Impact investing – one of three key trends expected in private markets

Following a decade of growth, COVID-19 hastens the end of the longest bull run in history and leads many private market investors to question - what next?

By David Gowenlock, Fund Advisory · September 9, 2020

McKinsey’s Private Markets Annual Review (Feb, 2020) reported that private market assets under management swelled by 10% in 2019. This growth follows USD $4 trillion of flows in the past decade, a total increase of 170% compared to the 100% expansion in global public market AUM. During this time the number of active private equity firms more than doubled.

This growth was most impressive in 2018, a record year for combined PE and VC fundraising with USD $497.4bn raised in total, topping the previous high of USD $442.6bn set in 2007.

The expansion of the industry has primarily been led by venture and growth equity strategies: buyout’s share of PE AUM dropped by a third in the past decade. During this time steadily climbing valuation multiples in buyout, reaching 12x in 2019, has continued to reverberate through the industry seeing a knock-on effect on transaction sizes in growth equity and venture capital. Growth equity capital raised almost tripled and fund count more than doubled between 2005 – 2019. As a result, growth equity dry powder rose from 6.5% of all PE dry powder in 2005 to 16.3% of all PE dry powder through 3Q 2019.

Co-investments has also been an area of growing LP investor interest – the value of co-investment deals more than doubling from 2012-2017. In 2017, roughly 20% of the private equity market accounted for this volume. The volume of co-investment deals in recent years has increased rapidly, illustrating the growing appetite investors have for this space. In 2019 Coller Capital found that almost 70% of private equity investors now co-invest alongside GPs, and some 44% of LPs actively pursue co-investment opportunities. 60% of LPs surveyed by PEI at the beginning of 2020 planned to participate in co-investment opportunities in 2020 and with speed being the major limiting factor for 40% of respondents many LPs have been dedicating resources to build out co-investment capabilities.

As the yields of USD $12 trillion of bonds globally fell below zero in 2019, interest in buying the equity and debt of private companies, property and infrastructure has surged. In recent times ‘peak’ private-equity fears spread through the market as institutions begin wondering if the large inflows chasing returns would soon warrant the words of Wall Street legend Barton Biggs: “In the history of the world there is no asset class that too much money cannot spoil”.

In late 2019, significant investors started to comment that the long bull run, growing valuations and competition for deals might see a reduction to the illiquidity premiums previously enjoyed by PE investors.

“Returns are coming down,” said Elliot Hentov, head of policy research at State Street Global Advisors. “A lot of money is going into that space and we are seeing excess returns shrinking.”

“When you have so much liquidity available, naturally the price for illiquidity will come down,” Calpers Chief Investment Officer Ben Meng commented .

Data from Pitchbook supported the claims, reporting that global outperformance of PE over the S&P 500 fell to 1.07 times in 2017 from 1.69 times in 2001.

“We think we have a reached a peak in the private-equity market,” Morgan Stanley Wealth Chief Investment Officer Lisa Shalett wrote in October 2019. “Investors tempted to chase the double-digit returns that many earned in private investment vehicles this past decade need to downgrade their expectations. The environment for private investing has gotten tougher.”

Looking ahead, 62% of fund managers and 61% of investors surveyed by Preqin in November 2019 believed that we were at the peak of the cycle.

Despite awareness that a recession may be in sight, Coller Capital’s Global Private Equity Barometer Winter 2019-20 reported that the large majority (70-80%) of North American and Asia-Pacific LPs believed their private equity portfolios needed modifying to prepare them for the next economic downturn.


COVID-19 hastens investors’ fears of the end to the bull run – but what next?

Although no-one could have predicted the cause of the end of the bull run would be a global pandemic (except perhaps Bill Gates) – many of the fears just mentioned were rapidly realised earlier this year.

As public stock markets rapidly crashed in response to the spreading pandemic so did private company valuations. ClearlySo’s Institutional Distribution Team previously reported in April up to 40% reductions in valuation multiples, and Numis reports a similar 25-50% valuation compression. Transaction volumes have suffered too – Pitchbook reports that private equity deal flow declined 31.5% in Q2 on a year-over-year basis.

