Private markets gaining on ESG implementation

ENVIRONMENTAL, social and governance (ESG) considerations have become increasingly important among corporates in recent years, as regulatory bodies around the world put pressure on companies to be more transparent about their ESG practices.

There is also pressure from the public. Companies that prioritise ESG policies are often seen as more attractive to employees, customers and suppliers, which can increase profitability and reduce exogenous risk.

Similarly, increasing numbers of investors are becoming interested in sustainable investing. Many now want to invest in companies that are not only profitable, but also have a positive impact on society and the environment.

However, while a lot has been done in public markets, private markets have so far remained a less-explored area in relation to ESG considerations. This gap needs to be addressed, as the total volume of private capital is projected to grow to around US$17.8 trillion by 2026, according to Preqin.

ESG implementation in private markets differs quite significantly from that in public markets. This is due to the divergent structures and regulations of the two markets. In public markets, companies are subject to more extensive disclosure requirements and regulations, making it easier for investors to assess a company’s ESG performance. Investors can also influence companies through shareholder activism and voting on corporate resolutions.

In contrast, private markets are less regulated and often operate under different rules. This means that embedding ESG factors can be more complex and might require a different approach. Hence, it tends to be harder to gauge private companies’ ESG performance.

Steps in the right direction

Private market investors are actually quite well-positioned to integrate ESG into their processes. In many private asset investments, the manager holds a majority ownership of the asset, which makes them more influential in driving significant change. Investors can actively engage management teams and influence decision-making processes to prioritise ESG initiatives.

This allows private market investors to be more flexible and make customised ESG-based targets and decisions, based on each underlying asset’s specific objectives and needs.

It has been heartening to see that private market firms are starting to recognise the importance of ESG factors in driving long-term value creation. A recent report by PwC found that more than 75 per cent of private market investors plan to stop investing in non-ESG products.

We also note that investors in private equity, venture capital and real assets increasingly incorporate ESG considerations into their investment decisions and portfolio management practices in a number of ways.

For example, the adoption of science-based targets in private markets is growing, and we have seen more private equity firms announce ambitious targets. These targets are designed to align a company’s emissions reduction goals with what is required to limit global warming to 1.5 degrees Celsius above pre-industrial levels. By setting these targets, companies demonstrate their commitment to reduce their carbon footprint and mitigate the impacts of climate change.

Private markets are also more focused on achieving a net-zero carbon footprint by 2050. This means that companies are committing to reducing their greenhouse gas emissions to a level where any remaining emissions are offset by actions such as reforestation or carbon capture and storage. This is a critical goal in the fight against climate change, and it is encouraging to see private markets take a leadership role to achieve it.

Another key reason for ESG integration in private markets is the desire to capture the attention of European and institutional investors who face more ESG regulatory requirements. Private markets are catching up to public markets in the development of Article 8 and Article 9 funds, under the EU’s Sustainable Finance Disclosure Regulation (SFDR).

A long road ahead

While strides have been made in private markets, there are still significant challenges when it comes to integrating ESG principles into investment decision-making and monitoring.

Since private market investments typically involve less public disclosure, the availability of reliable ESG data can be limited, making it more difficult for investors to fully evaluate both ESG risks and opportunities.

Compared to public markets, private markets have even less of a standardised approach to ESG reporting due to the diversity of private investments, and typically less transparency as well. This can make it difficult for investors to compare the ESG performance of different investments and to assess the impact of ESG factors on investment performance.

Addressing these challenges requires a collaborative effort among investors, companies and regulators to improve data availability, standardise ESG reporting and develop best practices for ESG integration in private market investments.

A good way to start is through engagement and setting credible ESG goals. Engaging with portfolio companies on ESG issues and setting robust goals can help to identify and mitigate risks as well as improve ESG performance. It is also important to track and measure ESG performance, which can involve helping companies develop metrics and benchmarks for reporting over time.

Something else to consider would be to integrate ESG factors into the decision-making process from the outset. This can involve developing a clear sustainable investing policy and criteria for screening investments, as well as conducting thorough due diligence on ESG factors based on established ESG evaluation and reporting frameworks.

As investor demand grows and regulations change, we expect ESG considerations to become a more prominent feature of private markets. The sheer variety of asset classes and investments available in private markets means that thorough research will be necessary to navigate the developing landscape.

Private ESG investments offer additional options for market participation and opportunities to drive capital towards positive impact. Greater commitment to ESG implementation will help build a more sustainable future.

The writer is director, sustainable investing, Fidelity International