Investors push alternative managers closer on ESG

Alternative investment managers are stepping up their environmental, social, and corporate governance efforts including diversity and inclusion, pushed along by investors' increasing demands for accountability.

Investors have been pushing for greater ESG efforts for years but now expect alternative investment firms to take larger strides in this direction.

The Black Lives Matter protests in 2020 brought the issue of diversity to the forefront for some asset owners and managers, while more investors in Europe and in the U.S. are incorporating it into their investment thinking.

According to a recent survey by secondary market alternative investment firm Coller Capital Ltd., 63% of institutional investor respondents expect the private equity industry to accelerate its focus on ethnic diversity within their firms and their portfolio companies, bringing about faster change. The other 37% indicated that increased diversity and inclusion efforts in the private equity industry have been slow to materialize "despite good intentions."

Managers are also moving forward on tackling climate change, spurred on by the pandemic.

In response to investor demand, Carlyle Group Inc. is one of the first alternative investment managers to provide climate change disclosures under the Financial Stability Board's Task Force on Climate-related Financial Disclosures, said Megan Starr, New York-based principal at Carlyle and the global head of impact.

"Our financial incentives are increasingly aligned with being at the forefront of the energy transition and how to do it faster because we see it impacting exit multiples in a positive way," Ms. Starr said. "If you take an oil and gas company from zero to 40% renewables during the hold period, you could potentially double the company's trailing EBITDA multiple."

Ms. Starr said that she sees 2021 as the year of adoption for a greater number of alterna- tive investment firms. Carlyle executives think that TCFD will become the leading framework globally, she said.

Managers are recognizing that they need to do more to more with regard to climate change.

"I think organizations are increasingly comfortable that they haven't achieved climate nirvana," she said. "You can own where you are today and set the goals of where you want to go."

ESG offerings have transitioned to mainstream from niche, said Pratap Singh, director, private equity and venture capital at research provider Acuity Knowledge Partners. Forty-two percent of the capital raised for alternative investment funds in 2019 was for ESG-focused funds, up from 33% in 2011, Preqin data shows.

This trend has been driven by large alternatives managers such as The Blackstone Group Inc., Apollo Global Management Inc. and Carlyle Group, with each manager including ESG mandates for all their funds regardless of their respective strategies, Mr. Singh said. "The pandemic has accelerated the acceptance of ESG offerings by alternative investment managers as they seek to gain a competitive advantage once markets normalize," he said.

Investors are already focused on climate-change issues. For example, the $254.7 billion California State Teachers' Retirement System, West Sacramento, established a low-carbon transition work plan in 2019. This year, CalSTRS officials are working on incorporating the low-carbon transition into their investment process.

Low-carbon is one focus of the CalSTRS Sustainable Investment and Stewardship Strategies unit, which also includes sustainable investment and stewardship. In 2021, CalSTRS officials plan to look for new ways to reduce portfolio carbon emissions and climate risk in its public asset investments. CalSTRS is also developing a new sustainable investment private asset portfolio and is expected to take up a sustainable investment policy for its alternative investment portfolios in March.

Carlyle is focused on the energy transition across its portfolio, Ms. Starr said.

"Carbon footprinting is not the answer," she said. "It's a piece of the puzzle but it doesn't tell the whole story."

Carlyle found in its analysis that the materiality of carbon emissions differs greatly across sectors. For example, one of the areas with the highest potential impact from climate risks and opportunities is Carlyle's international energy strategy. In the past year, Carlyle has created a renewable energy and sustainable resources business to access the opportunities the firm sees in the energy transition, she said.

Carlyle is not alone in seeing the increasingly important impact of ESG on alternative investments. Some private credit managers expect a growing focus on ESG will impact the type of companies that will apply for loans.

The industry trend focusing on ESG "might change the profile of the type of companies that come to the private markets," said Candy Shaw, Toronto-based deputy CIO at Sun Life Capital Management (U.S.). "(Investment) opportunities are expanding in certain sectors and industries and contracting in others," Ms. Shaw said.

"Old-school industries" are being pushed to the side, while new, more forward-looking industries like technology, renewable energy or the carbonless society space are getting a lot of traction, she said. "Coal is going the way of the dodo, especially in advanced economies."

Eric Deyle, a Rowayton, Conn.-based managing director at placement agent Eaton Partners LLC, has noticed an escalating focus on ESG by institutional investors including in their due diligence requests.

Five or 10 years ago, certain limited partners had some "no fly zones," meaning sectors in which they would not invest, he said.