Whilst guidance around COVID-19 from governments around the world has faced criticism for it’s lack of consistency, investors are just as perplexed by what will happen next in unpredictable financial markets.

As the crisis continues to evolve, countries come in and out of lockdowns, new bailout packages are unveiled and expectations of a recovery adapt as more data is made available, many are questioning how private markets will respond.

Following conversations with GPs and LPs, and our own market research, we would like to outline three trends we believe will shape private markets going forward in 2020 and beyond.

Trend 1: Increased awareness of ESG and Impact

Countless reports in the financial press have emerged to indicate that ESG and Impact Investment strategies are outperforming in the current market. Due to the availability of data to draw these conclusions, listed equities tend to be the most common asset class analysed. Just some of the more recent press includes:

  • Majority of ESG funds outperform wider market over 10 years, The FT [Link]
  • No Surprise: Sustainability Funds Outperform the Market – Despite COVID-19, Responsible Investor [Link]
  • A majority of sustainable funds outperformed their traditional peers over multiple time horizons, Morningstar [Link]
  • Sustainable funds provided returns in line with comparable traditional funds while reducing downside risk, Morgan Stanley [Link]
  • ESG funds continue to outperform wider market, The FT [Link]

Source: Standard Chartered, Sustainable Investing in a bear market

Refnitiv’s analysis of over 34,000 equity funds relative to their Lipper-assigned benchmark during the period of 31st January 2020 to 31st March 2020 showed that the average relative performance of the analysed ESG funds (+0.43%) was higher than that of conventional funds (-0.65%).

Data from Morningstar also showed that more than 50% of ethical and sustainable funds beat the MSCI World index. The MSCI World stock index fell by 14.5% in March, but 62% of global environmental, social and governance-focused large-cap equity funds outperformed the global tracker.

Bloomberg data shows another interesting trend – ESG funds are also outperforming sin stocks in slumping markets. In prior periods of recession sin stocks have shown resilience, however this time the tables are turned as lockdowns in cities around the world have significantly impacted the alcohol and gambling sectors.

Analysis of such funds over the longer term draws similar conclusions. Morgan Stanley’s Sustainable Reality Report compared over 10,000 funds between 2004 and 2018 and found that sustainable funds had 20% less downside risk than traditional funds and were more resilient in years of turbulent markets.

It would appear that ESG funds have benefited from ownership of companies with strong business models that as a result of their sound management of social and environmental issues have a degree of resilience that helps in such times of crises.

In private equity mainstream investors are finding impact a source of alpha too. Suggesting that private markets are becoming more efficient and ‘every efficiency is now fully priced’ Jason Thomas, Managing Director and Head of Global Research at The Carlyle Group stated the firm states that it ‘needs to think about new ways of value creation. Instead of the impact somehow degrading the return profile of the fund, many of these impact areas are actually a way to increase value because not only are you increasing the fundamentals of the business (ie revenue growth), but you are also repositioning the asset as something that is much more attractive to a potential buyer.”

Pricing being driven by greater understanding of drivers of consumer demand, business risks, and shifting resource prices

The crisis may accelerate equity analysts’ identification of other material risks presented to companies and business models – fragile supply chains with a dependence of overseas imports for example.

Ultimately this may lead to the inclusion of factors such as greenhouse gas emissions or resource intensity on a wider scale – metrics that some impact investors have understood and been tracking for years.

The cost of damage caused by climate change, for instance through increasingly volatile weather patterns, has risen quickly and we have seen large scale events around the world, from floods to fires. According to Moody’s data, the economic damage from recent Australian bushfires is likely to exceed the record USD $4.4bn set by 2009’s Black Saturday blazes.

The Bank for International Settlements, described as the central bank for the world’s central banks, issued a warning that climate change may create ‘green swan’ disasters, extremely disruptive events which could trigger a systemic financial crisis.

