Challenges European Dealmakers Are Facing with ESG Criteria in Private Equity Investments

Intralinks Mergermarket Dealcast M&A Podcast

In this week’s episode, we’re joined by abrdn’s Alistair Watson, head of strategy innovation for private equity, and Kanika Goela, investment manager. Together, we discuss the pressing challenges European dealmakers are facing in relation to sustainability and environmental, social and corporate governance (ESG) criteria within private equity investments.

Dealcast is presented by Mergermarket and SS&C Intralinks.



Welcome to Dealcast, the weekly M&A podcast presented to you by Mergermarket and SS&C Intralinks.

I'm Julie-Anna Needham, a journalist who's been covering M&A for a decade.

This week's special episode is in partnership with Aberdeen. In it, we'll be examining the challenges European deal makers are facing in regard to sustainability and ESG criteria in private equity investments.

I'm joined by Abrdn's Head of Strategy Innovation for Private Equity, Alistair Watson, and also by Investment Manager Kanika Goela.


Hi, Kanika. Hi Alistair. Thanks very much for joining me today.


Hi there.

So, can we begin with you, Kanika? What are the challenges of assessing sustainability or ESG criteria in private equity?

So Julie-Anna, sustainability is a broad topic. And the first and foremost challenge that arises is that different people mean different things when they talk about sustainability, which leads to a lot of misunderstanding and confusion. So maybe I can just set it in context of how we see it within the investing space.

So sustainable investing practices are focused on delivering financial returns but also long-term environmental or social value.

That broad topic covers ESG-focused investing. It covers thematic investing as well as impact investing. So ESG investing practices will typically focus on identifying and pricing environmental, social, and governance risks to a business and then translating that into your investment criteria.

Thematic investing will typically focus on identified outcomes that you want to achieve through your portfolio, which could, for example, be related to people and planet, like example, in the health care strategy. And impact investing is focused on intention of delivering a positive and measurable social and financial impact alongside financial returns. So it could be investing behind technologies, for example, which help decarbonization.

So to put it very simply, ESG practices focus on how a business does things. So it's more inward-looking and impact, and thematic investing practices focus on what a business does, so that's the environmental and social impact deliver from its products and services. So the next challenge that comes up is that different fund managers and different investors have different criteria on how they apply these practices on a day-to-day basis.

And there is no agreed or commonly accepted standard of best practices. So what looks good to someone may not look good to someone else. What's acceptable to someone may look great to someone else, and there are differences of opinion in the industry. And that is what leads to a lot of challenges in assessing ESG and sustainability.

Yeah, the standardization of how to have an agreed framework, I guess.

Yes. And, yeah, it becomes very philosophical.

Yeah, and Alistair, anything to add to that?

Yeah, I think we are making I think significant progress in ESG and sustainability just now within our industry. But we I would say we're in a slightly frustrating phase where we're really trying to catch up in terms of reporting, so being able to report on key metrics rather than really focusing on action.

And so what we've always trying to do in terms of our investments when we're investing with fund managers or in companies is really emphasize the action because there's such a positive opportunity that private equity can take. So it's all very well investing in companies that you can regard as sustainable, but what we're really trying to do, I think, for some of our clients is invest in businesses that are genuinely changing for the positive or businesses that are providing solutions because there's huge environmental and social challenges that we're all aware of and we really need to act now and make that progress.

Thank you. And that brings us nicely onto the next question looking at the parameters of ESG. There have been a lot of changes over the last 12 to 18 months when it comes to the move towards net zero. There's been a big rise in energy prices following the invasion of Ukraine. Although they've gone down slightly since bringing coal back online, talking about gas.

Kanika, can you tell us how have the parameters of ESG changed as a whole to bring us to this point in mid-2023?

I would say the parameters of ESG practices per se they haven't changed because of in the context of the war or rising energy prices. The what investors focus on might have changed. If you come back to ESG practices, as you were saying, there are different philosophies that different investors and practitioners are following in the market.

And I read this really interesting report which breaks it down in a very simple and easy-to-understand analogy. So, for example, you say we should eat more vegetables and vegetables are good for us.

So you could be a vegan and just have a plant-based diet, or you could choose to reduce your meat intake and increase your vegetable intake. Or you could say, look, I'm having pizza, and I'm loading that with tomato sauce, and that has vegetables.

So if you translate that, vegan is an ESG purist.

The one who is trying to reduce their meat intake is an ESG pragmatist. And the third philosophy is an ESG pluralist. So what we try to do is, for us in private equity, we would exclude certain sectors, for example, weaponry, oil and gas, et cetera, and then also take into account what the managers are doing or what the companies are doing in terms of ESG practices.

But oil and gas-focused fund could just say, look, we are focused on changing the operations of this company and making them greener. And it could be decarbonization of their operations. It could be better employee health and safety, better DE&I, and they consider that's positive ESG progress.

And Alistair, coming to you on that one.

