This article was first published June 23, 2022, in the special Insights+ report from Prequin entitled, ESG in Alternatives 2022: The Transparency Tipping Point.

Sustainable investment has become a driving force in financial markets. Asset owners and managers increasingly appreciate that their fiduciary duty to generate risk-adjusted returns requires an understanding of how vital financial, natural and human capital are in value creation. The commitment to a “just transition” means that the climate change ambition must put people at the heart of the plan. In seeking solutions, we make investments that incorporate other important elements set out in the United Nation’s Sustainable Development Goals (SDGs), namely, gender equality and “decent work.” This offers a new paradigm for sustainability. We are at the inflection point in harnessing the financial system to drive sustain­ability and innovation.

Public and private debt and equity funds can help advance impact-driven practices and policies. While the former engage companies in public markets, the latter can build better impact practices from the ground up. As companies list and transition from private to public ownership, this relationship becomes synergistic. We believe private equity has a vital role to drive impact, especially in emerging and frontier markets. By nature, private, and in particular, private equity, markets are well positioned to drive lasting, impact-driven practices. Their unique toolbox includes:

1. Deep engagement: Private equity firms engage with portfolio companies at board level, allowing them to influence key decision-makers to adopt and strengthen impact practices.
2. Long-term relationship: The longer-term nature of private equity investments allows an investment’s climate impact to be measured more effectively.
3. Contractual enforcement: Private equity firms can embed impact best practices into transaction documents and company charters as a precondition for investment.
4. Increased level of detail: Private equity firms often benefit from better information trans­parency than public market investors. This granularity helps improve data materiality.
5. Iterative process: The process of driving positive impact is inherently iterative, following a nonlinear “theory of change.” Private equity benefits from a close relationship with investee firms to build better impact practices through a regular, long-term feedback loop. Since impact measurement and reporting is a relatively new and evolving field, investee companies benefit from ongoing hands-on investor guidance.

Integrating climate impact in investing

The recent Intergovernmental Panel on Climate Change (IPCC) report highlighted what we can all observe—that global warming is real and driving climate change. Our call to action to find solutions through investing in innovative companies needs to incorporate impact assessment in earnest. We believe end-to-end integration of impact in the investment process is critical to developing a private equity impact management framework.

We believe a framework should start with an “Investment and Impact Thesis.” This needs to focus on the proper management of financial capital to foster returns, alongside human and natural capital performance measurement to ensure sustainability. This should mitigate climate change by promoting energy transition toward a low-carbon economy, and supporting adaptation through greater economic resilience of populations affected by climate change. This could be particularly effective in a private equity context as investment, capital and expertise are provided to growth-stage companies addressing these challenges. Such an impact management framework would imply impact integration at each stage of the investment process:

1. Deal sourcing: climate investment and impact objectives
   In the deal-sourcing stage, the investment impact thesis would be well developed, involving a coherent impact narrative and data points for each investment. Systematic analysis would identify the specific human and natural capital challenges being addressed, the enterprise and investor-level activities that will enable progress, and the measurable impact outputs and higher-order outcomes being targeted toward enhanced risk-adjusted returns. Systematically identifying the right target investments could be anchored to SDGs instead of the wide, and at times confusing, array of ESG metrics. We believe SDGs better reflect the policy goals of world governments, with close to 200 heads of state having signed off on the agenda. Meeting these goals requires significant private finance, which in turn can generate economic returns for investors.
2. Deal structuring: contractual obligations
   Apart from the typical financial and risk mitigation measures, investors can embed deal specific impact measurement and management measures into transaction documents. For example, the Sales and Purchase Agreement (SPA) can stipulate “conditions precedent” and “conditions subsequent” to deal closing.
3. Partnership: building value
   To help steward the company, the private equity team can engage closely with boards, management and operating teams. This extends to helping portfolio companies adopt and implement impact standards, frameworks and systems to measure and report on climate impact key performance indicators (KPIs), among others. The “network effect” of sharing experience and knowledge between investee companies is particularly effective.
4. Exit: creating value by reducing risk
   A successful exit is one which realizes the financial gains brought through a successful investment thesis, underpinned by sustainability considerations. Incorporating impact considerations into a company’s policies and practices can reduce risk for a buyer and raise company valuation, thereby helping a successful exit be to public markets or through a strategic sale.

Potential to drive alpha

We believe strong impact practices have potential to drive alpha in portfolios. Focus on climate, in our view, is where impact and financial return become mutually reinforcing and beneficial for key stakeholders including communities, employees, governments, busi­nesses and investors. With the right tools and impact approach, private equity is well placed to drive an investment framework focused on climate impact for a just transition, as envisaged in the Paris Agreement. This value-building approach works in a symbiotic relationship with the public and private markets in tackling the risks and opportunities of the global response to climate change.