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Private Equity International: The ESG revolution rolls on

February 3, 2023

7 min read

This article originally appeared in the February edition of Private Equity International

Dedicated ESG strategies continue to proliferate as mainstream managers adopt best practices to maximise value, say Natasha Buckley, Till Burges and Michael Dean at HarbourVest Partners

Q How would you describe the evolution in ESG focused strategies that you have seen in recent years?

Natasha Buckley: Investors are looking to ESG- and impact-focused strategies to achieve their own objectives, whether that is actively contributing to frameworks such as the UN Sustainable Development Goals or net zero, or for broader objectives related to investor purpose.

Conversations have moved on from whether these strategies are about sacrificing returns, to how investors can most effectively select strategies that meet asset allocation targets alongside specific impact objectives. There are a wealth of solutions in the market that have anticipated these investor preferences and acted accordingly. I believe there is a recognition that private markets are particularly well-positioned to offer more nuanced and targeted solutions for positive impact.

Q What is the delineation between impact and ESG?

Till Burges: The definition of impact involves the intent to deliver positive social or environmental outcomes, as well as the ability to measure that progress. There are also what we call ESG-integrated funds. These are funds that have the tools available to incorporate ESG considerations into investment evaluation or the value-creation phase, but without the intent and emphasis on measurement that defines an impact solution.

Q Are investors looking for impact funds to meet targeted objectives?

NB: We put this question to our clients when we were carrying out research into this area at the end of 2021, asking whether it was necessary for them to achieve their ESG objectives through an impact manager lens. Interestingly, the majority said it wasn’t a dealbreaker for their allocation decisions. 

There are investors that are looking for fund structures that report against predefined environmental and social goals and report against measurable impact – that requires a dedicated strategy and expertise. The biggest evolution we have seen on the supply side has involved the development of impact at scale, with many of the biggest private equity houses establishing dedicated impact teams. Other investors are less concerned about fund processes and are more focused on creating sectoral exposure to high-growth sustainability trends, such as health and wellness.  

Natasha Buckley

Vice President, ESG

Till Burges

Managing Director

Michael Dean

Managing Director

Q What types of ESG and impact strategies are proving particularly popular?

Michael Dean: Historically, the areas that have proved most popular have involved renewable energy power generation involving solar or wind assets. This is a sector that has seen significant growth because of the large capital need, the important role for private markets, and subsidies and incentives from governments that help to de-risk investments. More recently, we have seen growth in newer and more potentially disruptive areas such as battery storage and now hydrogen. In addition, we are seeing an increased focus on energy efficiency, with the decarbonisation of traditional sectors.

Q How are managers differentiating themselves within this broad energy transition space?

TB: On the private equity side, we are seeing a proliferation of strategies touching environmental or social investment themes across the venture capital, growth and buyout industries. The opportunity set is also global. This is a real departure from just a few years ago, where it was very much Europe leading the field. 

Meanwhile, the range of investment themes is enormous. There are buyout managers that are making existing industries more sustainable by removing certain toxic materials, lowering energy consumption and carbon emissions, changing production processes, or tweaking the product offering, for example. There are also managers investing in the renewable energy generation supply chain, targeting software and services solutions. In addition, there are growth and VC managers tackling the next generation of challenges with technologies supporting carbon capture and sustainable farming, for example. 

Against this backdrop, we can put together solutions that fit the ambitions of individual clients and their stakeholders. When it comes to selecting funds, what we are always looking for is a strong investment track record and the ability to showcase access to the types of opportunities that investors have been promised. 

MD: We are increasingly seeing managers hiring operators with industry backgrounds, rather than just financial professionals. Some firms are also seeking to differentiate themselves with their platforms. There are GPs out there that have historically invested in traditional energy infrastructure, for example. The off-takers for renewable energy power purchase agreements are often the same people these firms have been working with for years. They have the relationships and they know how these markets function. There are around 100 dedicated renewable energy infrastructure strategies raising capital today, so differentiation based on the ability to leverage platforms and experience in one market and apply it to another can be compelling.

