As economies begin the process of disaster recovery, ESG is the means to building back better. Sovereign wealth funds may be late adopters, but they are catching up fast
As economies begin the process of disaster recovery, ESG is the means to building back better. Sovereign wealth funds may be late adopters, but they are catching up fast
Politicians love a slogan. Of all those currently in circulation, none get more airtime than “build back better.” Joe Biden used it as the foundation of the economic recovery plan in his successful 2020 campaign for the US presidency, while in the UK, Boris Johnson has enthusiastically adopted it. Arguments over which premier used it first ignore the phrase’s disaster recovery origins, which date back to the Indian Ocean Tsunami in 2006, and its formal adoption in 2015 by the UN Office for Disaster Risk Reduction under the Sendai Framework.
While few would argue with the notion that making things “better” than they were is desirable, how can this lofty objective be turned into concrete action? The solution lies within environmental, social, and governance (ESG) principles, which are fast becoming mandatory for investors and fund managers.
As a group, sovereign wealth funds (SWFs) are late arrivals to the ESG fold; just 19% of the 98 SWFs tracked by Preqin have a stated ESG commitment. However, as is often the case, late converts try to make up for lost time. In 2017, six funds – Abu Dhabi Investment Authority (ADIA), Kuwait Investment Authority, New Zealand Superannuation Fund, Norges Bank Investment Management (Norway), Public Investment Fund (Saudi Arabia), and Qatar Investment Authority – established a Sovereign Wealth Funds Working Group as part of the One Planet Summit. They have since signed up nine more funds from countries including Ireland, France, Italy, Spain, Kazakhstan, the UAE, India, South Korea, and Senegal.
These SWFs are not looking to greenwash their investment portfolios. “Sovereigns do think about how they’re going to build new economies, how they're going to strategically get third-party relationships, and then build those relationships, not just for them but also for the private sector,” says Edwin Wong, Hong Kong-based Partner in law firm Baker McKenzie’s Funds Group. “Sovereign investors know that their future and the future of their economies – even oil economies – are very much tied to developing clean food, clean technology, and clean energy. As a result, access to people and portfolio companies in areas such as clean energy and sustainable processes are important considerations.”
Regulations Drive ESG Adoption
Legislation has been crucial in driving the sustainability agenda, and is largely responsible for the leadership of European institutions in the ESG field. Preqin data shows that 80% of private capital assets in Europe are managed under ESG commitment, compared with 47% in North America (Fig. 1). The Middle East (39% of AUM) and Asia (24%) have considerable ground to make up.
The EU is at the forefront of driving regulations that will maintain the momentum in Europe. Fund managers will be under an obligation to disclose quantitative and qualitative assessments of adverse sustainability impacts and remedial actions under the EU Sustainable Finance Disclosure Regulation (SFDR), with the initial implementation of such measures being effective from 10 March this year in relation to funds being marketed. SFDR disclosure obligations will not, however, be fully implemented until 2022 following industry lobbying – not because investors objected to the principles or details of the regulations, but because they needed more time to implement the necessary processes (many of which rely on detailed information on portfolio investments).
The direction of travel in the US – which had taken the view that sustainability goals came at a financial cost, and even legislated to ban companies and investors from considering ESG factors – has reversed. Acting SEC Chair Allison Lee appointed an ESG law professor, rather than a corporate or capital markets lawyer, to advise the powerful Division of Corporate Finance, which regulates public company disclosure. In a landmark speech on climate change in March, Lee said: “That supposed distinction – between what’s ‘good’ and what’s profitable – is increasingly diminished. ESG factors often represent a core risk management strategy for portfolio construction.”
The Risk/Return Benefits of ESG
Legislation will enforce measures that an increasing number of investors are already putting in place. While the Global Financial Crisis pushed ESG off the corporate agenda, COVID-19 appears to have entrenched the view that considering ESG factors enhances risk management. Crucially, a majority of alternatives investors surveyed by Preqin see ESG as having a positive (51%) or significant positive (7%) impact on returns, compared with 21% seeing no impact and 20% a negative or significantly negative impact (Fig. 2).
Preqin performance data on private capital funds validates investors’ views on ESG and performance, particularly from a risk/return perspective. We compared funds of vintages 2010-2017 (the most recent date where reported returns are meaningful) with an ESG or impact focus with those without, and our findings show there is no statistically significant difference in returns (Fig. 3). In fact, we can see a decrease in return variance across ESG-committed funds, indicating a reduced level of risk from manager selection for investors.
“Financial returns aren't necessarily – and shouldn't be seen as – separate from sustainability,” says Wong. “There are sectors in the market where you will get a good return and non-financial benefits. I recently talked to a GP that was raising real estate fund, converting real estate assets for social care use. The modelled financial returns were quite good and there's an obvious social benefit.”
SWFs’ Stealthy ESG Assimilation
A historical lack of ESG policies does not mean that sovereigns have not had exposure to ESG principles and investment expertise. Through their size, many SWFs tend to invest with large managers where they can write big checks. Half of all SWF commitments to private capital funds in 2020 went to funds larger than $1bn, with 22% going to $5bn+ funds. Preqin analysis of ESG performance at different-sized managers finds that GPs in the top quartile by AUM have significantly better transparency scores at the firm (41%), portfolio (26%), and asset (22%) levels than managers in the second AUM quartile (28% at firm level, 15% at portfolio, and 12% at asset), who in turn score better than managers in the bottom two AUM quartiles.
“There's been quite a mixed experience among sovereigns as to how they have approached the whole sustainability and climate change agenda,” explains James Burdett, Partner and Head of the London Investment Funds Group at Baker McKenzie. “It's not a function of being reluctant or disinterested, more a question of everyone having to rapidly move up a steep learning curve. The intention is largely there. They get it, they absolutely get it, but how that manifests itself is different in different sovereigns. Funds with large investment teams and sophisticated operations are better equipped to focus on this area than ones that are less well-resourced internally.”
Singapore’s GIC is among the best resourced sovereigns, with more than 1,700 employees operating out of offices in Singapore, Beijing, London, Mumbai, New York, San Francisco, São Paulo, Seoul, Shanghai, and Tokyo. Established in 1981 to manage the country’s foreign exchange reserves, GIC has invested more than $100bn across 40 countries. The fund is placing ESG at the heart of its investment and operational approach: “We believe that companies with good sustainability practices will offer prospects of better risk-adjusted returns over the long term. As regulators and consumers act on ESG and climate-related issues, and businesses rethink their operating models, new investment opportunities will open up.”
This thinking is now widespread among the investment community and the sovereign universe. “Maybe at some point in time sovereigns saw ESG as a cost, and so did fund managers, but that has certainly changed,” says Wong. “Managers and funds see the value both in terms of potential returns and risk mitigation. The old story around ESG was that it was simply about taking into consideration the investor's ESG policies when making investments, and was in some ways more of a box ticking exercise. However, we have seen a very rapid moving of the dial in the past few years to a point where fund managers have their own fully-baked ESG policies and criteria and are seeking to apply these criteria to every single investment, with the goal of every investment being a sustainable investment. If it's not, it's just not going to fly.”
This article is the last in a series ahead of the publication of Preqin’s Sovereign Wealth Fund Review in May 2021. To register your interest in receiving a copy of the report, please contact us at publications@preqin.com.