Alts managers plunge into ESG transformation

ESG is going mainstream, and alternative investment managers are having to get serious with their efforts to incorporate environmental, social and governance factors, or get left behind.

In an October report, Preqin estimated that $3.1 trillion in private markets assets under management were run by firms committed to ESG factors, representing about 36% of the total $8.52 trillion in private capital AUM globally.

Private credit had the highest rate with 49% of assets committed to ESG, while infrastructure managers had the lowest rate at 31% of assets, the report said.

Alternative investment firms have traditionally occupied a smaller corner of the ESG universe, but that is about to change with private markets managers starting to up their game, industry insiders say.

"We have seen a transformation," said Thomas Durkin, senior vice president in the Boston office of placement agent Monument Group Inc. In the past, ESG was adopted "more on a surface level, more as a public relations tool," Mr. Durkin said.

Now, more alternative investment managers see ESG as a "value creation lever," he said. "They've moved away from ESG as a check-the-box item."

While ESG is an overlay in investors' due diligence process that can boost a fund's desirability, alternative investment fund strategies can't rely solely on their ESG credentials. The fund has to perform as well as other funds in its asset class, Mr. Durkin said.

A majority (86%) of private equity investors reported that their impact investments performed in line with or exceeded their expectations, according to PricewaterhouseCoopers' 2021 Private Equity Responsible Investment Survey.

Among the ESG-related funds that are in the market are DIF Capital Partners' latest fund, DIF Core-Plus Infrastructure Fund III, a real assets fund focusing on digital, energy transition, transportation and social infrastructure investments in Europe and North America; Stonepeak Asia Infrastructure Fund, a fund managed by Stonepeak Infrastructure Partners that would invest in the energy transition as well as communications, transport and logistics; and Polestar Capital's Polestar Capital Circular Debt Fund, a venture debt vehicle that would lend to Dutch circular economy projects with sustainability goals.

One challenge to the incorporation of environmental, social and governance factors is that private markets managers differ on what constitutes ESG, mainly because there are no standard reporting metrics, Mr. Durkin said.

For example, some private capital managers slap an ESG label on an investment that includes a cost saving or efficiency initiative that they would have implemented anyway, according to a 2021 Bain & Co. report on private equity and ESG.

Private capital managers generally take one of two paths toward ESG adoption, Mr. Durkin said. They tend to either bolt on ESG to their legacy strategy or create a dedicated ESG fund in which environmental, social and governance considerations are core to its investment strategy, he said.

According to Preqin, ESG-committed managers raised $256.7 billion in the first six months of 2022, compared with $682.7 billion raised in all of 2021.

For example, BlackRock Inc. to date has raised more than $800 million in initial commitments toward the $1 billion target for a new fund, BlackRock Impact Opportunities Fund, a multialternatives strategy focusing on businesses and projects owned, led by, or serving Black, Latino and Native American communities in the U.S., spokesman Christopher Beattie said in a June 7 email. The fund has not yet held a final close, Mr. Beattie said.

The idea for the fund rose out of BlackRock's commitment in 2020 to help close the racial equity gap, said Pam Chan, New York-based managing director and CIO, and global head of alternative solutions group at BlackRock Alternative Investors.

BlackRock's alternative solutions group manages more than $10 billion in AUM. Mr. Beattie said all of BlackRock's private market strategies involve environmental, social and governance factors, and that the firm doesn't break out ESG from its alternatives AUM totals.

"We are creating a resilient portfolio by being flexible across (private market) asset classes" Ms. Chan said.

Alternative investment investors' demand for ESG-related investments has been building and has only accelerated, she said.

"There are definitely many more strategies that are environmentally focused than socially focused," Ms. Chan said. But world events have caused investors and managers to focus on the social aspects of ESG, she said.

Suzanne Tavill, Sydney-based partner and head of responsible investment at StepStone Group Inc., an alternative investment consulting and money management firm, said the definition of ESG is expanding.

"The range of topics falling under ESG continues to increase, and each one is becoming more complex, e.g., data privacy, inclusion and climate change," Ms. Tavill said in an emailed response to questions. "The latter is one of the biggest learning curves for the industry requiring considerable efforts at both the manager (corporate) level and at the asset level."

StepStone Group oversaw $570 billion in assets, including $134 billion in AUM as of March 31.

Even so, StepStone executives have seen an acceleration in manager ESG practices worldwide in the form of widespread adoption of ESG policies, "which are the precursor to more comprehensive ESG practices" within their investments, Ms. Tavill said.

But to have a competitive ESG practice, managers have to spend on resources — both people and systems to track progress and implement strategies. ESG is so multifaceted and fast-evolving that "giving this responsibility to someone junior or as a 'part-time' role quickly is not sustainable," Ms. Tavill said.

And these new ESG-focused executives have to operate in a private markets world in which there is a dearth of data, even less than in the public markets, said Jennifer Signori, a New York-based managing director leading impact investing in private equity at Neuberger Berman.