I think it's important to emphasize that everybody focuses on the environmental aspects of ESG.

But I think in the last few years, there has been increasing focus importantly on the social and governance aspects, particularly on the social. So we see much more emphasis when we're looking at investments on areas like gender diversity, employee engagement, treatment of employees. And I think these are really important aspects when we think about both and also sustainability of businesses.

Thank you. And staying with you, Alistair, where is the pressure to invest in ESG coming from, and to what extent is ESG transforming investments when it comes to private equity and also companies looking to do M&A?

There's a huge, I would say, generational change that's been happening over the last few years. So we look within our own team investments that we might have made five or 10 years ago. They're not bad investments per se, but there's probably investments that we would not make today, and there's a real push from our next generation of investment team and other employees who are really pushing us on all the aspects of ESG and sustainability to make better decisions and more informed decisions.

So it's happening from within our own team. I think the other thing I'd say is that our clients and the end asset owners are really pushing hard on these aspects. It's becoming absolutely paramount to focus on these areas.

And you say it's a generational thing. Do you see the younger generation-- without moving too much into cliches here-- but do you see the younger generation both in terms of the people that you work with and the investors being hot on those social aspects of ESG?

Absolutely. Absolutely. We were talking about this yesterday. There was an investment a couple of years ago where there was a very, very interesting investment opportunity, which has ended up performing extremely well from a financial perspective, but we had to decline it for ESG reasons really focused on social and reputational issues, and it was younger members of our team that challenged us and really pushed in those points which I think was fantastic to see. And we're seeing that more and more.

When we look more broadly, I think the ESG sustainability focus has really started in Europe. So we've really seen countries like France, the Netherlands, the Nordics really taking the lead. I think the UK now there's a lot of focus within the pension funds and within New governmental regulation that's really going to drive, I think, positive change in the next few years.

Great, thank you. And staying with you, Alistair, link to that, to an extent, greenwashing is a major topic. And there are some signs of pushback from investors who see their firms as placing too much emphasis on ESG. What are your thoughts on that?

Greenwashing is a real challenge. It's something that all of our investors bring up with us.

It is linked to the first point I made, really around action versus reporting, glossy marketing versus actually doing something and making changes and really pushing for changes within the companies themselves. The regulation is very strict, and I think you'll see, for example, that the UK regulation that's expected to come in over the next couple of years, the SDR, that's really focused on addressing this issue around greenwashing.

We try to invest in people of very high integrity, but with our fund managers and our underlying companies and we're really trying to, as I say, move from a sort of negative screening that we might have had five years ago to really making positive investment decisions within companies that want to improve in terms of sustainability and companies that want to provide solutions to some of these major challenges.

Thank you. And Kanika coming back to you.

Can we talk about the rise of impact funds in recent years? What's driving this, and is private capital best positioned to help drive impact?

Yes. So definitely Julie-Anna. We are seeing a rise in the demand for impact investing or sustainability-focused investing and therefore increasing supply. So if you look at within private equity is one of the fastest-growing asset classes growing at about 30% per annum though it's still a very tiny part of the overall private equity AUM.

But we've seen an acceleration, especially over the last couple of years, especially if you look at 2022, '23, where thematically, private equity fundraising has been quite challenged. But impact or sustainability-focused investing has been one of the areas of growth where a significant capital is still being deployed towards. So just as an example, in 2022 alone, about 8 and 1/2 billion euros was raised by impact funds, focus on Europe, which is four times the amount which was raised the previous year.

And then, what is driving this? Similar to what Alistair was saying earlier, it's really investor demand and wanting to align capital in line with your values. It started with family offices and developing financial institutions, but it is definitely becoming more mainstream among institutional investors as their clients ask for more exposure.

And then thematically, again, yes, the social outcomes are good. But if you look at the overall AUM, it's definitely climate change focus strategies which are garnering more interest in the market, and that's driven by the drive to net-zero, especially in Europe and in the US as well. So whether private capital is well-placed, so I think we would argue definitely, yes, private capital is very well placed to drive that impact, and that comes from one, just the governance rights that we have.

So whether you're a venture fund or a buyout fund, you'd have board representation. You have significant voting rights, et cetera, so really ability to influence a company's operations. And second is a longer holding horizon as well, where you can see some of that go through.

Great. Thank you. And staying with you, Kanika, can you explain briefly, if possible, what is an Article 9 Fund?

I try my best to explain it briefly.

So Article 9 Funds it's the Sustainable Finance Disclosure regulation which was introduced by European Commission. And it basically puts a strong ESG-related disclosure requirements on asset managers and financial market participants. And that's partly to address the point we were discussing earlier about greenwashing and just to make it more transparent for investors, especially for investors.

So there are three product classifications under SFDR which is Article 6, which is a fund which does not integrate any sort of sustainability criteria into that decision making. You have Article 8 Funds which are light green funds which promote social or environmental characteristics. And then we have Article 9, which are dark green funds, and these are products which target sustainable investment, and 100% of their investments will be deemed sustainable.

Great. And coming to you next, Alistair, can a GP actually adhere to all of the requirements of Article 9?

It's a good question.

We are seeing some managers choose to be Article 9 and others choose to be Article 8 Plus. You might want to refer to Kanika for a precise definition of that. But we do think managers can adhere to the requirements of Article 9, but it's evolving in terms of the landscape. I think people are having to take significant advice from lawyers, auditors, but it's really a practice that's developing.

Yes, so frustratingly, I think the Article 9 regulation it works fairly well for larger companies that can report and provide all information up front during the diligence processes and maybe for high-growth venture companies that also can provide that data. But there's a huge area within the middle market, smaller companies, for example, buyout businesses that haven't been able to report their carbon footprint yet.

So you might think a company's is sustainable, it's improving, it has a very strong culture, but you can't at this stage define that investment as an Article 9 because you cannot get all the information during the due diligence phase. So I think that's the big challenge, and it's an area that means a lot of people are having to move to Article 8 Plus or Article 8.

Thank you. And it sounds like that it's quite an onerous admin burden for all of the companies involved.

It absolutely is. And what we have to remember is, particularly in the buyout arena, when you're trying to win an investment, you're trying to having to do due diligence fairly quickly, you're having to move through a process, you're having to convince the management team to work with you.

If you're an Article 9 Fund competing with Article 8 Fund, it could be that the Article 8 Fund is able to win that deal because they don't have all those extra requirements. so it's pretty challenging.

And so, Alistair, what are your thoughts on that? What are the next challenges in sustainability, and what do you have your eye on?

I think one aspect that is often missed from the discussion is that private equity tends to focus on asset-light businesses, so on software that is enabling change, enabling efficiency, for example. There's a huge opportunity that's actually required to make the change we need in areas such as space tech, areas like EV batteries, and areas in health care that are very CapEx intensive.

So I think there needs to be discussion, even at the governmental level, as how to finance these CapEx-heavy projects that are going to be important in terms of making that change over the next 10 or 20 years. So debt financing and equity financing that's more suitable for those types of strategies.

And Kanika, let's finish by looking at what the next challenges are in sustainability. What do you have your eye on?

So I would say three things.

One is a bit more philosophical, not missing the wood for the trees.

Second is data. And third is returns.

So what I mean by the first is really not to, as asset owners or investors, not to get too caught up by regulatory labels. And you really need to look under the hood, understand strategy and design details of what the manager is doing and then make a judgment call on whether it's impactful in your view and really not let perfect become the enemy of good.

The second is data. I think Al was mentioning earlier we are collecting a lot of data non-financial KPIs from companies, and it will only increase with increasing regulation CSDR, SDR, et cetera. So the ability to just make sense of all of that data, which is not as agreeable or comparable like balance sheet or P&L metrics are, is a challenge.

And then how to interpret, analyze it, and then prioritize what data to gather and to measure and report, to really go meaningfully from what, so what, to the now what, the action that I was referring to earlier is a challenge the industry needs to go through and resolve over time.

And the third is returns.

It's very encouraging to see investor interest and a lot of funds being raised in the space. But if you look at impact investing historically, the financial returns have been mixed.

So we, as asset managers, currently want to focus on strategies where the managers are truly differentiated and disciplined in terms of pricing to be able to deliver good financial returns. We are seeing some track records emerge, which is very encouraging again, but we just need to see more of that evidence to really convince the broader investor community that this is an attractive asset class to invest behind.

Great. Thank you. And Alistair coming to you with the same question, what do you have your eye on? What are the next challenges in sustainability?

I think something that's often missed is that private equity tends to focus on asset-light business models, so software, for example, that's helping to enable environmental change and efficiency. I think when you look at investing in traditional industries or in industries that are going to change things going forward, such as space technology or, for example, EV batteries or those types of sectors, private equity today as it's structured is probably not set up to finance those capital intensive deals.

Those deals are, and companies are going to be super important in the change we've talked about in environmental change over the next 10, 20, 30 years. So I think in discussions with government and investors, we need to find a better way of financing those types of projects thinking about debt capital, government incentives, and how to structure the equity investing in those areas.

So I was just going to add on to that it's also encouraging, alongside private equity strategy, also to see infrastructure strategies raise a lot of money. And that's again key missing part of the piece of the puzzle to bring it all together.

Right. Kanika and Alistair, thanks very much.


That was Kanika Goela, Investment Manager, and Alistair Watson, Head of Strategy Innovation for private equity, both from Abrdn.

Thanks for listening to this week's special episode of Dealcast, presented by Mergermarket and SS&C Intralinks in partnership with Abrdn. Please rate, review, and follow the podcast. You'll find us on Apple, Spotify, or look out for your Mergermarket news alert.

For more information, have a look at our show notes. Join us again next week.