Navigating the evolving landscape of impact investing

Written By: Laure Villepelet Head of ESG/CSR Tikehau Capital

Laure Villepelet of Tikehau Capital emphasises the importance of asset managers in shaping investors’ approaches to impact investment in developed markets

The non-profit Global Impact Investing Network (GIIN) defines impact investing as “investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return”. Initially focused on social enterprise and emerging markets (microfinance, sanitation, access to energy), impact investing is now also widespread in developed markets, which is supporting a faster increase in impact assets under management. According to the GIIN, aggregate impact AUM increased from $502 billion in 2019 to $715 billion in 2020. The Phenix Capital “Impact Fund Universe” report of January 2021 focused on a subset of impact investments¹ and found that in 2020 impact funds primarily targeted developed markets, specifically Western Europe (42%) and North America (24%).

Looking at the target company universe, we see that at least three approaches have emerged for impact investing in developed markets:

• Investing in “pure players” i.e. companies focusing on products and services generating positive environmental and/or social externalities (e.g. renewable energy, education, healthcare, etc.)
• Investing in companies committed to the transition towards more sustainable models, either at the levels of their offer of products and services and/or at the level of their operations (e.g. enhance the energy efficiency offer of a building renovation company, invest in a digital company with the aim to improve diversity, etc.)
• Combining the above two approaches.

We believe the latter is the most effective approach to deliver the required transition of our entire economic system. The role of asset management is critical in making this shift, as we are responsible on behalf of our clients to direct their savings and investments to companies through our strategies.

Impact investments target a range of asset classes and returns depending on investors’ strategic goals. Combining competitive financial returns and positive environmental or social externalities is possible and we believe that asset managers have a role to play in institutionalising impact to tackle pressing challenges of our globalised economic system.

Pressing environmental challenges will institutionalise impact investing
The Coronavirus crisis has revealed the fragility of our economic system and its lack of resilience. It has also shone a light on the climate emergency and biodiversity collapse. In many regions, warming has already surpassed 1.5 degrees Celsius above pre-industrial levels. To avoid radical transitions and dramatic social costs, the Intergovernmental Panel on Climate Change (IPCC) indicates that emissions need to reach a tipping point no later than in 2030.

So we only have 3,000 days to unwind 50 years of unsustainable growth and return to 1970 emissions rates. This does not mean that we advocate a shrinking economy, it means that we should take coordinated action to accelerate the transition.

In its “Net Zero by 2050” report, the International Energy Agency (IEA) identifies a pathway to reach net zero through a radical transformation of the global energy system. Fortunately, most of the technologies needed to achieve the necessary deep cuts in global emissions by 2030 already exist and the global investment efforts needed represent $5 trillion per annum by 2030 or approximately 3% of the global AUM².

Despite all the claims, the financial system is clearly not yet doing enough. As an asset manager, we have the responsibility to both launch funds dedicated to fighting climate change and biodiversity collapse, and to engage across our mainstream portfolios to ensure support for the real economy to transition.

Building blocks for an integrated impact approach
A key pillar of any impact process should be demonstrating intentionality. The aim is to reconcile strong financial performance with a response to global and societal challenges such as the climate emergency. Scientific reports are already providing guidance on investment priorities. For example, a recent report from the International Energy Agency (IEA) identifies priority investments for the energy transition in energy efficiency in industry and buildings, renewables and low carbon transport.

The second pillar of this process is additionality. This means that instead of waiting for non-financial outcomes linked to pure players’ investments to unfold, support should be provided to scale up a given solution or approach.

The use of ESG ratchets in unitranche and corporate lending financings is a good example of this, whereby interest rate margins of credits can be adjusted based on the achievement of ESG targets. A deal team could typically negotiate three to five relevant ESG criteria and related ambitious targets with the company and/or the company’s equity sponsor. If annual targets are met, borrowers are rewarded with a marginal reduction of the interest rate ranging from -5 to -25 basis points depending on the ambition of the roadmap. Eventually, the proposed mechanism could also provide for a marginal upward adjustment in the event that targets are not met.

We believe that it is the role of an active investor to act as a sparring partner to accelerate positive change by negotiating relevant and ambitious ESG targets.

The third key concept of an impact approach should be impact measurement. In addition to monitoring financial performance, impact measurement contributes to transparency for investors regarding the companies under consideration. In terms of investments, impact measurement helps to provide a steering tool to encourage companies to take action and at fund level it helps provide a clear and actionable view of the investment thesis.

Investors now expect transparent reporting with detailed methodologies and sources to demonstrate progress clearly to stakeholders. The lack of consistent impact data should not be a barrier to increasing the reach of impact investing. Audit from external counsel is also important to provide stakeholders with an impartial and technical view on the impact achieved by the portfolio company but also to objectively assess the level of engagement of the asset manager.

Finally, the importance of alignment of interest cannot be underestimated. For us, alignment of interests signifies belief in impact investing and that it is the key to lasting success.

Disclaimer
This document is for Professional clients only and is provided on a confidential basis. Any investment product referred to in this document is only available to such clients. The communication of any document or information concerning the investment funds managed by Tikehau Investment Management and/or its affiliates (“Tikehau Capital”) may be restricted in certain jurisdictions. This document is for information purposes only.

1. Phenix Capital Impact Fund Universe Report, January 2021. Study based on 1,600 institutional impact funds managing €331 billion

2. PwC AWM Research Centre Analysis, IEA 2021