Diligencing Private Market Impact Investments

When it comes to alternative investments like Private Equity, non-financial factors such as ESG are increasingly important, but difficult, to consider.
David Gowenlock, Alternative Fund Advisory and Placement at ClearlySo
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It’s a tricky time to be an asset owner. Equity markets are turbulent and market shocks are turning into market shifts as certain industries boom whilst others face a bleaker future. Safe havens such as gilt yields remain hovering just above or below zero and real estate, of which 55% is office and retail, faces uncertainty as corporations adapt to the future of work and construction firms sink further into the red. In search of alpha to meet return targets many asset owners are increasing allocations to alternatives such as Private Equity, leading some market pundits to suggest this asset class’ historic outperformance cannot continue with the amount of capital now chasing deals.

Moreover, the next few decades present the potential for greater and faster change in markets than we have seen to date. Pressure comes from all sides.

  • Government policy is shifting following countries’ legally binding 2050 net-zero targets. China, the world’s largest emitter surprised markets with its 2060 target and we are now seeing policy announcements that begin to nudge economies towards these goals – such as the UK’s decision to ban the sale of internal combustion engines by 2030 and Norway’s goal of 2025. Decarbonisation of all industries will follow, and must follow, to meet the target 7% annual reduction in GHG emissions (which happens to be the COVID-induced decline observed in 2020).
  • Carbon markets are evolving. The EU is considering expanding the Emissions Trading System’s current 40% market coverage to help meet a 55% net GHG reduction by 2030 (this seemingly ambitious goal is required to meet 2050 net-zero targets). Meanwhile, EU carbon allowance prices broached €34/tonne this month as the fourth trading phase of the EU Emissions Trading System began, a figure still some way below the €84/tonne LSE claims we need to see by 2030. A rise in carbon prices of this scale will rapidly shift market dynamics as certain products and technologies become too expensive, and others become cost-effective.
  • Financial regulation is catching up with the explosion of financial products touting environmental or social credentials. Coming into effect in March 2021 the EU’s new Sustainable Finance Disclosure Regulation imposes new transparency obligations and periodic reporting requirements on investment management firms at both a product and manager level. Corporations are considering if a tightening of TFCD or similar reporting regulations will see greater inclusion and management of Scope 3 emissions. As part of the Anti-Racism Action Plan 2020-2025 the EU will assess its Racial Equality Directive, with possible new legislation introduced in 2022 to strengthen social related disclosures and reporting.

These changing market dynamics mean non-financial factors such as ESG are becoming increasingly important in many investors’ strategies. Just last November the IMF warned that public market investors were failing to adequately price climate risk.

At ClearlySo we have steadily seen the appetite for impact and ESG products grow at large institutions investing in private markets. In tandem with this growing demand, increasing numbers of asset managers are launching ESG and impact strategies and as these strategies flood the market, asset owners have new considerations to make during their diligence process.

LPs are now rightly asking themselves questions such as; how meaningful are the ESG and impact claims made by fund managers?, are they material to the strategy or just a PR exercise?, how should we evaluate them and will they be a driver of returns?

ClearlySo provides strategic advisory and placement services to impact fund managers, and maintains a network of European LP investors seeking access to such fund opportunities. Through our work reviewing hundreds of impact funds, and conversations with a diverse range of Institutional LPs to discuss allocation criteria, we have built up specific expertise on performing diligence on private market impact fund propositions.

LPs are very familiar in diligencing a fund’s target financial return and have rigorous processes to evaluate the likelihood that a blind-pool fund will deliver on its promises. However many struggle when attempting to conduct their diligence on a fund’s impact credentials. Is the GP really investing for impact, or are they greenwashing?

Following our recent webinar, How to Identify and Call Out Impact-Washing, we wanted to progress the discussion by sharing 5 areas we have found to be important indicators of a fund’s impact performance. During early fund diligence, the following proposed considerations can help quickly analyse and compare impact strategies.

1. Team

As is always the main area of scrutiny for LPs, impact diligence usually start at the Fund’s Partners and Investment Team. We like to see specific expertise around the impact themes the fund is targeting, relevant social or sustainability credentials, and experience or knowledge on scrutinising investments’ theory of change. It is also important to check that the firm’s team is diverse in all dimensions (the data shows it impacts financial performance), and seeks to eliminate inherent biases in decision making processes as to maximise financial and impact performance.

2. Investment Thesis

Looking at the fund’s investment thesis, a substantial (if not entire) proportion of the fund should focus on well-defined impact themes – typically based around the UN SDGs. SDG alignment and colourful SDG logos in marketing materials alone are not sufficient. The fund itself should have a well-considered impact thesis and theory of change explaining why the investments it will make will result in positive impacts. The best fund managers take consideration of impact additionality and evaluate the risks of unintended negative impacts, rather than focussing only on the desirable positive ones. We feel this last point carries more importance than most give it – we have seen cases recently where negative impacts have a greater impact on company performance than positive ones (and it’s easier to be blindsided by unconsidered negative impacts than underperforming positive ones).

Good investment teams have strong inbound dealflow and reach through their networks. Great ones ensure equal opportunity for initial review (rather than warm connections only for example).

3. Investment Process and Committee

Impact considerations must be present throughout the investment process. Adequate processes and checklists should be in place for deal review, and the fund’s Investment Committee must have an opportunity to veto transactions purely on an impact basis when they do not meet minimum targets. Can the fund provide examples of deals dropped for impact reasons?

It is important that impact measurement is not just a post-investment box ticking exercise – where the firm has impact professionals or assigned experts, they should be involved in deal origination, structuring and the IC process, not just post-investment portfolio management and reporting.

4. Impact Measurement and Management

Impact Measurement and Management is the area that receives the most focus and discussion, perhaps as this is the easiest area to evaluate. Comprehensive reporting on an annual basis and as appropriate in quarterly reports is expected, and the fund should have a clear understanding of the impact metrics which are both meaningful and straightforward for portfolio companies to provide accurately to ensure ongoing reporting compliance. The most used IMM resources are the SDGs (73%), the IRIS Catalog of Metrics (46%) and the Impact Management Project’s five dimensions of impact convention (32%) (Source: GIIN).

The very best managers ensure Impact outcomes are externally audited and use mechanisms to incentivise the team to achieve and outperform these outcomes. Some LPs require that funds tie fund carry to impact outcomes to ensure alignment, and we feel this is one of the strongest indicators of a GP’s intention.

5. Industry Engagement

Fund managers taking the topic of impact and ESG seriously dedicate time to industry engagement – ensuring the team’s continuous learning around impact management, best practices and industry initiatives. The GP should subscribe to the (IFC) Operating Principles and, where relevant for the fund’s thesis, PRI.

These five areas are not exhaustive and represent just some of the initial topics we advise LPs to consider when evaluating new manager relationships. With COVID limiting the potential for on-site diligence meetings, having a rigorous and structured impact diligence processes is important more now than ever before. We expect a growth in the use of mechanisms that tie GP incentives to impact performance, and this will certainly help build trust whilst performance data can be built across early fund generations.

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Diligencing Private Market Impact Investments