Private Equity Joins the Race to Net Zero

Misa Andriamihaja, Private Equity Lead at the Institutional Investors Group on Climate Change, explains how new sector-specific guidance will catalyse climate-related action.

Weak economic activity, high interest rates and myriad geopolitical pressures present significant headwinds for private equity, weighing down valuations and slowing investment at a time when the private capital is vital to accelerating the net zero transition.  

Put simply, the private equity market is in a challenging environment. However, sustainable investment continues to provide great opportunities in these times of hardship, according to Misa Andriamihaja, Private Equity Lead at the Institutional Investors Group on Climate Change (IIGCC). 

During SuperReturn International, the world’s largest private equity and venture capital event, held earlier this month, Andriamihaja tells ESG Investor that general partners (GPs) and limited partners (LPs) expressed their deepening commitment to engaging and deploying capital to ESG-related investment opportunities. 

Within this context, the IIGCC published its Net Zero Investment Framework Component for the Private Equity Industry, with the new guidance aiming to provide a global and cohesive framework for pursuing net zero via private equity investments, with an emphasis on achieving decarbonisation of portfolio companies. 

“The guidance provides a consistent approach for all actors in the private equity industry – GPs, LPs and portfolio companies – to set their own targets, engage with each other and report in alignment with one another,” says Andriamihaja, adding that the guidance is intended to be adopted by any private equity investor active in buyout, growth, and associated strategies. 

“We hope that the sector-specific guidance will catalyse climate-related action across the private equity industry.” 

Decarbonising private portfolios  

Despite their comparative size, with the global listed equities market valued at around US$124 trillion compared to US$10 trillion for private markets, according to data from Securities Industry and Financial Markets Association and McKinsey, mobilising climate action within private markets is vital.  

The key reason being that private equity and venture capital will play a crucial role in the path to net zero by accelerating the growth of new technologies that can facilitate the winding down of unstainable businesses and sectors.  

Analysis by non-profit Net Zero Tracker showed that only 32 of the 100 largest private firms have set net zero targets, compared to 69 of the biggest publicly traded companies – highlighting that the role that investor engagement can play in aligning private markets to the goals of the Paris Agreement.  

In a recent op-ed, Jennifer Signori, Head of Private Markets ESG and Impact Investing at asset manager Neuberger Berman, private equity investors are uniquely positioned to effect change, given they generally have controlling ownership of companies and, therefore, have greater potential to influence strategic and operational change to tackle climate risks and opportunities than many public equity investors.  

“Real economic value is at stake, so adaptation and mitigation plans are necessary. Companies that succeed in this changing environment or, even better, thrive while leading the adoption of new approaches, are likely to be viewed more favourably and to create value for their investors.” 

Andriamihaja, also Founder and CEO at Green Ventures Capital, shares similar sentiments, noting that the world will fall short on decarbonisation targets if investors only focus their attentions and engagement activities on publicly listed companies. 

“A lot of the investments that support this decarbonisation start in private markets, whether through venture capital or private equity,” she says. “Over the life cycle of these companies, they will need to pursue a decarbonisation journey as they aim towards a public listing in the future.” 

Unique characteristics 

The IIGCC’s private equity guidance builds on its Net Zero Investment Framework (NZIF), which aims to provide a consistent foundation for asset owners and managers to align portfolios with net zero emissions by 2050 or sooner. The sector-specific guidance expands the coverage of the NZIF to six asset classes following the recent addition of the NZIF infrastructure component.   

Andriamihaja says that the private equity component is inspired by and follows the core principles of the NZIF, but the IIGCC acknowledged that it had to adapt certain elements of the guidance to accurately reflect the unique characteristics of private markets. 

One such adaptation is a concept called the Influence Band System, which recognises that external investors (LPs) will not have the same level of influence on a portfolio company as wielded by the GPs that manage the funds. 

There are six influence bands in total that can be broadly grouped into two categories: direct influence and indirect influence.  

The three direct influence bands apply to investments made directly into a portfolio company and are most frequently relevant to GPs, while the three indirect influence bands apply to investments where a GP sits between the organisation and the portfolio company. All six bands are distinguished by the number of voting seats on the board appointed by the organisation, which impact the level of influence it has on the portfolio company. 

Expectations for the speed at which net zero alignment can be achieved vary across influence bands, with GPs’ or LPs’ exposure to different bands informing appropriate portfolio coverage targets, as well as tailored engagement actions that are designed around the influence levers available, given the band’s dynamics. 

The new guidance also includes specific engagement tools and best practice for GPs and LPs to apply transition-enabling actions at different stages of the investment life cycle to increase the alignment of their portfolios with net zero targets. 

“The guidance is all encompassing and covers how GPs and LPs engage with each other, as well as how portfolio companies report to the GP, which in turn reports to the LP,” says Andriamihaja, noting that consistency in these interactions is important.  

Stepping up on climate 

Last year, the Private Equity Climate Risks project, a collaborative effort investigating the industry’s impact on the climate crisis, published a scorecard report calling on several of the largest private equity firms to align their portfolios with science-based targets to limit global warming after revealing that 80% of their energy portfolios were in oil and gas.  

The eight firms assessed in the report, included Warburg Pincus, KKR and Blackstone, among others, with Carlyle Group ranked last among its peers, earning it an F grade.  

New data from PwC Luxembourg paints the industry in a more positive light, however, suggesting that the majority of GPs and LPs are shifting towards an “ESG or nothing” investment philosophy, with over three quarters of the 300 market participants it surveyed planning to cease investing or promoting non-ESG private market products by the end of 2023.  

“The global private markets landscape is on the verge of a substantial ESG-led transformation,” said Olivier Carré, Financial Services Market Leader at PwC Luxembourg, adding that LPs globally have been increasingly focusing on ESG considerations across various private markets asset classes, with GPs that fail to adapt to changing investor demands risk losing business. 

“In this rapidly changing backdrop, GPs are urged to rethink their modus operandi and embed sustainability considerations at the heart of the operational and investment philosophies in order to keep abreast with regulatory developments, meet investor demand and play a key role in the sustainable transition,” he added.  

The IIGCC’s new sector-specific guidance, therefore, has come at an inflection point for the industry, as it begins to take steps to significantly reduce greenhouse gas (GHG) emissions to mitigate the impact of the global climate crisis and limit investors exposure to transition risks.  

Andriamihaja acknowledges that the majority of the private equity industry is not yet adequately integrating climate change risks and opportunities into its investment decisions. However, she says there are core leaders within each sub-asset class – buyout, growth and continuation funds – who are vocal and setting an example for others in the market to follow.  

While private equity has had a bad reputation in some buyouts, it’s important to recognise that private equity is diverse, with specialist managers focusing on climate and an emergence of managers launching climate solution funds,” she says.  

Our job at IIGCC is to support investors in transitioning their thinking and implementing these changes – this is where our role becomes important,” she adds, noting that its new guidance will play a pivotal role in moving the industry towards sustainability. 

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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