Sustainability and private equity

Understanding the distinctions between ESG integration and impact investing is crucial for institutional investors. As per Preqin’s methodology, for the purposes of this article we differentiate the two types of funds under the following:

• ESG integration involves incorporating environmental, social, and governance factors into the investment process, but it’s primarily focused on financial performance. ESG funds may exclude harmful sectors, but their overarching goal is still profit maximization.
• Impact investing in contrast, is explicitly focused on achieving measurable social or environmental outcomes. These funds often target sectors like renewable energy, education, or healthcare, where the primary goal is positive societal impact, with financial returns being secondary.

• ESG-integrating funds perform similarly to non-ESG funds, with IRR and TVPI values remaining competitive.
• Impact funds show a clear underperformance, especially in the third quartile where the IRR is notably lower (-2.1%). For institutional investors, this suggests that while impact investing aligns with broader sustainability goals, it tends to offer reduced financial returns.
• The median IRR for ESG-integrating funds exceeds that of non-ESG funds, signaling that incorporating ESG factors may not necessarily compromise performance and in some cases could even potentially enhance it.

For pension funds and other institutional investors, the performance discrepancy between ESG-integrating and impact funds offers a compelling reason to prioritize ESG-integrating funds over impact funds, at least from a return-oriented perspective.

The Sustainable Finance Disclosure Regulation (SFDR), which divides funds into Article 6, Article 8, and Article 9 categories, has reshaped the way European investors assess sustainability. Article 8 funds can have a promotion characteristic or seek to invest a portion of the portfolio in sustainable investments, whereas Article 9 funds mainly focus on sustainable investing and achieving an environmental or societal impact. However, it’s important to note that the SFDR framework is under revision, with major changes expected by 2025. This revision leaves a considerable amount of uncertainty:

• It's unclear whether compliance with Article 8 or Article 9 requirements will become more difficult, potentially reducing the number of qualifying funds.
• What will the regulatory impact be? Non-European funds, especially those in the US or Asia, are not bound by SFDR regulations, allowing them to market themselves as impact funds without facing the stringent requirements imposed on European funds.

For institutional investors, particularly those with global portfolios, this creates an additional layer of complexity. Whilst many non-European private equity funds may brand themselves as impact, they might not adhere to the same rigorous SFDR standards, making it harder to compare them directly with European funds.

• The data indicates that Article 8 funds have seen a significant increase in launches across all strategies, particularly in buyout and venture capital categories. This aligns with the data showing strong financial performance for these funds. Notably there are only a small number of private equity fund-of-funds which are stated to comply with Article 8 according to Preqin. Such fund-of-funds may represent an opportunity for institutional investors looking to enjoy the benefits of a well-diversified multi-managers portfolio, whilst at the same time being invested in an ESG Article 8 portfolio.
• The data indicates that Article 9 funds, while growing, remains more limited. The Article 9 investment universe is dominated by growth and venture funds, with very few buyout or fund- of-funds labelling themselves as Article 9 compliant, according to Preqin. For institutional investors looking to gain exposure to impact private equity funds, in the current environment they will have to limit themselves to venture and growth funds, which are typically below USD 300 million in terms of commitment size.

One underexplored area is the alignment between ESG integration investing and Sharia-compliant investments. Both strategies share common exclusion criteria:

• No alcohol, tobacco, gambling, adult entertainment: Like ESG-integrating funds, Sharia-compliant investments avoid these sectors.
• No leverage: Sharia investing prohibits the use of leverage, a requirement that does not exist for ESG-integration funds. However, this can add a unique layer of financial stability to Sharia investments, aligning with certain long-term, risk-averse institutional mandates.

For institutional investors, especially those with a global or multi-faith clientele, considering Sharia-compliant funds alongside ESG funds could offer another ethical investment option, diversifying the portfolio while adhering to strict Sharia ethical criteria.

For institutional investors, particularly pension funds, the growing demand for sustainable and impact investing presents both an opportunity and a challenge. ESG-integrating funds offer a balanced approach, considering ESG factors, while maintaining competitive financial returns. The more stringent impact funds, whilst seeking to achieve a greater level of environmental or societal impact, may not always meet the financial return targets of a pension fund. Given the relatively small investment universe of impact funds, it may be impractical to shift a large portion of the portfolio toward impact-focused investments. This is mainly due to the typical lifespan (ca. 10-15 years) of private equity funds. Furthermore, such statistical comparisons must be viewed with caution, due to the relatively small sample size of impact and ESG-integration funds listed in such databases and the potential for self-reporting bias.

In the view of the writers of this article, institutional investors wishing to satisfy both financial obligations and the increasing demand for sustainable investing, may be best served by adopting a balanced approach to portfolio construction by:

• Focusing on ESG-integrating and Article 8 funds, which consider ESG aspects and focus financial performance.
• Gradually allocating a smaller portion of the portfolio to impact or Article 9 funds for their mission-driven impact, while managing expectations regarding potentially lower financial returns.

The views and opinions expressed in this article are those of the authors and do not reflect the views of UBS or the UBS Framework on sustainability.