NB: Fundamentally, managers can differentiate on the ‘E’ of ESG by demonstrating they understand both the risks and opportunities that the energy transition represents. What are they doing to decarbonise now and, more importantly, how are they turning that into a value proposition for investors?

Q What about the ‘S’ in ESG? Are investors focused on socially oriented strategies?

TB: Around 50 percent of the more than 250 impact funds that we are tracking are focused on the ‘E’; a further 25 percent incorporate aspects of both the ‘E’ and the ‘S’; and the final 25 percent are more weighted towards social objectives. When we talk to investors about their sustainability agendas, we often find they are open to investments that target both people and the planet. 

Q How is the regulatory backdrop impacting the evolution of an impact- and ESG-focused ecosystem within private markets?

NB: Regulation has been positioned as an opportunity to promote ESG strategies more appropriately because, of course, greenwashing is a real issue that needs addressing. However, when regulation is introduced without clear, asset-class-specific guidance it creates confusion and a compliance burden, and can have a chilling effect on the market.

There is also an issue with proliferation. Two years into the EU Sustainable Finance Disclosure Regulation regime, the UK Financial Conduct Authority is currently consulting on sustainability investment labels for funds. 

Furthermore, we are also facing proposed amendments by the US Securities and Exchange Commission, which plans to introduce its own ESG categorisation and disclosure requirements. These are all positive developments in themselves. But navigating the different regimes presents a potentially enormous compliance burden. There is therefore a growing call for interoperability between regulatory regimes under globally accepted standards. 

Q How significant a role with ESG-integrated and impact funds play in the broader private markets universe?

TB: The growth of impact funds that has already taken place has been tremendous. In just a few short years, we have already seen more than 250 self-proclaimed impact funds being launched, representing between $70 billion and $80 billion of assets. As the industry continues to mature, producing more exits, sharing more best practices, and creating greater consistency around how KPIs are calculated and communicated, it will continue to go from strength to strength. 

At the same time, private markets asset managers more broadly are increasingly adopting features of impact and ESG investing because they recognise that it ultimately helps to create valuable companies. This is a very encouraging trend for the industry and for society more broadly.

Q How does your due diligence of ESG and impact credentials work in practice and how challenging is it to compare managers in these respects?

NB: Our ESG scorecard evaluates managers based on their ESG programmes, policies, and the integration of ESG into the investment process. We also look at managers’ ability to execute on their ESG commitments, in terms of resource and training, as well as ESG reporting and transparency. That manager evaluation is based on industry standards. We think it is important to have a consistent way of asking questions, while applying a proprietary methodology for analysing responses and generating ratings for GPs.

Our ESG analysis is integrated into broader due diligence materials presented to the investment committee because we view a sophisticated approach to ESG as a proxy for manager excellence. However, it can be challenging to compare portfolio level ESG data without meaningful context or benchmarking. We access that insight through close monitoring of our GPs and through our role on limited partner advisory committees. This allows us to gain an understanding of specific portfolio companies and how they are applying ESG processes.

MD: Within energy and infrastructure in particular, there has been clear progress when it comes to measuring Scope 1 and 2 emissions and emissions avoidance. However, we have not yet reached the point where we can readily come up with a number and rank managers by quartile. There is still an element of applying judgement based on a manager’s processes and how robust those are, and then combining that with the data provided by the GP and data we can generate ourselves.

TB: When it comes to impact managers, meanwhile, there is an additional layer of due diligence that is applied on top of broader ESG. That framework allows us to analyse how an impact strategy is applied in practice, how the firm culture reflects these values and how impact measurement takes place. We seek to identify best practices within impact and then get a sense of where a particular manager sits on that spectrum.

At the same time, private markets asset managers more broadly are increasingly adopting features of impact and ESG investing because they recognise that it ultimately helps to create valuable companies. This is a very encouraging trend for the industry and for society more broadly.