Whilst this may have seemed a far-fetched proposition until only recently, the impact of coronavirus has highlighted the systemic risks hidden below the surface in a global, just-in-time economy with few buffers.

The Climate Disclosure Project presented in a 2019 report that 215 of the world’s largest companies reported approximately USD $1tn at risk from climate-related impacts, with many projected to be incurred within the next 5 years. Of these, USD $500bn are rated as virtually certain to occur.

Even before these risks and others not yet anticipated become realised, tightening regulation will impact companies. Carbon markets have remained relatively buoyant during the crisis largely due to the high expectations of growth in prices (which are still far below those required to reach net zero targets) offsetting a short-term reduction in demand.

Refnitiv estimates that USD $4tn worth of carbon taxes needs to be paid by firms to meet 2°C warming targets (this is above the Paris Agreement target of 1.5°C). This taxation equates to a staggering 4% of global GDP and amounts to around 13% of revenues for companies with the greatest exposure.

Source: Refinitiv, The finance industry should prepare now for a carbon correction

Carbon taxation is an easy example to demonstrate, however other resource constraints are expected to effect businesses and asset managers invested in them. For example, Blackrock’s research arm, the BlackRock Investment Institute, just announced it believes that investors are overlooking the risk of water scarcity and the impact it could have on their portfolios in the coming decade.

It is clear to see that certain businesses can benefit from the transition to a low carbon and resource efficient economy, either as a result of being sustainability leaders or by developing technologies which allow the incumbents to accelerate their transition.

Investors appear to be responding to these market signals

The GIIN recently reported in the organisation’s 2020 Annual Investor Survey that 15% of respondents are likely to commit more capital to impact investments in 2020 as a result of COVID-19. It’s worth noting that despite this being an impact investing survey – most investors are commercially focussed; 81% seek market-rate returns and 84% find financial performance in line or outperforming (14%) their expectations. To give those expectations some context – developed market PE investors report an average return of 16% since inception of their impact investing activity.

Private Equity International recently reported that private equity investors are placing greater importance on and paying closer attention to environmental, social and governance integration across their portfolio. This view appears to be holding even during the COVID-19 crises as most investors say they are more likely to stay firm with their current ESG policies than relax them. Only 14% say they will relax ESG policies.

Standard Chartered recently reported that money market deposits focused on helping finance sustainable development initiatives saw record inflows in March as coronavirus failed to push investors away from their sustainability goals.

We’ve seen a remarkable upturn in the amount of sustainable deposits that we’ve been taking as an organisation. We could have expected things to fall by the wayside as the crisis hit, but it’s been heartening that treasurers and corporates still want to have some impact with their dollar.” stated Alex Kennedy, director of sustainable finance ESRM at Standard Chartered.

PenSam, the €20bn Danish pension fund announced earlier in the year that it had switched weightings in its passively-managed listed global equities portfolio to take account of climate factors, adopting the MSCI climate index for the entire €4.8bn allocation.

The ‘S’ of ESG is not being forgotten –  Boohoo recently saw investors scramble and share prices tumble by over 40% as a result of an expose on working conditions and wages in the fashion giant’s UK supply chain. Some ESG labelled funds had significant exposure to this firm, and industry ratings agencies such as Morningstar are asking for greater transparency whilst criticising the continued lack of consistent information and disclosures on ESG issues.


Asset managers react with new hires to build out ESG / impact capabilities

PE News reported late last year how private equity firms were planning a hiring spree to increase the number of dedicated responsible investment professionals they employ, as pressure to address environmental, social and governance issues intensifies. The COVID-19 crisis has seen this trend accelerate as asset owners and asset managers have been recruiting talent to build out ESG capabilities:

Financial institutions continue to make acquisitions and launch initiatives

We previously reported on acquisitions in this area by Schroders, Christian Super, Natixis and Goldman Sachs Asset Management.

In July Sumitomo Mitsui Financial Group acquired a stake in UK-based fixed-income impact house Affirmative Investment Management. The partnership will see it distribute Affirmative’s funds to Japanese clients in return for an exchange of impact investing and sustainability intelligence.

