25 Mar 2020

Private markets: A decade with a new imperative

Private markets are moving from a prosperous decade into a decade of change. Strategies that have been successful so far must be reviewed for sustainability risks and thus for their licence-to-operate. Read our trend report to find out which trends (e.g. ESG) will shape private markets in the new decade.

by Marie-Lucie Linde

Private markets can look back on a decade of prosperity and steady growth. In recent years, however, developments have emerged that announce a new decade of change and bring leading players in the private markets to the question: How can a new growth formula look like in times of climate change and global sustainability goals (in short: SDGs)?

Considering that about 5 years ago, very few Limited Partners (LPs) and General Partners (GPs) were acting in the sense of impact investing and according to ESG criteria, the developments of the last few years are all more impressive. After all, more and more LPs and GPs are taking care that capital is invested for greater impact. And the market proves them right: Impact-oriented investments have proven to be an attractive investment opportunity with an appealing risk-return profile. As a result, the pressure to focus more on alternative investments is steadily increasing. And so a decade of new trends, which entail changed requirements and new opportunities, is looming on the private markets.

A new era for Private Markets

Looking at the private markets – i.e. investments such as private equity, private debt, infrastructure and real estate projects – five trends in particular are becoming increasingly important:

Trend 1: Climate change and climate scenarios as part of risk management
Climate change is not a passing fad, but a serious reality affecting society and economy. For the global economy, the effects of climate change have become one of the greatest threats – and not just since fridays-for-future. For this reason, the Task Force on Climate-related Financial Disclosures (TCFD) of the G20 Financial Stability Council has already published recommendations for standardised climate reporting in 2017. Investors and companies should thus be able to quantify the financial impact of climate change on their business model and strengthen their resilience. The Sustainable Finance Advisory Board has just recently even published a proposal for a climate label that foresees a “mandatory product classification” in terms of climate impact for all financial products. The current ESG reporting, in which the two topics “climate change” and “emissions” are the most important aspects, also reinforces the importance of climate risks. Consequently, climate scenarios are moving to the top of the agenda of private market participants’ risk management.

Trend 2: Sustainable Finance and ESG as the imperative of the hour
The financial market plays a central role in guiding the real economy into a sustainable and decarbonised transformation. European decision-makers, among others, have recognised this fact and with the EU action plan “Financing Sustainable Growth” or “Sustainable Finance” have developed a framework or path for Responsible Investing. With the action plan, financial approaches and instruments such as the Transparency and Taxonomy Directive are meant to promote a sustainable and resource-efficient economy. Indeed, financial actors (e.g. insurance companies and banks) already have to report according to TCFD. However, “sustainable finance” has become an established trend internationally as well and generally refers to the inclusion of environmental, social and corporate governance aspects in the decisions of financial actors. As a result, public interest and pressure from LPs – especially institutional investors – to take environmental, social and governance (ESG) factors into account when making investments has increased significantly. ESG is becoming the imperative in private markets, not only since studies have confirmed that the inclusion of ESG criteria has a positive impact on investment performance. And yet, private markets are only at the beginning in terms of the material incorporation of ESG factors into investment and portfolio management processes as well as the development of new products that target ESG-driven demands.1

Trend 3: Impact instead of profit maximisation as the guiding principle
In the last 5 years – in times of low interest rates – more and more investors are following sensitively where their money is going and put sustainability more clearly in the focus of their investment decisions. Under the term “Impact Investing”, investors put their money into very specific industries, assets and projects that they hope will have a positive impact on society and/or develop solutions for socio-ecological problems. For example, there are so-called impact investment funds, where private, impact-oriented and state investors join forces across sectors. The aim of impact investing is to make the impact measurable and to link it to the return and repayment of the investment.

Trend 4: The new concept of inclusive growth
Many international economic experts, including Prof. Dr. André Reichel, expect growth rates of less than one percent by 2050. This means that a new way of thinking is needed: Those who want to be successful must emancipate themselves from the classic growth paradigm and focus on inclusive growth, which strengthens the economic and social inclusion of people in political economic measures. This also applies to the financial market and, within it, to private markets, which are equally faced with the challenge of translating externalised costs into a new growth formula. At IPEM 2020, the largest trade exhibition for private markets in Europe, it came as no surprise that this year’s motto was “Shaping a new growth formula”. Private markets are obviously looking for a new growth formula in terms of sustainability.

