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Though the terms are often used interchangeably, ESG is essentially a tool for mitigating risk, while impact investing is a strategy for investing according to one’s values.

Key Takeaways

  • ESG, however it is applied, is fundamentally a defensive framework, intended to identify and avoid risks that could erode shareholder value.
  • Impact investing is a proactive strategy, exclusively targeting companies looking to make a quantifiable positive social or environmental impact, for example, climate tech companies.
  • Private impact funds are awash with capital and look set to continue to dominate investment in the most innovative companies in the responsible investing space.
 
The movement of investment capital into funds that seek to effect positive change has been substantial in recent years. Environmental, social, and governance (ESG) assets rose to more than $35 trillion in 2020 to account for more than one third of total global assets under management.1 This figure is expected to rise above $50 trillion by 2025.2
 
Despite this rapid growth, there remains deep skepticism about the effectiveness of the ESG framework. Some of this is because ESG classifications and regulations remain somewhat underdeveloped. There is still significant ambiguity about what investments can potentially be defined as ESG compliant. It was only in November 2021, for example, that the Chartered Financial Analyst (CFA) Institute published new guidelines on ESG product-level disclosures in the United States. In Europe, the challenge of consistent ESG labeling was highlighted by the implementation of the Sustainable Finance Disclosure Regulation (SFDR) across the continent in March 2021, following which more than $2 trillion in assets had ESG labels dropped.3
 

ESG: a defensive framework

At its core, it is important to remember that ESG is only intended to be a risk framework and should be judged as such. While an ESG fund’s specific approach or theme can vary, ESG is fundamentally defensive, informing what an investor does not invest in as much as what they do.

An ESG framework is designed to systematically incorporate relevant factors – e.g., sustainability, climate change and environmental impact, emissions, or racial and gender equality – into the selection process, helping investors to identify opportunities and risks that might be material to performance. It is effectively a screen, defending investment returns from ESG-related risks.

Furthermore, ESG applies almost exclusively to public markets, which provide limited exposure to the companies with the greatest potential for positive impact. For investors looking to actively make a difference, the most innovative and impactful businesses are generally found in the private space via impact funds.

Impact Investing: a strategy aligning investing with values

Impact investing is a defined strategy rather than a framework and is therefore proactive rather than defensive. It exclusively seeks out companies whose primary products and services are directly tied to a quantifiable positive social or environmental impact – while also hopefully generating market-rate returns. Put simply, the entire ethos of impact investing is to pursue the often elusive “double bottom line” of doing good while doing well for investors.

All impact funds are (or definitely should be) ESG compliant, but ESG-compliant funds do not necessarily have to actively make an impact.

We can illustrate the difference by looking at greenhouse gas (GHG) emissions. An ESG framework might generally prevent investment in companies that produce significant GHG emissions. But an impact fund can only invest in businesses providing a product or service that actively helps reduce them.

Private markets take the lead

Many of the businesses with the most innovative products or services in ESG-related sectors are in the early stages of their development and are private. A substantial share of these are likely to remain private for a significant period of their growth, taking advantage of the ecosystem built by private capital over the last two decades that allows companies to remain private and thrive.

For example, in climate tech alone there are now 45 unicorns globally, which have collectively raised more than $46 billion in funding in the last decade and are, in aggregate, valued in excess of $130 billion.4 There is little sign of a slowdown: In 2021, dry powder among dedicated climate tech funds rose by $35 billion.5

Thankfully for investors, data suggest that investing in impact funds is not typically done so at the expense of returns. Nine in 10 impact investors recently reported that their portfolios either met or exceeded their performance expectations,6 while the Cambridge Associates PE/VC Impact Investing Index (Developed Markets) benchmark showed annualized pooled returns over a three-year period of 17%.7

Yet, it is important to point out that while the impact investment model is entirely geared toward positive impact – and there are readily available metrics for many measures of impact, like emissions – there remains no single, centralized way to measure their environmental and social performance. The onus still falls on investors to remain vigilant and scrutinize the data presented by asset managers to ensure that they are delivering what they promised.

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(1) Source: Global Sustainable Investment Association, July 2021.
(2) Source: Bloomberg, “ESG Assets Rising to $50 Trillion Will Reshape $140.5 Trillion of Global AUM by 2025, Finds Bloomberg Intelligence”, July 21, 2021.
(3) Source: FundFire, “European Managers Drop ESG Labels as Regulatory Scrutiny Intensifies”, September 30, 2021.
(4) Source: HolonIQ, “The Complete List of Global Climate Tech Unicorns”, January 3, 2022.
(5) Source: Climate Tech VC, “2021: A year of climate hits and misses”, December 20, 2021.
(6) Source: Global Impact Investing Network, “Impact Investing Decision-Making: Insights on Financial Performance”.
(7) Source: Cambridge Associates, “Private Equity & Venture Capital Impact Investing”, March 31, 2021.

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Kunal Shah

Kunal Shah

Kunal is Managing Director and Head of Private Equity Solutions, Co-Head of Research at iCapital, focused on the identification, selection and due diligence of private equity funds to be offered on the Flagship Platform. Previously, Kunal was a Principal in the private markets group at Meketa Investment Group, a leading global investment consultant serving pensions funds, endowments and foundations, and family offices. He received a BS in Business Administration with a concentration in Finance from Drexel University. See Full Bio.