Deutsche Bank Research has announced the launch of dbSustainability, a platform that will provide reports to help clients identify sustainable investment opportunities, as well as detailing the impact of ESG themes on the economy and individual companies

A collaboration between APG, AustralianSuper, British Columbia Investment Management Corporation and PGGM announced the launch of a USD $1T Asset Owner solution for identifying SDG-investments. The platform’s standard and artificial-intelligence driven data enables investors to assess companies on their contribution to the UN Sustainable Development Goals.

Even Central Banks are responding by shifting their mandates at this time. This July, the European Central Bank under Christine Lagarde announced it is exploring using its €2.8tn asset purchase programme to bolster environmental objectives and fight climate change.

Trend 2: Changes in commitment activity and shifting asset allocations

Analysis of historical fundraising activity following crashes in public markets would suggest there will be a significant decrease in LP activity private capital fundraising as a result of the COVID-19 crisis.

For context, the S&P 500 reached its peak at approximately 1,550 in October 2007 and bottomed in February 2009 sixteen months later (a decline of 53%). Private fundraising peaked in 1H2008, six months after the stock market high and fell circa 56% the following year. During the recovery, the S&P 500 took 5 ½ years to recover to pre-crisis levels, whilst private fundraising did not return to the pre-crisis high until 7 years later.

Forecasts produced by Preqin suggest that 2021 fundraising levels will be down 39% on those seen in 2019:

Source: Preqin, Private capital fundraising

In the period immediately following crashes in public markets, investors can find their portfolio allocations overweight to other asset classes. This ‘denominator effect’ can lead some investors with strict asset allocations to need to liquidate positions to rebalance their portfolios. Private equity is one asset class that can suffer from the denominator effect. With many fund LPs wanting to sell typically illiquid holdings at the same time private asset and portfolio valuations can be substantially impacted regardless of underlying fundamentals.

We have not seen this happen as a result from COVID-19, at least yet. Eaton Partners recent survey in May found at concerns over the denominator effect, capital calls, and liquidity do in fact appear overblown. Half (51%) of the limited partners (LPs) surveyed stated that they were not making changes to their portfolios at this time, while 23% are increasing allocations and 26% are cutting allocations. This balanced response is probably led by LP stability from the fact that half have not seen a noticeable change in capital calls and a majority (56%) say they are not facing liquidity issues.

If LPs do decide to exit their stakes there’s plenty of demand on the buy side – the secondaries market has over USD $170bn of dry powder to deploy. For the moment GPs are likely to be well capitalised with significant dry powder themselves following a period of record fundraising, so the crisis has led many to focus on portfolio management and opportunist acquisition of well-priced assets.

Among the LPs surveyed by Eaton Partners private equity continues to be the most appealing alternative asset class right currently now (45%), up from 39% from the April survey. Data/tech and ESG/renewables are the strategies in greatest demand currently.

Increasing allocations to growth capital

Some are projecting that growth equity’s momentum detailed above will continue in the current environment.

It’s different from and, in many ways, uncorrelated with buyouts. There is typically very little leverage, it is less sensitive to credit availability and interest rates and it is less sensitive to entry and exit multiples. Historically, it has been far less affected by financial market cycles.” proposed Miguel Luiña, Hamilton Lane Principal in May in Private Equity International.

At a time when public markets are turbulent and the potential for listings are negatively impacted there will be a tendency for companies to stay private longer, assisted by these growth equity investors who can help capture value as the companies working capital and cash needs grow with their revenues.

I think we could see the performance of growth equity outshine that of other asset classescommented Gabriel Caillaux of General Atlantic to PEI. “That’s because of structural reasons – most of the companies we back take advantage of transformational shifts in the economy – many of which are being accelerated by the need to lock down economies”.