This article was sponsored by HarbourVest Partners for Private Equity International. It is solely for informational purposes and should not be viewed as a current or past recommendation or an offer to sell or the solicitation to buy securities or adopt any investment strategy. The opinions expressed herein represent the current, good faith views of the author(s) at the time of publication, are not definitive investment advice, and should not be relied upon as such. This material has been developed internally and/or obtained from sources believed to be reliable; however, HarbourVest does not guarantee the accuracy, adequacy or completeness of such information. There is no assurance that any events or projections will occur, and outcomes may be significantly different than the opinions shown here. This information, including any projections concerning financial market performance, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.

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Professional Investor Definition

“Professional Investor” under the Securities and Futures Ordinance (Cap. 571 of the Laws of Hong Kong) (the “SFO”) and its subsidiary legislation) means:

(a) any recognised exchange company, recognised clearing house, recognised exchange controller or recognised investor compensation company, or any person authorised to provide automated trading services under section 95(2) of the SFO;

(b) any intermediary, or any other person carrying on the business of the provision of investment services and regulated under the law of any place outside Hong Kong;

(c) any authorized financial institution, or any bank which is not an authorised financial institution but is regulated under the law of any place outside Hong Kong;

(d) any insurer authorized under the Insurance Ordinance (Cap. 41 of the Laws of Hong Kong), or any other person carrying on insurance business and regulated under the law of any place outside Hong Kong;

(e) any scheme which-

(i) is a collective investment scheme authorised under section 104 of the SFO; or

(ii) is similarly constituted under the law of any place outside Hong Kong and, if it is regulated under the law of such place, is permitted to be operated under the law of such place,

or any person by whom any such scheme is operated;

(f) any registered scheme as defined in section 2(1) of the Mandatory Provident Fund Schemes Ordinance (Cap. 485 of the Laws of Hong Kong), or its constituent fund as defined in section 2 of the Mandatory Provident Fund Schemes (General) Regulation (Cap. 485A of the Laws of Hong Kong), or any person who, in relation to any such registered scheme, is an approved trustee or service provider as defined in section 2(1) of that Ordinance or who is an investment manager of any such registered scheme or constituent fund;

(g) any scheme which-

(i) is a registered scheme as defined in section 2(1) of the Occupational Retirement Schemes Ordinance (Cap. 426 of the Laws of Hong Kong); or

(ii) is an offshore scheme as defined in section 2(1) of that Ordinance and, if it is regulated under the law of the place in which it is domiciled, is permitted to be operated under the law of such place,

or any person who, in relation to any such scheme, is an administrator as defined in section 2(1) of that Ordinance;

(h) any government (other than a municipal government authority), any institution which performs the functions of a central bank, or any multilateral agency;

(i) except for the purposes of Schedule 5 to the SFO, any corporation which is-

(i) a wholly owned subsidiary of-

(A) an intermediary, or any other person carrying on the business of the provision of investment services and regulated under the law of any place outside Hong Kong; or

(B) an authorized financial institution, or any bank which is not an authorised financial institution but is regulated under the law of any place outside Hong Kong;

(ii) a holding company which holds all the issued share capital of-

(A) an intermediary, or any other person carrying on the business of the provision of investment services and regulated under the law of any place outside Hong Kong; or

(B) an authorized financial institution, or any bank which is not an authorised financial institution but is regulated under the law of any place outside Hong Kong; or

(iii) any other wholly owned subsidiary of a holding company referred to in subparagraph (ii); or

(j) any person of a class which is prescribed by rules made under section 397 of the SFO for the purposes of this paragraph as within the meaning of this definition for the purposes of the provisions of the SFO, or to the extent that it is prescribed by rules so made as within the meaning of this definition for the purposes of any provision of the SFO.

