capital flows into dedicated funds. Energy transition is a key driver, along with technological innovation and greater focus on the impact of investments beyond profits, especially amongst younger investors.
In Asia-Pacific, the rise in ESG as an investment priority for PE is clear: Investments in utilities and renewables made up 60% of deal value in the energy and natural resources sector. Interest in renewable energy companies is especially strong, with many GPs planning to significantly increase their focus on ESG in the next three to five years.
PE and VC firms, many of which are sitting on an abundance of dry powder, can seize the day by investing in cleantech platforms, clean infrastructure, transmission and distribution technologies, and other assets needed to support utility-scale clean energy.
Governments are moving the needle through legislation and regulation. The EU’s Green Deal (2019), Fit for 55 (2021) and RePowerEU (2022) programs raised targets for emission reductions. Now the Green Deal Industrial Plan of 2023 aims to keep Europe competitive in clean tech.
Government action is also generating major capital infusions. The EU Green Deal and America’s 2022 Inflation Reduction Act both commit billions in funding to mitigate climate change. Europe’s contribution could exceed €1 trillion in public and private funds.
"ESG today is a real and concrete concern, close to the hearts of all stakeholders across investors, clients, suppliers, regulators, employers and employees – and as soon as Gen Z become the new business leaders, ESG will become even more paramount. There is no way back."
The environment remains on top, but LP interest in the social component is mounting
LPs are increasingly recognising the connection between the “S” in ESG and the long-term prospects of portfolio companies, which will suffer if they fail to treat employees and customers fairly, use reputable suppliers throughout their supply chains, and avoid negative impacts on the communities in which they operate.
LPs are also being more selective about investing in companies and funds that prioritize diversity, equity, and inclusion (DEI) in their operations and decision-making processes. Gender diversity has become particularly relevant in private equity and venture capital with the awareness that “gender-smart investing” can both create value and mitigate risk.
In industrial companies, there is significant room for improvement. For example, only one in five leadership roles in the energy sector are held by women, according to the World Economic Forum’s Global Gender Gap Report 2022. PE firms are in a unique position to enact change and reap the rewards.
PE firms that have integrated gender diversity into their organisations have seen valuable outcomes in terms of attracting diverse portfolio companies and unlocking their potential, as well as improving internal processes and making more balanced investment decisions.
"With the right investors and talent, the 21st century could trigger the economy because of everything that needs to be addressed in society. We are seeing more startups and more companies willing to focus on social impact. Diversity, in every way, is essential to innovate, gather new visions, solutions and new perspective to better understand the changes occurring in society, and where the investment are needed. There is a huge opportunity to promote new technological advances and tools for society. The more diversity and vision of the complexity of the markets a company has, the better understanding it will have about the current world and the better it will be able to reach the required levels of resilience and results."
Accountability, transparency and corporate responsibility are the holy trinity of governance
Along with increased emphasis on ESG considerations comes a growing demand for proof. A global survey of LPs by Bain & Company and the Institutional Limited Partners Association identified transparency as a key area of focus, with LPs seeking more reporting on ESG data points. Most GPs struggle to provide it, but the market is developing ways to measure impact and compliance.
A recent survey from Coller Capital revealed that nearly three-quarters of LPs would consider eliminating a manager from consideration if it could not provide acceptable ESG-related disclosures. Transparency on sustainability is especially important in the industrial sector. Companies that have clearly defined greenhouse gas reduction goals – and disclose their progress towards these goals – are valued twice as high on average as those that do not.
LPs are increasingly incorporating governance considerations into their investment strategies and decision-making processes. This can take the form of conducting governance audits of potential targets and prioritizing companies with strong governance. As investors seek to promote greater transparency and accountability, the emphasis on issues such as board diversity, executive compensation and shareholder rights is growing.
"Private equity players are facing broader and a significantly higher focus from their stakeholders and investors on ESG goals – and the ability to proof progress in their portfolio companies. Transparency in a goal-driven and progress proof approach becomes increasingly important, yet the good news is that progress creates more attractive companies for employees, stakeholders, value creation etc., and have the potential to earn a premium at exit."