Commentary

ESG and the Liquidity Spectrum

Patrick Ghali, Managing Partner, Sussex Partners, reviews actively managed options for ESG-focused investors from alternative UCITS to impact-oriented private equity.

When looking at investing into ESG-specific strategies, the liquidity of underlying investments is an important factor to consider. Investors have different liquidity preferences and constraints, which may largely determine the types of strategies available to them. It consequently makes sense for investors to carefully consider the outcomes they want to achieve from their ESG allocations and ensure these ambitions are matched by the liquidity profiles of underlying strategies.

For the purposes of this analysis, we have ignored index-like products, and instead have focused on actively managed strategies, particularly those available to European onshore investors. Active management has a crucial role to play in ESG investing, given the additional complexities involved. Investors thus primarily have a choice between two ends of the spectrum: liquid UCITS products or impact investments which typically require longer lock-ups and tend to be offered in private equity format.

The ESG UCITS universe has grown rapidly in the past few years, with 7,459 ESG UCITS funds as of September 2021 and an estimated AUM of US$3.9 trillion[1]. Equity strategies continue to dominate, representing roughly 40% of the universe as of June 2021, followed by bond and multi-asset funds which represent 30% and 19% of the universe respectively. Not surprisingly, the vast majority of funds are located in Europe with the US taking a distant second place, and other geographies trailing behind (the current regulatory changes in Europe clearly are having the desired effect and leading to more and more ESG focused products).

Exhibit 1 Global Sustainable Funds Q3 2021 Statistics

Exhibit 2 Asset class split by # of funds (as of H1 2021)

Of interest is that fees of ESG UCITS funds tend to be lower than those of traditional UCITS funds, almost certainly a reflection of the fact that ESG funds have launched most recently, and managers are having to adapt to continuing fee pressure rather than anything to do with ESG as a strategy.

Fertile ground

While a large part of the UCITS universe is comprised of long-only funds, our focus at Sussex Partners is on the more difficult-to-access alternative UCITS universe. Whilst data on this space is hard to come by, our research estimates that about 600 alternative UCITS funds currently have an ESG policy in place and comply with relevant disclosures under the Sustainable Finance Disclosure Regulation. Of these, about 100 comply with Article 8, are mainly domiciled in Europe and represent an AUM of approx. US$100 billion. But as with long-only funds, care needs to be employed here as evidence of greenwashing seems to be widespread and we have uncovered a good number of managers that purport to be ‘green’ or ‘ESG’ managers, but that are neither Article 8 nor 9-compliant. This is of concern as it shows that the true integration of ESG policies in the investment focus is still quite superficial.

Alternative ESG UCITS funds offer a more varied mix of strategies than their long-only peers but our experience has shown that the vast majority (85% by our own internal estimation) of the funds are focused on the E in ESG rather than the S or the G.

Exhibit 3 Strategy breakdown

It is in this alternative UCITS space that we believe investors will find the most interesting, liquid, strategies going forward. The reasons are similar to other markets and include the current lack of competition (given the still small size of AUM, and limited number of managers active in this space), the enormous amount of capital being directed towards ESG projects (some of which, no doubt, will be misallocated and will lead to shorting opportunities) and the general inefficiency of often nascent markets (such as carbon trading and renewable energy). Rapidly increasing valuations in certain sectors, often with little regard to fundamentals, can also create opportunities for managers both on a momentum and a mean reversion basis. We envisage more strategies will be developed which bear little correlation to traditional markets (e.g., carbon trading, energy trading, etc.). Similarly, we expect there to be fertile ground for experienced fixed income managers as these markets continue to mature.

Rewarding patience

Impact-oriented strategies, on the other hand, can generally be assumed to be less liquid, and target specific outcomes (think blue economy, decarbonisation, deforestation and such like) which often require not just a very specific skill set, but crucially time to effect the desired impact. It is not unusual for these funds to allocate across the life cycle of companies, and they tend to have venture capital as well as late stage/industry consolidation investments in their portfolios. Many of the industries targeted by these funds include elements of new technology, or infrastructure which still needs to be created (e.g., refuelling networks for hydrogen, new technologies for shipping hydrogen over large distances, new marine technologies to improve biodiversity etc.).

These funds often include a scientific advisory board or an impact investment board which plays a crucial role in approving or vetoing investments. Impact investments therefore tend to better suit investors with a longer-term time horizon, and a different risk appetite. But for those who specialise, the sector is attractive. Impact investing has increased rapidly in recent years with a size now estimated be more than US$715 billion in AUM (with AUM growth of US$48 billion forecast this year according to one recent survey), with half of the investors based in the US and Canada and around 29% based in Europe (excluding Eastern Europe).  It is a sector that we believe will continue to attract healthy investor capital inflows.

It may be easier to measure the actual impact of these investments compared to those of liquid UCITS funds. It is therefore now also possible to find impact managers that are willing to tie a large part of their performance fees to very specific, pre-defined impact measures, something which is much harder to do with liquid strategies where investors can redeem before any measurable impact has been achieved.

With any investment, it is always important to ensure that the liquidity offered by an investment matches the liquidity of the underlying assets to avoid liquidity mismatches. In the case of ESG investing, ensuring that the liquidity matches the targeted outcome of each strategy is an additional element that investors need to carefully consider, and which adds an additional level of complexity to the due diligence and ongoing investment process. Investors need to reconcile their financial with their ESG expectations. Failing to do this properly may lead to significant disappointments on both fronts.

[1] Morningstar. (2021). Global Sustainable Fund Flows: Q3 2021 in Review.

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