Asset owners' investment lens changes

Many asset owners in private markets say they are looking at investments through an ESG lens, not simply as an afterthought.

A biannual private equity investor survey of limited partners released June 8 by Coller Capital Ltd., an alternative investment secondary markets manager based in London, found that 65% of survey respondents see ESG as adding value, both through proactive change to portfolio companies and exclusion of high-risk investments and business practices.

By environmental, social and governance topic, 93% of the private equity investors surveyed said they focus on climate change as a risk, followed by water quality/access at 42%, air quality at 33%, microplastics and biodiversity at 28%, and deforestation at 25%.

"Our ESG policy has evolved since 2011 and as it evolved, the managers have evolved," said Stephen O'Neill, head of private markets at the National Employment Savings Trust, London. The £24 billion ($30 billion) defined contribution multiemployer plan has roughly 10% allocated to private markets, and plans to double that in five years, Mr. O'Neill said.

Another survey conducted in February by the Institutional Limited Partners Association in Washington and Bain & Co. in Europe of more than 100 limited partner organizations found that over the next three years, 68% expect to increase both their ESG investment allocations and in-house ESG capabilities, and 80% will be ramping up ESG reporting requests to fund managers.

Climate risk tops many investors' ESG priority list. A Pensions and Lifetime Savings Association survey of 91 U.K. pension funds in May found that 74% have net-zero plans in place or planned within the next two years. After climate, diversity and inclusion and human rights were the next priorities for pension funds over the next 18 months.

For NEST, a big priority "will be to crystallize our path toward net-zero," Mr. O'Neill said.

As more investors adopt strategies and investments that address climate change and other environmental challenges, "the focus is starting to shift to the 'S,'" Mr. O'Neill said. In terms of investments, that social category of ESG could mean an investment such as affordable housing in an infrastructure debt portfolio, or private asset classes with more tangential effects, such as the impact of an onshore wind project on the surrounding communities.

ESG priorities also vary by geography, said Suzanne Tavill, Sydney-based partner and head of responsible investment at StepStone Group Inc., an alternative investment consultant and money manager.

U.S.-based limited partners focus on diversity, equity and inclusion, while in Europe "the dominant focus is around climate change," said Ms. Tavill, who expects climate to gain more attention from U.S. investors when proposed regulations take hold.

The ILPA survey found more North American limited partners concerned with ESG risk mitigation, while their European counterparts focused on opportunities to drive or improve ESG performance. They also diverged on what would be a deal-breaker that would cause them to walk away: 72% in North America thought negative publicity would do it, while only half in Europe agreed. A manager's disinterest in improving poor ESG performance would kill a deal for 78% of European LPs, but only 44% of North American ones, the ILPA survey found.

Asset owners take various approaches to addressing ESG in private markets. The $279.7feet billion New York State Common Retirement Fund, Albany, evaluates investment managers' ESG policies and practices to assess their approach and commitment to ESG, spokesman Matthew Sweeney said.

"As part of the due diligence process, the fund completes a full ESG review for every proposed investment, which includes a review of a manager's practices related to addressing climate change, human capital management and DEI. After an allocation is made, the fund monitors progress on an ongoing basis," Mr. Sweeney said. Pension fund officials evaluate and expect to see improvement over time in such things as how the manager integrates ESG factors into its own due diligence, how the manager reports ESG performance to clients and ESG integration as part of the manager's investment committee reviews.

That sounds right to Mr. O'Neill of NEST. Investors in private markets "ought to have more influence on how a business operates. We are also a lot more selective. We select managers and we hold their feet to the fire in periodic updates," said Mr. O'Neill, who stressed that its mandates are discretionary.

NEST is also building its own performance indicators, to "have a sense of the overall picture and how it leads to change," he said.

The $312.2 billion California State Teachers' Retirement System, West Sacramento, has a private markets working group that focuses on estimating portfolio carbon emissions, and defining and identifying low-carbon investments.

