Impact Investing: Private Equity's Power And Potential

Impact investing is a strategy that seeks to generate financial returns while also creating a positive social or environmental impact. Impact investors consider a company's commitment to corporate social responsibility and the duty to positively serve society as a whole. The term impact investing was first coined in 2007 by the Rockefeller Foundation, and it has since grown to encompass a wide range of investment strategies across asset classes, impact areas, sectors, and geographies. Private equity continues to be the most popular asset class for impact investors, with more than half of all impact funds in databases belonging to private equity. Impact investing in private markets is a rapidly growing subset of the sustainable investment universe, particularly for investors who want to allocate real-world outcomes for society and the environment while seeking better returns.

Impact investing in private markets

Private equity, in particular, has become the most popular asset class for impact investors. It offers a wide range of opportunities, from venture capital to later-stage transactions and buyouts. Impact investors in private equity can focus on various themes, such as circular economy, energy efficiency, environmental support, waste management, food, agriculture technology, education, and financial inclusion.

When investing in private markets, impact investors should consider three key elements:

• Intentionality: The investment should have a clear and intentional positive social or environmental impact.
• Financial Returns: While impact is a priority, financial returns are also important, and impact investments can offer market-rate or even above-market returns.
• Measuring Impact: It is crucial to measure the impact of the investment to evaluate its success and report back to stakeholders.

By adopting impact investing strategies, investors can contribute to addressing the world's most pressing challenges, such as climate change, resource stewardship, basic needs, well-being, and empowerment. Impact investing in private markets allows investors to strike a balance between financial returns and creating a positive impact, making it an attractive approach for those seeking to make a meaningful difference while also generating profits.

Impact investing vs ESG investing

Impact investing and ESG (Environmental, Social, and Governance) investing are often used interchangeably, but they are not the same. Both are forms of responsible investing, but they have distinct differences.

ESG Investing

ESG investing is a framework that helps firms maximise financial returns and minimise risk while aligning with socially responsible business practices. It is a set of criteria across environmental, social, and governance dimensions that may have a material effect on business performance. Investors use ESG considerations to assess the risks and opportunities present in potential investment decisions.

ESG investing can be forward-looking, for example, choosing to divest from funds that use fossil fuels and instead invest in businesses aligned with a net-zero strategy. However, it also focuses on identifying areas of growth from traditional business practices, through screening for emerging risks at companies.

Impact Investing

Impact investing is an investment strategy that seeks to create a specific, measurable social or environmental benefit, with financial returns being an added benefit. A core principle of impact investing is intentionality, with an explicit aim to generate a specific outcome from investments. It is inherently forward-looking and does not consider an organisation's past activities. Another key component is the commitment to measure and report on the impact of their investments, prioritising transparency and accountability.

Differences

The main difference between impact investing and ESG investing is their primary focus and implementation. Impact investing targets specific sectors or issues, such as clean energy or affordable housing, with the intention of creating a positive impact. On the other hand, ESG investing incorporates ESG factors into the investment decision-making process, analysing a company's ESG performance and practices to assess its sustainability and risk profile.

While ESG investing has financial returns as the primary objective, impact investors are often willing to forgo some financial return to achieve specific social and environmental outcomes. Impact investing is often associated with private equity, infrastructure, real estate, natural resources, and private debt.

Similarities

Both approaches aim to generate positive outcomes beyond financial returns by considering environmental, social, and governance factors. They reflect investors' desire to support companies that align with their values and contribute to positive societal and environmental outcomes. Both impact investing and ESG investing encourage a long-term perspective, recognising that sustainable practices can lead to more resilient and successful businesses.

The choice between impact investing and ESG investing depends on an individual investor's goals, values, and risk appetite. Impact investing allows for a more direct and measurable impact on specific issues, while ESG investing provides a broader framework for considering sustainability factors across a range of investments. Understanding the differences between these strategies helps investors make better investment decisions and generate long-term value creation.

Impact investing in private equity

Impact investing involves making investments that aim to generate positive social or environmental effects while also producing financial gains. Impact investors consider a company's commitment to corporate social responsibility and its duty to positively serve society as a whole. Impact investing is often associated with private equity, infrastructure, real estate, natural resources, and private debt.

Private equity continues to be the most popular asset class for impact investors. As more players join in, increasing impact transparency and reporting will help distinguish truly impact-driven investment strategies from those that are not. According to data from Phenix Capital, more than half of all impact funds in their database are private equity funds. Major private equity firms are increasingly introducing impact investment funds. For example, KKR raised nearly $2 billion for its second impact fund, while TPG successfully closed its Rise Climate Fund at $7.3 billion.

Impact themes within private equity include the circular economy, energy efficiency, environmental support, waste management, food, agriculture technology, education, and financial inclusion. Impact investors in this space can apply innovative technology and business models, transforming segments and creating new products and services in legacy industry sectors.

