ESG considerations are influencing capital allocation, investment decisions and portfolio company management.

Private capital, with its emphasis on active ownership and long investment horizon, fits neatly with the trend toward ESG investing. Investors increasingly pay attention to ESG considerations, seeing ESG as a set of tools or framework that can shape strategy, mitigate certain risks and drive value creation.

Strong demand for ESG and impact investing

According to a 2022 Bain survey of approximately 100 global LPs, 70% of investors said their organizations’ investment policies included an ESG approach, underscoring ESG’s role as a mainstream consideration. Developing investment products to meet this investor demand often dovetails with private capital firms’ own ESG goals and their drive to improve portfolio risk and return profiles. Consistent with these drivers, we have observed a growing focus on ESG considerations in investment decision-making, and increased ESG governance and policy requirements applying during the hold period.

PE firms are seeking to help portfolio companies improve ESG performance during hold periods, largely due to the value they acknowledge ESG can often provide on exit. Firms can meaningfully guide portfolio company strategy, and enhancing ESG performance is particularly valuable for IPO exits and attracting public market investors, as well as in any M&A sales to sponsor buyers who too are focused on ESG matters for the reasons described above, as well as to strategic buyers who too have to contend with ESG stakeholder demand, as well as increasing ESG regulation.

Further, notwithstanding the current challenging fundraising environment, we are still seeing high demand for impact investing. LPs continue to recognize the importance of investing in companies and projects that create a positive social and environmental impact alongside financial returns. Following the United Nations Biodiversity Conference, or COP15, in 2022 and in light of frameworks such as the Taskforce on Nature-related Financial Disclosures (TNFD), we also expect that biodiversity and nature will be elevated to the fore of environmental action. Impact investors are likely to focus on these themes and target related opportunities.

Anti-ESG initiatives in the US

While ESG has become a more prominent consideration globally, anti-ESG initiatives in the US may pose potential challenges to private capital investors. The US has witnessed a proliferation of anti-ESG initiatives in recent times, primarily at the state and US Congressional level, creating a complicated patchwork for market actors to navigate. For example, several large GPs publicly listed in the US have disclosed as a risk factor in their most recent annual reports, the anti-ESG backlash among potential risks to financial performance.

Regulatory developments in the US and Europe

The EU’s Sustainable Finance Disclosure Regulation (SFDR) remains a key driver of demand for ESG funds in Europe and for funds marketing into Europe. SFDR introduced a number of additional requirements for firms wishing to market investment products as sustainable, which in turn has led to greater demand for diligence and data on ESG. Analysis from the European Fund and Asset Management Association found that Article 9 funds (the most “sustainable” of the categorizations under SFDR representing funds with a sustainable investment objective) attracted €26 billion of new capital in 2022.

EU regulation and enhanced scrutiny of ESG funds presents a risk for private capital firms. Following a series of fund downgrades from Article 9 to Article 8 in 2022, we expect a continued push and pull on sustainable fund categorizations, as well as continued regulatory clarifications. Alongside SFDR, legislation to prevent greenwashing in financial markets has sprung up around the globe, a further regulatory factor to consider for firms marketing and pursuing ESG strategies. In 2022, the European Securities and Markets Authority (ESMA) proposed that funds with the words “impact,” “impact investing,” or any other impact-related word in their names must demonstrate how they generate a positive and measurable social or environmental impact in addition to a financial return. In addition, if an investment fund's name contains any impact-related words, a minimum of 80% of investments would need to meet impact investment objectives per the investment strategy.

The same is true in the US with the US Securities and Exchange Commission proposing various regulations that would affect private funds. In 2022, the SEC proposed a similar 80% amendment to apply to ESG funds, as well a broad ESG Funds proposal which, like SFDR, would require detailed disclosures in fund prospectuses, annual reports and adviser brochures from subject funds and advisers that either integrate ESG factors into their funds or hold themselves out as ESG or climate funds. While the majority of the rule would not directly affect private funds, the proposal would require changes to their Form ADV and affect their compliance policies, procedures and marketing.

The US Inflation Reduction Act, considered the most meaningful climate legislation in US history and which is geared toward the energy transition, net-zero emissions, and clean energy and infrastructure projects, is set to further increase interest in impact investing. The Inflation Reduction Act’s extension of tax credits for wind, solar, batteries and green power industries are intended to allow developers that invest in them plan longer-term for these projects, thereby making the US a more attractive investment market, including for private capital firms pursuing environmental or energy strategies. However, anti-ESG sentiment and legislation in certain US states could raise fundraising challenges that need to be navigated down the road.

Meanwhile, the EU has responded to the Inflation Reduction Act with its Green Deal Industrial Plan. Launched in February this year, the Green Deal Industrial Plan looks to fast-track clean technology production in Europe, providing a boost to the region’s carbon capture and renewable energy sectors among others. The Green Deal Industrial Plan may therefore also present significant opportunities for private capital investors.

A focus on data

Private capital firms will increasingly seek reliable and robust data on ESG indicators as firms incorporate ESG principles into their investment strategies. Historically, ESG data has been challenging to gather. However, recent advances in data analysis provide new and promising solutions. Increased demand for ESG data has additionally led to initiatives focused on gathering helpful comparative information.

The ESG Data Convergence Initiative (EDCI) aims to standardize the private equity industry’s approach to ESG data collection and reporting. Consisting of over three hundred members in total, the EDCI is focused on its GP members collecting and reporting on an initial set of six core ESG metrics which EDCI expects will grow over time. Meanwhile, the ESG Integrated Disclosure Project, a private credit industry initiative launched in November of last year with the support of EDCI, is seeking to improve transparency and accountability. Private credit investors continue to face challenges because, unlike equity investors, they do not typically have access to the underlying data they require. We expect continued development in regard to ESG data quality, enabling leading LPs and GPs to become more and more sophisticated in how they incorporate ESG.