Pitchbook’s 2Q 2020 analyst note delves further into growth equity investment and performance. Analysis of performance metrics indicates growth equity really is a standalone asset class. TVPI and IRR metrics provide LPs with a similar return profile to buyouts but with a lower risk of loss than traditional VC.

Elias Korosis, Partner at renowned funds investor Hermes GPE has observed that LP appetite is indeed shifting this way:

We’re seeing the technology-oriented growth funds achieving closings at a time when others are being pushed out, a number of growth funds will reach their hard-caps even during this period”.

Pitchbook also suggests that whilst recent declines in private asset prices are less than ideal for buyers, LPs find comfort in knowing growth equity target companies are often uniquely positioned to withstand downturns due to their high-growth nature and relative proximity to profitability.

Growth equity seems well positioned to continue its trajectory despite the current macroeconomic environment.

Trend 3.    Proactive adjustment to a new normal rather than waiting for return to business as usual

In the early days of the crisis ClearlySo found that talks of a V, U or L shaped recovery dominated discussions. Next was the topic of when offices were due to reopen and if our GP/LP client firms were going to return en masse to their offices or adapt with more flexible working arrangements. Largely now, people seem to have come to the conclusion that complications around international travel, potential second waves of the virus and long-term social distancing measures mean that perhaps the most successful firms will be those which adapt to a new normal rather than attempt to rush back to how things were previously.

In recent Real Deals July webinar ‘Fundraising in the new normal’ Charterhouse Capital Partner Tom Patrick highlighted how these changes increase the importance of placement agents at this time.

If you’re looking for new investors, you would need a placement agent due to current restrictions. One of the main features we would be looking for is in terms of geographical reach, possibly taking on placement agents on a geographical basis, due to travel limitations.”.

LPs adapting to these constraints on doing business, especially those with an allocation to emerging managers, are finding ways to maintain coverage given the cancellation of the industry’s networking events. The more cautious are focusing on their trusted GP relationships for the time being. Many GPs are aware of this and concentrating their efforts on securing re-ups for new fund launches.

We can expect that as a result overall competition for re-ups from LPs will increase and where re-ups are made commitment sizes may decrease, resulting in GPs needing to fill fundraising gaps with new investors.

Realignment with Fundamentals

At the venture end of the spectrum ClearlySo’s Institutional Distribution Team have been hearing how company valuations are increasingly being based on solid fundamentals rather than optimistic forecasts. There appears to be a growing focus on a company’s ability to reduce customer acquisition costs, customer churn, demonstrate actual rather than forecast LTV and successfully manage operating costs to boost unit economics. Early stage companies with shorter, clearer roads to profitability are certainly in favour at this time as investors become more cautious of the long-term economic environment.

For most asset managers, and asset owners, this rebasing will need to incorporate a clear thesis of the relevant sectors’ trajectory resulting from COVID-19 and an understanding of which business models are set to benefit and suffer from changing consumer habits.

Chasing performance

ClearlySo’s CEO Rod Schwartz provided analysis that periods where fundraising is hard often engender above-average private equity returns. This is not surprising. When investment capital is scarce, returns on that capital are likely to be better and investors sometimes fail to appreciate how large the gap can be. The chart below (data courtesy of Pitchbook) is illustrative of this point.

Source: Pitchbook

Wylie Fernyhough, a private equity analyst at PitchBook, mirrored this sentiment in a recent report commenting that private equity performs better in down or flat markets, compared with public equities which thrive in bull runs. Against the backdrop of a pandemic, the market seems unlikely to soar in the coming months and potentially years. Fernyhough suggests that if valuations begin to plateau across public and private markets, PE will likely outperform.

Accelerated adoption of technology

Eaton Partners recent survey in May found that respondents anticipate a shift in the way investors evaluate future opportunities, with 20% saying their new normal will be heavily reliant on video conferences over in-person meetings with general partners (GPs). Another 53% expect to have a mix of virtual and physical meetings. Only 27% expect things to go back to the way they were before the COVID-19 pandemic.

PEI’s survey ‘Investor outlook on 2020 in light of COVID-19’ published in June found similar trends. