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The drivers behind a rise of ESG allocations to private asset

30 April 2024

The search for consistent long-term risk-adjusted returns in a low-return era is just one factor driving environmental, social, and governance (“ESG”) investing, according to a global research survey of pension plans.

“Private markets will continue to attract ESG capital from pension plans, but only for as long as asset managers deliver on their clients’ ESG goals.” This quote from a participant in the survey of 152 pension plans, on their approach to investing in ESG across private equity and private debt, sums up both the prospect of ESG allocation growth in these asset classes and a prevailing attitude on what needs to sustain that rise.

While the advancement of ESG investing in private equity and private debt is still at a nascent stage, key findings on the drivers and obstacles to allocation growth among pension plans were discovered in our research. With responses drawn from pension plans across Asia-Pacific, European, and North American regions, the research survey clarifies the prospects for ESG allocations in the near future. 

As depicted in the diagram below, more than half of the respondents (54%) said they will increase allocations to ESG-related private equity funds during the next three years, while just under half (47%) said they would do the same for private debt. 44% of participants said they will keep ESG allocations for private debt static over this timeframe, and only 9% of respondents said they would decrease them for this asset type.

Answering a separate question, 63% of respondents said private equity is a suitable asset class for ESG investing, while 54% stated the same for private debt. This sentiment has persisted despite signs of under-performance for ESG investing in public equities in 2022, as well as fears about greenwashing amid the rise of climate-related litigation in the past two years.

Different drivers will fuel momentum for this allocation growth, but an underlying impression is that pension plan managers genuinely believe ESG investing can withstand volatile markets, yield societal benefits, and deliver consistent risk-adjusted returns.

Influences and hindrances

Ultimately, the pursuit of consistent long-term risk-adjusted returns in a low-return era is driving interest in ESG opportunities for most pension plans. Other elements are also at play, such as the improving bargaining power of limited partners due to rising interest rates, which have increased the cost of leverage in private equity and private debt deals.

The rising influence of asset allocator networks in advancing progress on ESG issues is also relevant. For example, Climate Action 100+ is enhancing its scrutiny of carbon offsets and capital expenditure on climate action through a new set of disclosure indicators.

Amid this trend of increasing transparency on ESG, imposed by regulators, activist shareholders, and activist groups, short- and long-term goals on climate are being embedded into fund mandates. This has enabled pension plans to better steward firms in the fund. It's another reason why private equity is perceived as conducive to ESG integration.

The onset of ESG regulation is not just one-way traffic though. Across some US states, legislation has been introduced and is increasingly proposed to ensure that ESG considerations are not used punitively against firms in investment decisions.Even within this context, the largest allocations of ESG assets are skewed towards the U.S. due to its less restrictive M&A rules. The largest allocations tend to feature in large pension plans, where accounting rules make private equity assets more attractive.As is often the case with ESG in its infancy, the bigger picture beyond these influential factors is nuanced.

Growing pains

After a performance setback across equities last year, investors are demanding evidence that ESG investing achieves key objectives. Asset managers are facing more exacting pressure to demonstrate their stance on ESG goals and what they can deliver meaningfully.

Another obstacle is that, at this stage, a lack of consistency persists in how ESG data is collected and assessed. High fees and charges over long-time horizons, which apply to ESG investing, present another constraint, along with a wide dispersion in reported returns and, above all, concerns about a credit crisis if interest rates in key economies remain higher for an extended period. But as one survey respondent acknowledges, there will come a time when ESG investing will be indistinguishable from fundamental investing.

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