CalSTRS expects to commit about $1 billion per year in a collaboration with its private asset class teams, and its sustainable investment and stewardship strategies program. Near-term plans are to focus on two investment opportunity sets: climate-related solutions for large industrial processes, with annualized return profiles of 10% to 15%, and commercially viable low-carbon solutions requiring growth equity, with annualized return profiles of 20% or more, according to a staff report.

At the Washington State Investment Board, Olympia, which oversees a total of $192.3 billion in state defined benefit plan, defined contribution plan and other assets, each asset class team is responsible for ensuring that their own investment process adequately addresses financially material ESG risks and opportunities, said Chris Phillips, director of institutional relations and public affairs at WSIB.

WSIB increased its exposure to renewable energy, for example, by 34.8% to 0.71% of total assets, according to its 2021 ESG report. In private equity, it is looking at investments in the developed markets in alternative energy as well as less carbon-intensive fossil fuels such as natural gas.

In April, for instance, WSIB committed up to $250 million to The Rise Fund III, a private equity fund with an impact investing focus managed by TPG.

Institutional investors' ESG interests in private markets are starting to converge, said Edward Dixon, London-based head of ESG for Aviva Investors' real assets platform that includes real estate, infrastructure and private debt, representing £47 billion out of £268 billion in assets under management.

"Over the last two years, we're seeing much greater commonality between clients in terms of their ask of asset managers and their consultants," Mr. Dixon said. "We are also seeing much more informed asks from clients in terms of understanding the trajectory of their portfolios" when it comes to their ESG priorities.

"We are also seeing more examples of asset managers coming together with a structured ask of the borrower community or the (real estate) occupier community, so that more comparable data is being collected and referred now from asset manager to asset owner," he said.

"The bottom-up initiatives and the top-down push are finally starting to tie together a little bit, which is really positive," Mr. Dixon said.

Still, when it comes to data and metrics for risk and results, it is "a huge mountain to climb, and we might be 10 to 20 years from where liquid markets are now in terms of comparability and availability of data. I think we are in the foothills and it's going to take another 10 years to get there, most likely," he said.

Private market managers also can learn from public markets when it comes to engaging with underlying assets on ESG criteria, Mr. Dixon said. "The topic of engagement in private markets is becoming much better understood between asset managers and asset owners, which is leading to the need for asset managers to better engage in a much more structured way in private markets, and be able to prove it, which is a great place to be," he said.

Steve Doire, head of strategic client and platform advisory at investment accounting and reporting firm Clearwater Analytics in Boston, thinks that key performance indicators for private markets are on the horizon. "The frequency of questions by stakeholders continues to build, and increasingly it is by regulators, too. Given the lack of standards, and as regulators center their attention, it is likely they will drive some sort of standard" key performance indicators, Mr. Doire said. In private markets now, "an asset owner has to ask these questions," he said.

Geordie Cox, investment manager for Cardano Group in London, a pensions advisory and investment manager with £50 billion in assets under management and advisement, said they use private markets within client portfolios in many circumstances. "It's a really valuable tool to build diversified portfolios … as long as pension funds are able to invest over the long term," Mr. Cox said.

The key is having control over managers. "That ability to put the right people in a governance structure, to put right policies in place, the right focus in data collection and reporting has always resulted in a better outcome," he said.

Allocators need to be clear with managers, "so we incorporate ESG before our discussions, during and when we are looking to exit," Mr. Cox said.

Lynn Forester de Rothschild, founder and chairwoman of the New York-based Council for Inclusive Capitalism, a group of business and religious leaders representing $10.5 trillion in assets under management, is concerned about a lack of oversight of private market managers when it comes to what ESG means. Instead of ESG labels, managers should show their metrics and be engaged with companies in their portfolios.

"What a pension fund owner should make sure (ESG) means is that the fund manager has a clear articulation of what metrics it uses when analyzing a potential portfolio investment along the lines of human capital and natural capital. The manager should tell the pension fund very clearly these are our metrics before we make any investment … and we will report back to you on our achievement of these metrics," Ms. Forester de Rothschild said.

While some private market managers get that, more "are going to get it once their investors make it clear that this matters. They are not going to do it without the pressure from investors," she said. "All the power is with the pension funds."