The first of such classes of additional “professional investor”, under the Securities and Futures (Professional Investor) Rules (Cap. 571D of the Laws of Hong Kong), are:

(k) any trust corporation (registered under Part VIII of the Trustee Ordinance (Cap. 29 of the Laws of Hong Kong) or the equivalent overseas) having been entrusted under the trust or trusts of which it acts as a trustee with total assets of not less than HK$40 million or its equivalent in any foreign currency at the relevant date (see below) or-

(i) as stated in the most recent audited financial statement prepared-

(A) in respect of the trust corporation; and

(B) within 16 months before the relevant date;

(ii) as ascertained by referring to one or more audited financial statements, each being the most recent audited financial statement, prepared-

(A) in respect of the trust or any of the trust; and

(B) within 16 months before the relevant date; or

(iii) as ascertained by referring to one or more custodian (see below) statements issued to the trust corporation-

(A) in respect of the trust or any of the trusts; and

(B) within 12 months before the relevant date;

(l) any individual, either alone or with any of his associates (the spouse or any child) on a joint account, having a portfolio (see below) of not less than HK$8 million or its equivalent in any foreign currency at the relevant date or-

(i) as stated in a certificate issued by an auditor or a certified public accountant of the individual within 12 months before the relevant date; or

(ii)  as ascertained by referring to one or more custodian statements issued to the individual (either alone or with the associate) within 12 months before the relevant date;

(m) any corporation or partnership having-

(i) a portfolio of not less than HK$8 million or its equivalent in any foreign currency; or

(ii) total assets of not less than HK$40 million or its equivalent in any foreign currency, at the relevant date, or as ascertained by referring to-

(iii) the most recent audited financial statement prepared-

(A) in respect of the corporation or partnership (as the case may be); and

(B) within 16 months before the relevant date; or

(iv) one or more custodian statements issued to the corporation or partnership (as the case may be) within 12 months before the relevant date; and

(n) any corporation the sole business of which is to hold investments and which at the relevant date is wholly owned by any one or more of the following persons-

(i) a trust corporation that falls within the description in paragraph (k);

(ii) an individual who, either alone or with any of his or her associates on a joint account, falls within the description in paragraph (k);

(iii) a corporation that falls within the description in paragraph (m);

(iv) a partnership that falls within the description in paragraph (m).

For the purposes of paragraphs (k) to (n) above:

  • “relevant date” means the date on which the advertisement, invitation or document (made in respect of securities or structured products or interests in any collective investment scheme, which is intended to be disposed of only to professional investors), is issued, or possessed for the purposes of issue;
  • “custodian” means (i) a corporation whose principal business is to act as a securities custodian, or (ii) an authorised financial institution under the Banking Ordinance (Cap. 155 of the Laws of Hong Kong); an overseas bank; a corporation licensed under the SFO; or an overseas financial intermediary, whose business includes acting as a custodian; and
  • “portfolio” means a portfolio comprising any of the following (i) securities; (ii) certificates of deposit issued by an authorised financial institution under the Banking Ordinance (Cap, 155 of the Laws of Hong Kong) or an overseas bank; and (iii) except for trust corporations, cash held by a custodian.

Institutional Investor / Accredited Investor Definition

An institutional investor as defined in Section 4A of the SFA and Securities and Futures (Classes of Investors) Regulations 2018 is:

(a) the Singapore Government;

(b) a statutory board as may be prescribed by regulations made under section 341 of the SFA, as prescribed in the Second Schedule of the Securities and Futures (Classes of Investors) Regulations 2018;

(c) an entity that is wholly and beneficially owned, whether directly or indirectly, by a central government of a country and whose principal activity is —

(i) to manage its own funds;

(ii) to manage the funds of the central government of that country (which may include the reserves of that central government and any pension or provident fund of that country); or

(iii) to manage the funds (which may include the reserves of that central government and any pension or provident fund of that country) of another entity that is wholly and beneficially owned, whether directly or indirectly, by the central government of that country;

(d) any entity —

(i) that is wholly and beneficially owned, whether directly or indirectly, by the central government of a country; and

