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Sustainability Matters

Private Markets Offer Sustainable Opportunities

Material risks can be addressed while companies are young.

Editor's Note
This article originally appeared in the Q2 2022 issue of Morningstar magazine.

Not so long ago, but for a few impact funds, not much was happening in private markets when it came to sustainability. Today, not only have impact funds proliferated, but environmental, social, and governance analysis is fast becoming a standard feature of private equity and venture capital investing.

This makes sense because of the need to drive capital to address pressing problems facing the world, particularly climate change, natural resource constraints, and economic inequality. Private markets offer many unique opportunities to influence these issues. More-specific impact themes include clean energy, sustainable food and agriculture, clean water, access to quality education and healthcare, and diversity, equity, and inclusion.

It also makes sense because of today’s heightened public expectations for companies to meet the needs of all their stakeholders and embed sustainability into their long-term business models. A company that addresses material ESG risks and opportunities early, before it goes public, may find it a more-efficient use of resources than having to confront them once it’s grown into a larger, more-complex organization. As a result, more private equity funds are evaluating how their portfolio companies are handling material ESG issues.

As for investors in private markets, they are much like investors in public markets when it comes to sustainability. For one thing, all private-market investors are also public-market investors. And if they are demanding a sustainability lens on their public investments, why not on their private investments as well?

Impact Funds

In 2021, Morningstar subsidiary PitchBook identified more than 1,800 funds that were seeking social or environmental impact alongside financial returns. In a PitchBook survey released in October, 55% of general partner respondents said they now offer impact funds, and another 16% said they have impact funds in development. Most impact funds are less than five years old, and 40% were launched within the past two years.

On the demand side, according to the survey, 57% of those allocating to private equity funds said they were now making allocations to impact strategies, with another 18% saying they were developing an impact-investing approach.

ESG Analysis

In addition to the proliferation of impact funds, more private equity funds are evaluating the ESG risks and opportunities of all the companies they hold in their portfolios. In the PitchBook survey, more than half of respondents said they had integrated sustainable-investment principles through their portfolios or had partially done so. And more than 60% of those allocating to private equity funds said they consider a fund’s ESG risk factor framework during their due-diligence process.

That is a major shift from the days when companies held in private equity and, especially, venture capital funds were solely focused on achieving profitability, with sustainability a “nice to have” that might come later when a more established company could afford to address ESG issues. But today, more investors think early stages are the best place for companies to start considering their broader social and environmental impacts, focusing on stakeholders, and addressing the particular ESG risks and opportunities facing their industry.

Challenges remain, of course. The availability of ESG metrics for private companies is limited. And the effectiveness of impact investments is difficult to measure for impact investors who want to see an “impact return” alongside their financial return.

But the broader trend toward sustainable investing in private markets—consisting of both the incorporation of ESG risk assessments across the board and an increasing number of impact funds—will continue because the concerns around big systemic issues like climate change, inequality, and corporate responsibility aren’t going away.

The imperative of private equity investing is to create value by nurturing companies to profitability but also now to sustainability.