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Impact investing through private markets
February 15, 2023
5 min read
For more than 40 years, private markets have consistently shown an ability to navigate difficult macroeconomic conditions, outperform public markets, and create value through new investment opportunities. This resiliency continues to be put to the test against a backdrop of declining public markets, rising inflation, energy shortages, and lingering supply chain issues.
While it can be difficult to find investment solutions that play both defense and offense within a portfolio, one strategy steadily gaining momentum is targeting investments that seek to create a measurable social or environmental impact. These types of opportunities tend to benefit from transformational market dynamics and trends, bringing potential for both compelling performance and downside risk protection.
Resilience through purposeA growing number of investors are adding ESG and impact exposures to their portfolios for their resilience and performance potential. In a recent industry survey, 50% of LPs said they view ESG factors as being additive to performance.1 This potential stems in part from the distinct, two-pronged approach sustainability-focused investments take in assessing risk and opportunity, which typically includes:
1. An ESG risk management framework integrated into the standard due diligence process, providing a level of protection against idiosyncratic risk. This additional angle gives investors a valuable view into how a company or investor manages the myriad of environmental, social, and governance risks.
2. Long-term environmental or social theme(s) as the key return lever, where capital expenditure is lacking, required, and likely relatively inelastic due to supportive regulation, socioeconomic benefits, and/or a shift in consumer preferences.
Why impact investing and private markets are highly compatible
While sustainability-themed and impact investing are still relatively nascent within private markets, there are several key features that make the two a good match:
Long-term focus: Many of the themes targeted are oriented toward critical forward-looking goals. This aligns well with the long-term investment horizons in private markets, which allow sufficient time for thoughtful and meaningful execution against these goals.
Access: Private markets provide access to investment opportunities that are often not available to, or easily accessed by, broader public equity markets.
Point of entry: Developing innovative solutions to support these long-term goals requires both time and capital in the early stages to truly drive progress. Given the key role private markets play across a company’s lifecycle, including the ability to invest in businesses that are not yet revenue-generating, private capital helps facilitate this early development in a rapidly growing space.
Point of exit: Investors are taking note of the premiums being paid for businesses that have a strong focus on ESG or sustainability themes that may lead to real-world impact, such as commitments to diversity, equity, and inclusion and climate change.
Nearly three-quarters of all private equity firms (72%) say they expect to capture a premium in businesses they are considering exiting based on specific ESG qualities.2
Ability to influence: Many private market opportunities offer majority ownership across a highly concentrated group of stakeholders, providing a greater ability to influence and use specific expertise to guide management teams toward optimal development plans and value creation initiatives. For private markets managers, it allows for more emphasis to be placed on impact in their value creation plans, including not only maximizing value for shareholders, but also for customers, employees, local communities, suppliers and distributors, and the planet. Managers can also leverage their operating partner model to share best practices across their portfolio companies, creating efficiencies and scaling businesses for impact.
Streamlined accountability: Company management teams are not subject to daily market movements or large numbers of minority shareholders, and instead maintain more focused relationships with stakeholders. This nimbleness allows for the optimal development of products or services supporting the goals driving investment.
Assets in impact-focused investments have doubled in just two years — and surpassed $1 trillion for the first time in 2022.3
Low carbon transition and energy security driving a huge opportunityThe risks posed by climate change are increasingly evidenced by physical damages caused by more frequent and intense extreme weather globally4 and the rising prevalence of climate attribution science.5 Global conflicts have further underscored the importance of more self-sufficiency in power grids and access to local, alternative energy sources. From an investing standpoint, tailwinds from lower-carbon consumption, mandated net-zero targets, and increased demand for energy alternatives are churning out new opportunities across a broad range of energy solutions. The IPCC, for example, estimates a need for annual investment in energy systems of around $2.4 trillion in order to help limit global warming to 1.5°C or less by 2035.6 More broadly, the OECD projects the investment need for water infrastructure to range from $6.7 trillion by 2030 to $22.6 trillion by 2050.7 While the growth projections may vary, the broader takeaway, in our view, is ironclad: There will be significant opportunity for investment into some of these themes going forward and we anticipate private capital playing an increasingly important role. One area that continues to benefit from private investment is clean technology, including renewables like energy and wind solutions and other alternatives such as hydrogen and hydroelectric. While demand has been steady over the past decade, investment in clean tech has shot up recently. In the past decade, private managers have sponsored more than 1,000 US-based cleantech companies, investing nearly $150 billion along the way.8
Clean tech deal activity
Source: PitchBook, data reflects clean tech companies across global private equity and venture capital categories as of 12/31/2022.
Social disparities driving the need for integrated solutions
These and other long-term, secular trends are driving the need for innovation and investment across key sectors. Increased long-term capital investment into technology, healthcare, and financials – three of the S&P 500’s top-five performing sectors over the past decade9 – should yield an abundant supply of impact-focused opportunities for investors.
We expect to see GPs focus on digital transformation across end markets. For example, technology is expected to drive improvements in education globally, enhancing accessibility, infrastructure, and student/teacher outcomes. It will also play an essential role in helping to develop more robust cybersecurity solutions as governments, businesses, and personal consumers seek to safeguard sensitive data.
The urgent need for a system that offers more equitable access and distribution of care will require significant investment and is further supported by a heightened global focus on research, development, and deployment. Aging populations, epidemics, and the need for personalized medicine should also be catalysts for investment demand.
As the need to provide greater access to formalized financial systems continues, we anticipate significant opportunities to help accelerate small business expansion, increase spend on financial and payments technologies, and support financial solutions for lower-income demographics.
The future looks bright
For the foreseeable future, companies in these and other sectors will be focused on solving specific, significant, global challenges that will require long-term private capital support to succeed. There are also strong secular tailwinds in place around climate and energy transition, consumer preferences, and social inequities – transformational shifts that we expect will drive major growth across the private markets landscape for years to come. As investors continue to face an uncertain macroeconomic environment, investing for impact through a private market lens can play a very effective role in portfolios by helping to counter the highs and lows.
Would you like to discuss the expanding opportunities for impact investing through private markets?
1 Limited Partners and Private Equity Firms Embrace ESG, Bain & Company, 2022
2 E&Y: 2021 Global Private Equity Divestment Study, “How private equity is refining exit strategies for stronger valuations”
3 Global Impact Investing Network (GIIN). “2022: Sizing the Impact Investing Market.”
6 Intergovernmental Panel on Climate Change, Global Warming of 1.5°C, Summary for Policymakers, 2018
7 World Economic Forum, Mercer, “Transformational Investment: Converting Global Systemic Risks into Sustainable Returns”, May 2020
8 American Investment Council, “The Clean Tech Revolution”, December 2021
9 S&P 500 historical 10-year returns, data as of 12/31/2022
This material is solely for informational purposes and should not be viewed as a current or past recommendation or an offer to sell or the solicitation to buy securities or adopt any investment strategy. The opinions expressed herein represent the current good faith views of the author(s) at the time of publication, are not definitive investment advice, and should not be relied upon as such. This material has been developed internally and/or obtained from sources believed to be reliable; however, HarbourVest does not guarantee the accuracy, adequacy, or completeness of such information. There is no assurance that any events or projections will occur, and outcomes may be significantly different than the opinions shown here. This information, including any projections concerning financial market performance, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.