Can private equity make an impact?

Written By: Stephen Hearle Co-Head of Institutional & Wholesale Distribution Nordea Asset Management UK

Stephen Hearle of Nordea Asset Management IK looks at how private equity impact investing can make both attractive returns and a positive contribution towards a sustainable future

The simple answer to this question is yes. In fact, private equity is ideally positioned to create impact, given the close relationships the general partners have with the companies they invest in (e.g. seats on the board). Just as any private equity partner expects to help management achieve their financial targets, a private equity impact partner also expects to work with management on their ESG objectives. They can do this because the two goals are not separate, but dependent on one another. Very often, the best financial returns will be achieved through success in meeting the company’s ESG targets. How does this work? Let’s take a look at impact investing first.

What is impact investing?
Impact investing has evolved from the philanthropic movement (the term was coined by the Rockefeller foundation): investments are made with the intention to generate positive, measurable social and environmental impact while at the same time targeting a financial return.

Key characteristics of impact investing
Intentionality
Impact investors aim to make measurable social or environmental benefits, starting from their baseline assessment of potential investments. The positive impact is as important as the financial return and the two investment goals are very closely intertwined, from the entry point through to the exit.

Return expectations
Impact investors do expect a financial return for their investment. The Global Impact Investing Network’s (GIIN’s) 2019 Annual Impact Investor Survey shows that two-thirds of impact investors expect risk-adjusted, market rate returns. In addition, impact funds targeting market-rate returns have amassed $71 billion in AUM in private markets alone (according to the International Finance Corporation). It is not unreasonable, in fact, to believe that the returns generated by these funds are directly related to the impact benefits they bring. A recent article published in Institutional Investor by Michael E. Porter, George Serafeim and Mark Kramer on October 12, 2019 refers to data indicating that a basket of companies which delivered profit-driven social impact outperformed the market between 2015-2017.

Impact measurement
Measurement is a critical part of impact investing to ensure transparency and accountability. There are, however, challenges measuring social or environmental impacts; market participants have not yet defined a clear framework for standardised impact reporting. We therefore see this as an evolving field, including dependencies to the data reported by companies themselves.

Measurement needs an assessment framework
Finance-first investors have clear expectations regarding key financial data from their investments. In the absence of normative standards, it has been more difficult for investors to identify social or environmental goals and targets for their investments.

As a result, investors across asset classes have benefited greatly from the establishment of the United Nations’ Sustainable Development Goals (SDGs) in 2015. The UN SDGs are a collection of 17 global goals set by the United Nations that aim to tackle global challenges such as poverty, inequality, climate, health and prosperity – to name a few – by 2030. The adoption of SDGs not only by governments and non-profits but also by financial institutions has opened a new avenue for sustainable investing. The SDGs provide a high-level framework to assess impact opportunities and materiality. For private equity impact investors, who establish specific ESG goals for their investments, the SDGs offer a particularly useful starting point.

Impact investing in private equity
Impact investing has historically been focused in non-public markets and funded by investors such as microfinance, private equity and government investors. Within the range of financial return expectations, private equity owners are most likely to look for a market spectrum risk-adjusted return. But how do they achieve a strong social or environmental benefit at the same time?

As with all impact investing, the private equity impact investors make not only a financial assessment of potential investment opportunities, but also an impact assessment. The first step in this is to establish their own impact framework, whether it be based on the UN’s SDGs or some other set of sustainability criteria. Using this framework, the investors can identify the specific impact they expect to deliver through a given investment. At the same time, they can establish the metrics by which they will later assess their success.

The next step the investors might consider is how they will help the portfolio company to meet these goals. In private equity, knowledge transfer is often one way the investor contributes. Often drawing upon an expert network, the private equity investors may work with the portfolio company to develop an integrated roadmap. This will of course include due diligence around the baseline contributions to the relevant goals, target contributions to these goals, and milestones to be met along the way. A private equity investor has a unique ability to work closely with the management to develop and execute these plans, and the opportunity to aid the management as they work towards their goals.

In this way, ESG and impact management are fully compatible with the financial goals, they are integrated into the investment process, and the measurement framework is established. A true private equity impact investor will measure the impact of every investment. The measurement at entry and exit are key, but by working closely step by step with management and identifying KPIs to measure the milestones, the private equity investor is well-positioned to ensure its investments are on-track to meet their targets – both financial and impact ones.

Juggling the skill sets
Being a private equity impact general partner is first and foremost being a private equity general partner. It goes without saying that the skill set required is the same as any private equity professional requires. However, with the ESG and impact components so deeply integrated into the investment process, this alone is not enough: a successful private equity impact team also needs Responsible Investment (RI) expertise. This is most likely to come in the form of a large, dedicated and experienced Responsible Investment team that is able to conduct its own proprietary ESG analysis and to integrate this analysis into the overall metrics of a company. Managing the twin aspects of private equity impact investing needs both sides of the equation (financial and sustainability-related) to be strong.

The market is demonstrating strong interest in illiquid asset classes that can deliver attractive returns, in particular in the private equity space. At the same time, investors’ concerns around sustainability issues are growing. Private equity impact investing can be a powerful way to make both attractive returns and a real impact as the world moves towards a sustainable future.

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