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Why Invest in ESG?

In this article

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A range of factors like the 2008 GFC, the Covid-19 pandemic, and emerging social and environmental challenges have increased adoption of ESG considerations among the investor community. These changes are also in the process of being further adopted by policymakers in the US and EU, with new regulations designed to shape and give authority to the inclusion of ESG factors.

What Is an ESG Investor?

There is a new generation of investors that want more than just financial gain from their investments. An increasing number are also demanding that their portfolios offer greater transparency, and that ESG factors are taken into account when making investment decisions.

These investors are often described as the “values-driven generation” – an emerging group that are more conscious about where they allocate capital, and pay more attention to the underlying operations of companies within their portfolio.

While this shift is in part driven by younger generations – one Morgan Stanley study found that millennials are twice as likely as the general population to invest in companies with social or environmental goals. Over time we are seeing the more traditional and established players of the financial services industry entering the ESG forum too. This trend means that nearly half of all investors are currently investing in ESG products globally – almost double the number in 2019.

How Does the Adoption of ESG Policies Vary Across Alternative Assets?

In the chart below, you can see the difference in opinion between all the asset classes Preqin covers, across investors already having an ESG policy, to those with no future plans to implement one.

Some investors may have investment policies in place, but what about fund managers? An increasing number of fund managers are also choosing to establish an ESG policy. What is causing this trend?

In Preqin's 2021 Investor Outlook, 79% of the respondents surveyed stated that fund managers establish ESG policies in order to satisfy investor demands. Meeting industry standards or best practices was seen as a secondary driver, with 66% citing this as a reason for ESG policy adoption among fund managers. The chart below shows other key reasons for an ESG policy, such as risk, or moral imperative.

Does Purpose Drive Returns?

We discussed the role of ESG investing in risk management in Lesson One: What is ESG? While ESG investing has a clear role in helping to reduce portfolio risk, a major roadblock to wider adoption is the concern about its impact on financial returns. Both managers and investors alike have historically worried that limiting their investments to transactions that meet ESG requirements will negatively impact performance.

However, investor attitudes to ESG investing are changing rapidly, and investors surveyed in 2019 and 2020 for Preqin's Investor Outlook gave significantly different answers when comparing the performance of ESG-focused funds to non-ESG-focused funds. In 2019, only 23% of investors said ESG funds performed better, and 21% said they performed worse. However, in 2020, 40% of investors viewed ESG-focused funds as performing better, while only 12% thought they performed worse.

This shift in opinion breaks apart the misconception that impact comes at the cost of financial returns. Preqin data shows that ESG investments perform on par with funds that that are not managed by ESG-committed GPs, while also offering significant benefits in terms of risk management.

A look at the median IRRs of private equity fund vintages over the past decade show that the difference between returns for ESG-committed managers vs non is insignificant - 14.04% vs. 14.24%, respectively. This dispels the myth that ESG integration can potentially generate lower returns than their non-ESG focused strategies.

Driving Sustainable Business Practices

A surge in demand for ESG investing, coupled with an increase in rules and regulations around ESG, means that companies are increasingly being held accountable for their performance against a range of environmental, social, and governance measures.

Companies that are leading the way in the adoption of ESG policies not only generate comparable financial results, but also offer lower downside risk for shareholders and investors.

In previous years, shareholders have suffered substantial losses following ESG-risk events – events that might have been mitigated with proactive ESG policies in place. The negative environmental and social impacts of oil spills, mining explosions, and unsafe products have proven to be fatal in some instances, and shareholders pay a heavy price as a result. Additionally, poor governance and accounting controls can undermine the success of great businesses looking to uphold sustainable competitive advantages and long-term growth. While there is no guaranteed way to avoid such catastrophes, incorporating ESG analysis can help to alleviate these risks, thereby helping to drive more sustainable business practices across organizations.

In the chart below, Preqin data explores the most prevalent issues for investors, with plastic, waste, and pollution being a big concern. COVID-19 economic recovery and diversity were also among the concerns raised by investors.

ESG adoption is also often considered an indication of management quality within a company. ESG initiatives are long-term in focus, and a company’s ability to successfully deliver these programs alongside the core business goals requires strong leadership. Therefore, these companies are likely to hold competitive advantage, and the potential to deliver strong financial results over the longer term.

Why Invest in ESG?

As shown above, there are many potential benefits to ESG investing. Managing investment risk, addressing client demand, and ESG performance as an indicator of management quality, are often the most common motivations, according to Preqin data.

This suggests that for the most part, investors are choosing to adopt ESG guidelines proactively, rather than reactively, as investors begin to understand the benefits that ESG investing can bring in reducing downside risk, without compromising financial returns.

You have now reached the end of our ESG lessons. To explore Preqin's latest ESG research, visit the content hub here