"Now they are more proactive," Mr. Deyle said.

Investors are asking their managers or potential managers about their ESG policies and how these policies are being implemented, he said.

Even so, Mr. Deyle has not seen an overall standard yet emerge.

"But I see LPs pushing for ESG and diversity," he said. "In my mind, these are big positives. LPs are increasingly becoming advocates for change and are more demanding of sponsors (managers)."

Manoj Mahenthiran, Chicago-based partner and private equity leader at PricewaterhouseCoopers US, said that ESG considerations are becoming more important to private equity managers but they are "not yet pervasive across the industry."

Investors are asking a lot of questions the managers' efforts to reduce their carbon footprint and the carbon footprint of their portfolio companies, Mr. Mahenthiran said.

He added that there is definitely more of an effort to create a little more consistency in how managers report ESG at the portfolio level. Everyone is trying to put their heads together to decide what they should be tracking, he said.

"Now it's more free-form," Mr. Mahenthiran said. "In the future, it (reporting) will be more organized and more deliberate. Very quickly, it will be something every private equity fund has to think about and report out."

Lori D. Campana, Boston-based partner at placement agent Monument Group Inc., said an increasing number of institutional investors in the U.S. are following the lead of European LPs to focus on making their portfolios carbon-neutral.

Among them is the $226.4 billion New York State Common Retirement Fund, Albany, which announced in December that it would be reducing its investments in energy companies in an effort to attain a net-zero carbon emissions target by 2040.

Also in December, the $5 billion The Rockefeller Foundation, New York, said it would be divesting from fossil fuels. The $6.9 billion endowment of Cornell Unversity, Ithaca, N.Y., in May instituted a moratorium on new fossil-fuel investments in new private equity and bond vehicles.

A focus on ESG considerations is also expanding beyond the largest alternative investment managers. Value-added multifamily real estate manager Interstate Equities Corp. in November appointed San Francisco-based Bakari A. Adams, director of asset management, to the new position of director of ESG. Interstate Equities Corp. has about $1 billion in assets under management.

For the first time the firm is incorporating ESG into its annual budget, he said. The plan is to create an ESG report and share it with its investors.

IEC doesn't have an impact investing approach, but sees incorporating elements of ESG as good for the environment and society as well as the firm's returns. The firm invests in Class B apartment buildings in California. The firm buys properties and fixes them up, including making them more energy efficient, Mr. Adams said. "Historically, we've always used LED lights and we've always tried to reduce energy, water consumption. Now we are shining a light on it," he said

IEC executives also plan to investigate what more they can do to minimize the carbon footprint of their portfolio, he said.

Monument Group's Ms. Campana said she expects more focus on aspects of ESG in 2021 including a greater awareness of the need to increase diversity and inclusion across the industry.

The Pension Real Estate Association's foundation in March announced a $4 million grant to Sponsors for Educational Opportunity, a non-profit aiming to offer educational and career opportunities to underserved communities, to support the development and growth of a real estate program to promote diversity across the real estate industry.

A lot of investors have put a growing emphasis on women-owned or minority businesses and are targeting funds to invest in them, Ms. Campana said.

"It's (the industry) has always been made up of all white men," Ms. Campana said.

There's a new generation of more diverse executives evolving but it takes time for the next generation of vice presidents and principals to move up the executive ladder.

"The founders are all white men but they have to demonstrate their commitment to the next generation with positions that are meaningful," she said. "Over time we will get there because the money is going to demand it."

PwC's Mr. Mahenthiran said that investors are not only asking managers about the diversity of their staffs but also about diversity at portfolio companies.

In December, more than 40 limited partners and general partners signed onto the Institutional Limited Partners Association's Diversity in Action initiative, committing to take concrete steps to advance diversity, equity and inclusion at their firms and across the industry. The initial set of signatories include the $155.2 billion Texas Teacher Retirement System, Austin, $37 billion Connecticut Retirement Plans & Trust Funds, Hartford, KKR & Co., Carlyle Group, Blackstone Group Inc., Ares Management Corp., Landmark Partners, TPG and Welsh, Carson, Anderson & Stowe.

Real estate investors are also increasingly viewing diversity and inclusion as an important topic, especially when they are hiring managers, said Nancy Lashine, New York-based founder and managing partner of Park Madison Partners LLC, a boutique real asset private equity placement firm.

Investors are asking a lot more questions on ESG topics, she said. They want to know whether managers have plans to address the lack of diversity across the industry, Ms. Lashine said.