In the space of a few decades, private equity has grown from a niche investment to one that cannot be ignored, to the point of becoming an essential part of an asset allocation. The numbers speak for themselves. In 2021, the amount of unlisted assets under management reached USD 10,000 billion, up from USD 3,000 billion a decade earlier (more information).

A growing asset class

Why such a success? First of all, for its high return potential. Secondly, because of its diversification attributes, as performances are most often less correlated with those of the financial markets. With private equity, investors can also exercise greater control over the management of the companies they finance, which allows them to play a more active role in the management of their investment, especially when they have a majority stake.

Long term potential

For those reasons, and also because it is a long-term asset class, private equity is particularly well placed to effectively integrate environmental, social and governance (ESG) criteria into its investment approach. Considering the 5-year historical holding average, private equity backed companies have more time than others to deploy their strategy. As such we can better understand their latitude to act in a way that has a positive impact. In particular, small and medium-sized companies also have a greater capacity for transformation than large capitalizations, which are generally prone to greater inertia.

Increasingly responsible investors

The investment world has been changing. Even if all categories of investors do not yet fully adhere to the principles of sustainable finance, the new generations and institutional investors have given an impetus that will be difficult to reverse. More and more institutional investors have been implementing responsible investment charters to set out principles that shall apply to their investment decisions. To support them, the Institutional Limited Partners Association (ILPA) has also set up analytical grids to help evaluate General Partners’ ESG policies.

Increased pressure on companies

Monitoring as well as assessing sustainable investment approaches in private equity are more stringent than before. Starting from a few questions on ESG issues asked during the due diligence process, monitoring is now done “before, during and after” the deployment of the strategy, until the completion of exit. Similarly, while investors were previously satisfied with strategies that valued companies with a good ESG rating or excluded those with strong links to industries deemed negative (unconventional weapons, tobacco, etc.), they are now seeking to generate a more measurable, concrete and positive impact. They are therefore primarily interested in companies whose value creation and financial performance integrate environmental and/or societal themes and activities (climate, health, education, technology, food, etc.).

The challenge of transparency

As we can see, the subject has now taken hold of private markets and the players are structuring their approach. But vigilance is still required. Although private equity is increasingly positioning itself on sustainability issues, one must not lose sight of the fact that this is only the beginning. To seek sustainable private equity is to make a committed investment. However, to understand the scope of this gesture, it is essential to assess what a manager or a company is really doing. Consequently, the more transparency, the higher the potential level of compliance with ESG criteria. In any case, this is what investors expect from this rapidly changing world.

Article written by Sophie Bourroux and Florian Ménard, Private Markets Investor Relations, Indosuez Wealth Management Switzerland.