Trend 5: The financial sector facing changes in the digital age

Digitisation does not leave the financial system unaffected. On the contrary: the financial sector is in the midst of digital transformation. Many private market companies are therefore thinking about how they can digitise their investment processes. The largest GPs have taken the lead in the market, especially in the real estate sector, where investors have access to larger and more accurate data sets. In addition, the number of technology-oriented private market firms has grown rapidly in recent years.2 At the same time, digitisation is creating more and more crowd and community-based financing opportunities, i.e. private equity through community. This includes, for example, so-called crowdfunding platforms, where projects are financed by small amounts of money from people of equal interest. The crowd and everyone in it thus becomes an “investor”.3

Digression: Clearing up the myths about sustainable finance

The more often we deal with “sustainable finance”, the more often we face allegations that appear as being true in the market. These statements often turn out to be myths that can be proven wrong by simple facts. At this point, we would like to clear up the five most common myths about sustainable finance:

Myth Truth
1. Sustainable investments/assets underperform compared to conventional ones. 90% of current studies show that assets with a pronounced ESG profile perform just as well, if not better (good risk/return profile).
2. Sustainable investing consists only in sorting out “sinful” investments. Investment managers increasingly incorporate positive aspects of sustainability by integrating ESG factors into the investment process.
3. Sustainable investing is a passing fad. Sustainable investing has been around for decades and is becoming increasingly important, not least due to increasing regulations.
4. Interest in sustainable investments is usually limited to millennials and women. There is a broad interest in sustainable investment strategies, with institutional investors leading the way.
5. Sustainable investing only works for stocks. Sustainable strategies are offered across all asset classes.

You can find a visually appealing presentation including the detailed facts under Visual Capitalist who carried out the myth check.

Regulations on the rise: EU action plan & Co.

As indicated in trend 2 “Sustainable Finance and ESG as the imperative of the hour”, the density of regulation for financial markets is increasing, which will have an impact on private markets that have only been regulated to a limited extent up to now. The aim is to create orientation and clarity as well as frameworks for the implementation of sustainable finance. Private market participants should be aware of the following legal developments:

  • EU action plan “Financing Sustainable Growth”
    The EU action plan “Financing Sustainable Growth” contains two EU regulatory measures which are to come into force by 2021 at the latest:
    • The EU Transparency Directive is supposed to come into force in March 2021 and stipulates that financial market players have to report on how they deal with sustainability risks in their investment decisions. This will also apply to financial advisors and their investment or insurance consulting services.
    • EU Taxonomy Directive establishes clear criteria for the classification of assets to identify when an asset is considered green or sustainable. It also requires providers of sustainable financial products to report on how they have applied the taxonomy to determine the sustainability of the underlying investments, to which EU environmental objectives the investment contributes and for which share of the investments the taxonomy is justified. The directive is expected to come into force in December 2020 for the first two EU environmental targets (“climate protection” and “adaptation to climate change”) and in December 2021 for the other four environmental targets (“closed loop management”, “waste prevention & recycling”, “pollution reduction” and “sustainable use and protection of water and marine resources”). More can be found here.
  • „Green Deal for Europe”
    The EU Commission’s “Green Deal for Europe” includes a European climate law and a plan for sustainable investments. More can be found here.
  • ESMA strategy for sustainable finance & climate-related stress tests 
    On the 6th February 2020, the European Securities and Markets Authority (ESMA) published its sustainable finance strategy, which puts sustainability at the heart of all activities. ESMA’s framework is broad in scope and includes, among other things, emission certificates, ESG ratings of EU investment funds and so-called climate-related stress tests. More can be found here.
  • Recommendations of the Network for Greening the Financial System (NGFS)
    The Network for Greening the Financial System published six recommendations in 2019, in which they call, among other things, for climate-related risks to be included in supervision and to define supervisory expectations. More can be found here.

The recently published “Bafin memo” provides a concise overview of how to deal with sustainability risks, including recommendations for action.