(ii) whose funds are managed by an entity mentioned in sub‑paragraph (c);

(e) a bank that is licensed under the Banking Act 1970;

(f) a merchant bank that is licensed under the Banking Act 1970;

(g) a finance company that is licensed under the Finance Companies Act 1967;

(h) a company or co‑operative society that is licensed under the Insurance Act 1966 to carry on insurance business in Singapore;

(i) a company licensed under the Trust Companies Act 2005;

(j) a holder of a capital markets services licence;

(k) an approved exchange;

(l) a recognised market operator;

(m) an approved clearing house;

(n) a recognised clearing house;

(o) a licensed trade repository;

(p) a licensed foreign trade repository;

(q) an approved holding company;

(r) a Depository as defined in section 81SF of the SFA;

(s) a pension fund, or collective investment scheme, whether constituted in Singapore or elsewhere;

(t) a person (other than an individual) who carries on the business of dealing in bonds with accredited investors or expert investors;

(u) a designated market‑maker as defined in paragraph 1 of the Second Schedule to the Securities and Futures (Licensing and Conduct of Business) Regulations;

(v) a headquarters company or Finance and Treasury Centre which carries on a class of business involving fund management, where such business has been approved as a qualifying service in relation to that headquarters company or Finance and Treasury Centre under section 43D(2)(a) or 43E(2)(a) of the Income Tax Act 1947;

(w) a person who undertakes fund management activity (whether in Singapore or elsewhere) on behalf of not more than 30 qualified investors;

(x) a Service Company (as defined in regulation 2 of the Insurance (Lloyd’s Asia Scheme) Regulations) which carries on business as an agent of a member of Lloyd’s;

(y) a corporation the entire share capital of which is owned by an institutional investor or by persons all of whom are institutional investors;

(z) a partnership (other than a limited liability partnership within the meaning of the Limited Liability Partnerships Act 2005) in which each partner is an institutional investor.

An accredited investor as defined in Section 4A of the SFA and Securities and Futures (Classes of Investors) Regulations 2018 is:

(i)  an individual —

(A) whose net personal assets exceed in value $2 million (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount;

(B) whose financial assets (net of any related liabilities) exceed in value $1 million (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount, where “financial asset” means —

(BA) a deposit as defined in section 4B of the Banking Act 1970;

(BB) an investment product as defined in section 2(1) of the Financial Advisers Act 2001; or

(BC) any other asset as may be prescribed by regulations made under section 341; or

(C) whose income in the preceding 12 months is not less than $300,000 (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount;

(ii)  a corporation with net assets exceeding $10 million in value (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe, in place of the first amount, as determined by —

(A) the most recent audited balance sheet of the corporation; or

(B) where the corporation is not required to prepare audited accounts regularly, a balance sheet of the corporation certified by the corporation as giving a true and fair view of the state of affairs of the corporation as of the date of the balance sheet, which date must be within the preceding 12 months;

(iii) A trustee of a trust which all the beneficiaries are accredited investors; or

(iv) A trustee of a trust which the subject matter exceeds S$10 million; or

(v) An entity (other than a corporation) with net assets exceeding S$10 million (or its equivalent in a foreign currency) in value. “Entity” includes an unincorporated association, a partnership and the government of any state, but does not include a trust; or

(vi) A partnership (other than a limited liability partnership) in which every partner is an accredited investor; or

(vii) A corporation which the entire share capital is owned by one or more persons, all of whom are accredited investors.

Continuation solutions encompass a host of transaction types in which a GP secures interim liquidity and/or additional primary capital for their LPs in a strongly performing asset, or set of assets, that the GP will continue to own and control. Specifically, they include continuation funds, new funds created by GPs for the purpose of acquiring the asset(s) that continue to be managed by the same GP and capitalized by one or several secondary buyers, or equity recapitalizations involving a direct equity or structured equity investment into a portfolio company. These transactions can also include a parallel investment from the GP’s latest fund into that same pool of assets (a “cross-fund trade”).