When investing in private markets, impact investors should consider three key elements: intentionality, potential financial returns, and measuring the impact. Intentionality refers to how the investment creates a positive social or environmental impact. Measuring the impact involves evaluating the specific outcomes and having a positive impact on the world. This can be challenging in private markets due to limited data availability. However, developments in impact mapping and collaboration with clients help capture the positive and negative effects of investments.

By aligning their portfolios with efforts to address pressing global issues, impact investors in private markets can use their investments as a powerful tool for positive change. Impact investing in private equity offers a wide range of opportunities, from venture capital to later-stage transactions and buyouts.

Impact investing and financial returns

Impact investing is an investment strategy that aims to generate financial returns while creating positive social or environmental change. It involves deploying investment capital with a focus on both financial gains and social and/or environmental considerations. The idea of sustainable investing has existed for decades, but the term "impact investing" was coined in 2007 by the Rockefeller Foundation.

Impact investing is more than just a financial strategy; it is about using money and investment capital to create positive social outcomes. Investors who adopt this approach consider a company's commitment to corporate social responsibility and its duty to positively serve society as a whole. This type of investing actively seeks to create positive change through supporting nonprofits, clean technology enterprises, or other initiatives that benefit the community or the environment.

Private equity continues to be the most popular asset class for impact investors. As the impact investing space matures, there is a growing emphasis on transparency and reporting to distinguish truly impact-driven strategies from those that are not. This increased scrutiny challenges private equity investors to demonstrate the impact of their investments and ensure transparency in the process.

While the primary goal of impact investing is to create positive change, financial returns are also a key consideration. Impact investors typically seek market-rate returns or even outperformance, believing that their investments can do well while also doing good. However, there has been a long-standing debate about whether achieving positive social and environmental outcomes requires concessionary or below-market-rate financial returns.

In recent years, the discussion has evolved. Data from public markets, where information is more readily available, suggests that sustainable funds can outperform their conventional peers. Additionally, the rigour and risk management associated with impact investing can enhance financial returns across asset classes. As a result, impact investing is increasingly viewed as a way to invest with higher standards and potentially outperform the market.

To balance financial returns and impact, impact investors must define their impact goals and identify strategies that align with their values and ambitions. This involves determining the specific social or environmental impact they want to have and selecting investments that offer both financial returns and alignment with their conscience.

In summary, impact investing in private markets aims to address pressing global challenges while seeking competitive returns. By aligning their portfolios with efforts to create positive change, investors can use their capital as a powerful tool for driving social and environmental progress. Impact investing in private equity, infrastructure, real estate, natural resources, and private debt offers a range of opportunities to complement portfolios and generate financial returns while creating meaningful impact.

Impact investing and regulatory compliance

Impact investing is an investment strategy that seeks to generate financial returns while also creating a positive social or environmental impact. It involves making investments to help create beneficial social or environmental effects while generating financial gains. Impact investors consider a company's commitment to corporate social responsibility and the duty to positively serve society as a whole.

Regulatory compliance is a critical aspect of impact investing, especially as institutional investors face increasing scrutiny from regulators and governments. Here are some key considerations regarding impact investing and regulatory compliance:

• Understanding Regulatory Requirements: Impact investors need to be aware of the legal and compliance obligations attached to impact investing strategies. This includes understanding the regulatory requirements and policies of relevant committees and clients in accordance with investment agreements.
• Addressing Greenwashing: Greenwashing, or conveying investments as overly environmentally responsible, has become a significant issue. To avoid this, impact investors should use appropriate terminology and agreed-upon classifications when marketing their strategies to ensure faithful claims.
• Conflict of Interest Management: Large asset managers often have multiple investment groups pursuing different strategies simultaneously. Establishing clear internal processes and policies is essential to manage potential conflicts of interest effectively.
• Reliance on Third-Party Service Providers: Due to the lack of uniform terminology, asset managers rely on third-party providers for compliance frameworks. However, thorough due diligence of these providers is critical as they can make significant errors in data aggregation or custom index setup, leading to investments inconsistent with clients' mandates.
• Reporting and Measurement: With various approaches to measuring impact investing due to the lack of uniform guidelines, agreeing on a framework beforehand is essential. Impact investors should also be prepared to address investors' due diligence requests, including explaining their investment processes, criteria used, and the expertise of their investment teams.
• Authenticating Impact: Impact investors, particularly in private equity, are facing increased regulatory and market scrutiny. Demonstrating the impact of their investments involves the involvement of sustainability professionals at each stage, from selection to reporting. Certification or audits are increasingly sought after to validate impact claims and ensure transparency.
• Performance-based Compensation: Some private equity players introduce financial structures that tie part of the performance-based compensation to impact outcomes. This approach is seen as a way to assess investors' commitment to their impact claims.

By addressing these considerations, impact investors can ensure they meet regulatory requirements while achieving their social and environmental goals.

Frequently asked questions