While there are still data challenges, there has been progress in the form of a number of initiatives in which managers are collaborating with other stakeholders with a common goal, Ms. Signori said. For example, the Institutional Limited Partners Association's ESG Data Convergence Project is creating core metrics and common definitions to streamline private equity's historically fragmented approach to ESG reporting, she said.

Hedge fund managers are also increasingly paying more attention to ESG, said Tristan Thomas, Chicago-based managing director of portfolio strategy for 50 South Capital's hedge fund investment team.

"Hedge funds have been a little later to the party" than other types of alternative investment managers, Mr. Thomas said. 50 South Capital is an alternative investment subsidiary of Northern Trust Asset Management. 50 South has $12.3 billion in assets under management and advisement.

In 2019, 50 South asked managers in its hedge fund-of-funds strategy for their ESG policies and did not receive many back, he said. The majority didn't have one, Mr. Thomas added.

"Last year, every manager we work with had an ESG policy in place," he said.

Paul Lanna, a partner in the New York office of secondary market alternative investment manager Coller Capital Ltd., said managers such as Coller are building up the size of their ESG teams "and the reach of those teams as to what to invest in and how to invest, not just pre-investment but post-investment."

Another challenge managers have to contend with is meeting clients' differing needs.

For instance, investors' exclusions lists have been growing over time, said Christopher Cox, New York-based chief risk officer at Churchill Asset Management LLC, the $27 billion private credit business of Nuveen, which incorporates ESG into its investment decision-making.

"Investors are more sensitive to certain sectors or areas, which results in our goal line moving as well," Mr. Cox said.

While Churchill doesn't have "an outright exclusions list," controversial industries and products are screened away during the early stages of due diligence, he said.

One "clear" example is firearms, especially in light of recent mass shootings in the U.S., he said.

But gray areas exist, such as a hunting accessories business that may sell a scope connecting to a firearm. That becomes more difficult, he said.

Churchill uses a proprietary ESG rating template it created in partnership with a Nuveen ESG ratings tool, which provides an ESG assessment for private companies, both risks and opportunities, Mr. Cox said.

"It (that ESG assessment) is something that is in every investment committee memo and discussed at investment committee meetings," he said.

Nuveen reported $1.3 billion in assets managed under ESG principles as of Dec. 31, up 8.3% from a year earlier, Pensions & Investments' annual money manager survey showed.

However, not everyone is on board with excluding or divesting from certain industries or companies as a way of achieving ESG goals. In a study released in May, The Carlyle Group Inc. said investors that want to curb the carbon emissions in their portfolios cannot do it by eliminating the polluters.

"If you want to decarbonize, then you have to go where the carbon is," said Megan Starr, New York-based global head of impact at Carlyle Group, in an interview.

Some 80% of economic life is still powered by fossil fuels, including 95% of all transportation in the U.S., the study said.

"We can eliminate 90% of carbon from portfolios without having any positive impact on underlying emissions," she said.

Carlyle could divest from a dozen portfolio companies and on paper, it would reduce emissions by 90%, "but it wouldn't reduce a single molecule from the atmosphere," Ms. Starr said.

Denying energy companies access to equity and bond markets has not resulted in a reduction of fossil fuels, said Jason Thomas, a Washington-based managing director and head of global research at Carlyle and author of the study.

In recognition of this, Carlyle is in the process of restructuring its energy business, Carlyle International Energy Partners, and combining it with its global infrastructure business to invest in the energy transition across traditional and renewable energy, as well as infrastructure.

Divestment is not popular with some investors either. They say they prefer to keep their seats at the table by remaining invested in fossil fuel companies. Among investors with this view are the C$550.4 billion ($437 billion) Canada Pension Plan Investment Board, Toronto; $454.8 billion California Public Employees' Retirement System, Sacramento; and $312.2 billion California State Teachers' Retirement System, West Sacramento.

Both CalPERS and CalSTRS oppose a state bill that would require the nation's largest two public pension plans to divest from fossil fuels.

But ESG is not just a way to help limit portfolio risks and do good for the society and the planet. Private market managers see ESG as a source of potential returns in themes such as the energy transition.

ESG and impact investing make up just a tiny slice, 1% to 2%, of the entire private equity landscape, estimated Warren Valdmanis, a Portland, Maine-based partner at Two Sigma Impact, the impact investment business of Two Sigma Investments LP that focuses on workers.

However, it has the potential to grow because "the risk-adjusted returns in the space can be quite attractive," Mr. Valdmanis said. Impact investing is a "non-concessionary effort." Rather than give up returns, investors could gain alpha, he said.

In the public markets, there's now a greater push from investors for better reporting on workforce data because investors realize that employees are a big asset for companies, Mr. Valdmanis said.

But private equity managers consider investing in companies' workforces as inflating costs, he said.

"Private equity has long thought of workers as a cost they had to reduce," Mr. Valdmanis said. "And that's got to change."

Companies that provide good jobs, offering better wages, benefits and career advancement, should perform better, he said.