Expect more sustainability discrimination in all asset classes

RELATED TOPICS

Due to a lack of listed mid-sized sustainable companies, private equity currently offers increasingly popular opportunities in the ESG space for HNWIs and institutional investors, writes Vincent Manuel (pictured), Global CIO, Indosuez Wealth Management…

2020 has been a remarkable year of performance for environmental leaders in equity markets, and more broadly for ESG champions. In terms of flows, more than USD30 trillion is already invested globally in sustainable assets, according to KPMG (a 34 per cent increase in two years), but USD90 trillion in investments is required to meet the goal of limiting global temperature increase to 1.5°C by 2030. Therefore, the investment opportunities should be as significant as the challenges facing us. Indosuez Wealth Management predicts this trend will continue, extending into private assets as a key contributor.

Fundamentals are structurally positive for environmental and ESG themes to outperform. Firstly, from a financial perspective, companies that do better from an environmental and social standpoint tend to be less exposed to reputational issues and litigation risks. The same goes for governance matters – think of the long list of companies whose market value has been affected by governance or transparency issues over the last years. This means that ESG leaders deserve a lower cost of capital and therefore a valuation premium. Market analysts confirm this argument, and MSCI ESG research shows that the top quintile of US ESG rated firms is granted a 25 per cent P/E premium to the market. This can be of course explained by sector bias after a decade where quality and growth companies outperformed value and cyclical stocks. However, the conclusion remains: investing in ESG leaders was a source of better resilience in the market downturn (Morningstar highlights that best ESG players lost 18 per cent in Q1-20 vs -24 per cent for the S&P).

Business models exposed to stranded assets and running the risk of being disrupted by innovation and new regulations are putting investor money at risk. Hence the accelerating repositioning of oil majors on renewable energy in the last two years – it is not just to look fancier to pension funds, it is a question of survival. A PWC survey indicates that 79 per cent of companies quote climate change as the major risk to address.

We are evolving from a vision where ESG is seen as a risk-enhancing driver to a vision where sustainability is perceived as a value creation driver. The current and upcoming challenges are about finding solutions, investing into carbon neutral infrastructure, transportation and housing. Governments are moving in this direction, and the amount of money they are finally ready to spend to fight climate change is an acceleration driver. For example, the European Recovery Plan and US President Joe Biden’s Build Back Better plan integrate a significant amount of investments on climate, with specific plans dedicated to new energy sources such as hydrogen.

For fund managers, these are vital topics, as ESG has become the new normal. Significant inflows have been piling up in ESG funds and ETFs last year; and the trend shall continue, with KPMG anticipating USD400 billion inflows in ETFs in the next decade. This should raise eyebrows, as there is a growing concern that a large proposition of funds (and notably passive investing) is not really contributing to reducing carbon footprint, raising the risk of greenwashing. TrackInsight recently mentioned that two-thirds of the USD175 billion ESG ETF market would not be aligned with the UN Sustainable Development Goals, an issue that regulators are trying to address. In this acceleration wave of new regulations, SFDR aims at imposing asset managers and financial advisors to disclose how they integrate sustainability criteria in their strategies. This may result in a better discrimination between players with significant credibility and those without a genuine sustainability DNA, or without the evidence that ESG integration leads to a material impact in their portfolios.

Private equity is a strong asset class to tackle these issues and invest into companies well positioned in the ESG space, benefiting social themes such as education, housing and health. Recently, Norway’s largest private asset manager and two significant pension funds from Denmark decided to launch a USD5 billion climate and infrastructure fund. Beyond the obvious story of infrastructure, private equity is an attractive channel to invest into niche and innovative business models. While public equity markets are crowded with multi-line multinationals with a less clear focus on specific solutions, private equity is attracted by resilient, sustainable models such as the circular economy.

Since ESG is also about being an active shareholder, private equity can play a strong role in transforming business models facing disruption related to climate change and become a key engine of the current green transformation. ESG integration does not come without challenges though; even if a high proportion of private equity firms have implemented ESG policies, the degree of what end-investors received on the investments with a private asset fund is limited compared to listed equities. The triple effect of competition, regulation, and investor demands will probably generate progress on this dimension over the next years.