Thinking beyond profit, investors make ESG a priority

December 13, 2023
This post is part of our 2023 Market Trends Report. Download the full report for more insights into how GPs are navigating the new GP-LP dynamics.

Environmental, social, and governance (ESG) factors are increasingly influencing private capital markets, spurred on in part by the growing demand from investors. If recent trends continue, firms that embed ESG into their investment strategy as well as their firm-level operations could have access to new types of capital.

A majority of GPs report ESG as being a higher priority for investors than 12 months ago

Despite continuing to be politicized, over 7 in 10 (73%) fund managers and GPs say investors see ESG as a higher priority in their fundraising efforts now than 12 months ago, with over a quarter (27%) saying it’s a much higher priority.

“GPs are definitely getting pressure from their stakeholders,” says Tamara Close, Founder and Managing Partner of Close Group Consulting, a specialty firm that focuses on ESG Integration strategies for asset managers, general partners, asset owners and corporations. “[LPs] are looking at their portfolios now and performing deeper risk analysis around long-term capital market assumptions, and looking at systemic issues—climate change being a big one—that are hitting every single one of their asset classes.” 

ESG isn’t a synonym for Impact investing

ESG criteria have evolved from the industry’s simplistic early days of “socially responsible” investing. Funds would just promise not to own stocks of tobacco companies, gun makers, or other companies seen as distasteful.

“ESG integration or sustainable investing is still focused on financial returns, and also ensuring you're investing in companies with good corporate governance and sustainable business models,” says Tamara. “Compare this to impact investing, which is putting something besides financial returns as a priority.”

This foundational misunderstanding of the difference between ESG and Impact investing could be why ESG is still a political hot button. Asset owners surveyed by Morningstar think about financial relevance before politics. They see themselves as fiduciaries first and are adamant that ESG considerations are a material part of the investment process despite whatever political pressure comes into play. 

Critics say ESG investments allocate money based on political agendas, such as a drive against climate change, rather than on earning the best returns for savers. They say ESG is mostly virtue signaling and rarely involves follow-through on the actions stated or implied by ESG practitioners. Importantly, regulators are working to ensure that sustainability-related claims of financial products are substantiated.

ESG risks themselves are not inherently political. Consider data privacy and security, which are key ESG risks: It would be difficult to plot these on the political spectrum. And while diversity and inclusion are occasionally controversial, any discrimination or harassment lawsuits would be not only expensive but also bad for business.

The ESG industry, meanwhile, says it helps highlight companies that may be riskier than traditional investing guidelines alone might suggest. That could lead to more stable, safer returns for investors. It also says using an ESG lens could help investors find better, more profitable opportunities.

Institutional investors—such as Cal State Teachers’ Retirement System, State of Wisconsin Investment Board, and Massachusetts Pension Reserves Investment Management—now consider climate change and carbon emissions as their leading ESG criteria, along with the restriction of investments in companies doing business with conflict risk countries, board issues, sustainable natural resources and agriculture and exclusions on tobacco. Board issues are among the top governance criteria identified, which includes the consideration of the directors’ independence, diversity, pay and responsiveness to shareholders, according to US SIF.

Investors who prioritize ESG are growing in number, and AUM. Funds are following suit

As a group, investors who use one or more ESG criteria controlled $8.4 trillion in US-domiciled assets in 2022, according to a recent count by US SIF. Public funds represented both the largest value of ESG AUM and the greatest number of institutional investors incorporating ESG in their investments, with 497 institutional investors applying ESG incorporation practices across $6.6 trillion in AUM.

More LPs are asking GPs to integrate ESG throughout both their fund strategy and at the firm level, and asset managers develop new funds in response to investor demand and market opportunity. The steady stream of new ESG fund launches—and conversion of traditional funds that have changed their investment strategies—indicates that managers have experienced the increase in demand and are testing what it might mean for their fund strategy.

“It’s evolved exponentially,” says Tamara. “Six years ago I would speak with a GP about this, the response was, ‘why do I need to do this?’ and now the narrative has changed to, ‘how do I do this?’ It's also much more integrated within the investment strategy than ever before, and less of a standalone strategy.”

Materiality considerations are key to ESG strategy

“The most important thing is to consider what’s material to investments,” says Tamara. “We look at the fund exposures, the industries, portfolio companies, holdings, depending on the asset class, and find the most financially material ESG issues for each of these holdings and how it fits into the business model. It could be social issues, water issues, or on the environmental side, climate issues are now in almost every industry.”

ESG priorities differ by company and industry, and there’s generally a trade-off. In some industries, the impacts of ESG issues are direct and well known: regulation has meant that there is a long history of tracking them, with more metrics available. Other issues may be less quantified, either because they’ve emerged more recently and appropriate metrics haven’t yet been standardized or implemented, or because the impacts are indirect or intangible, and are therefore harder to quantify. In any case, it’s important to take a holistic view and understand the complexities of ESG due diligence.

“Tesla is a common example,” says Tamara. “They produce electric vehicles, therefore they’ll score well according to one ESG data provider and be considered a sustainable company, versus another provider that will look at internal governance processes and human capital issues and score them low. So is Tesla sustainable or not sustainable? It depends how you look at sustainability.”

If ESG is to be a part of your fund strategy, relentless incrementalism is key

For GPs wanting to focus on their ESG strategy, Tamara’s advice is not to wait. “We're seeing a widening gap between the leaders—the GPs that have been working on this for a few years and have created a robust process and foundation to do this type of analysis—and the rest of the industry,” she says. “It's moving so quickly and it takes a lot of time. This is not something you do in a couple of weeks, you can't just hire one person and you're covered. If you truly want to integrate ESG you need to build a team to integrate the way you think about investments, how you analyze and do due diligence on investments, how you calculate risk, how you follow the portfolio companies over the holding period, and how you look at exit. It's across the whole deal lifecycle.”

“You can start off slowly and have a roadmap,” Tamara continues. “You don't have to do everything at once, just continuously start to integrate new things with relentless incrementalism because the industry drivers are constantly evolving. Two or three years ago, people weren't talking about climate change or biodiversity as much as they are now. You need to have a good foundation to be able to leverage those changes.”

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