New strategies and requirements for private markets

Throughout the financial market, the assessment of sustainability risks imposes new requirements on the regular business organisation, risk management and communication of financial actors: They have to deal with sustainability in a strategic and holistic way and translate sustainability risks into known risk types (e.g. market price risk, liquidity risk and credit risk) as well as ESG risks. That means no more and no less than having to review their existing business and risk strategies and convert them into a consistent ESG strategy. It is therefore not surprising that at this year’s Private Markets Exhibition in Europe – “IPEM“ – ESG was proclaimed by several leading financial players as the new imperative for private markets.

At the operational level, current developments demand financial actors to increasingly engage in stress tests and scenario analysis. They are regarded as a proven tool for assessing corporate and investment risks. Especially when applied to climate change, they help to assess future climate developments. The French banking group and asset management company BNP Paribas is one of the leading players that already integrates climate scenarios into risk management.4

Furthermore, the requirements on communication in the context of sustainability have increased in the private markets: complex issues need to be assessed and communicated in a transparent and comprehensible manner for all relevant stakeholders. The forthcoming EU Transparency Directive and increasing ESG reporting will contribute to making communication on sustainability risks in the financial market more comparable and effective.

Digitising the investment process with the “ESG Management” solution

One of the biggest challenges for professional ESG management is the large amount, complexity and aggregation of ESG data, as well as the need to ensure data quality and security. In the course of digital transformations (see: trend 5), software solutions are increasingly important in meeting this data challenge. One of the biggest challenges for professional ESG management is the large amount, complexity and aggregation of ESG data, as well as the need to ensure data quality and security. In the course of digital transformations (see: trend 5), software solutions are increasingly important in meeting this data challenge. In the BNP PARIBAS global ESG survey 20195, the surveyed institutional investors and asset managers named the following areas of potential use for digital solutions in the context of the professionalisation of ESG management processes:

  • Aggregation/analysis of ESG data
  • ESG reporting at all levels (company, portfolio and fund)
  • Increased depth of ESG-specific data for research
  • Creation and tracking of an ESG index
  • Creation of company profiles
  • Creation of new products based on the principle of sustainability

WeSustain’s “ESG Management” solution – a software for professional ESG management in the entire investment lifecycle of private market investments or alternative investments – has been designed to meet these requirements. It primarily supports portfolio, asset and risk manager who have to report ESG relevant data and manage ESG risks. The solution is also suitable for investors who want to make investment decisions based on ESG criteria. In addition to controlling relevant workflows centrally, software user can collect, evaluate and report ESG data securely. With the data management approach of the “ESG Management” solution, user gain a greater depth and significance for ESG data management. Developed as a collaborative IT infrastructure, the software enables easy and transparent networking and the integration of existing ESG tools via common interfaces in the company.

An agitated decade is on the horizon

This trend report throws a glance at the future of private markets and shows which trends the sector will be driven by during the new decade. It has become clear that sustainability has found its way into the business models and strategies of private market players and will continue to do so as a result of market pressure and future regulations. In the long run, there will be no way around sustainable finance.

In times of climate change and global sustainability goals (SDGs), ESG has become the imperative for private markets to implement a new growth formula. The challenge is not only to introduce a consistent ESG strategy, but also to transform the business organisation itself. This also includes the question of “diversity and inclusion”, as up to now only 20% of employees in private market companies are women. In addition, the potential of digital technology must be leveraged and the speed of its further development accelerated. To achieve this, private markets must build up digital expertise and integrate digital tools into the investment process to an increasing extent. Algorithms and machine learning will ultimately make their own contribution to optimising the quantity and quality of relevant data.

It can be assumed that we are facing an agitated decade for private markets.

Note:
Learn more about WeSustain’s ESG Management solution and discover the functionalities for your ESG compliance in an individual demo.

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1 McKeansey & Company, “A new decade for private markets – McKinsey Global Private Markets Review 2020”, LINK, 15.03.2020.
2 McKeansey & Company, “A new decade for private markets – McKinsey Global Private Markets Review 2020”, LINK, 13.03.2020.
3 Zukunftsinstittut: LINK, 11.03.2020.
4 LINK, 11.03.2020.
5 BNP PARIBAS: “Die globale ESG Befragung 2019 – Institutionelle Investoren und Asset Manager legen ihre Strategien zur ESG-Integration fest”, S. 29,  LINK, 18.10.2019.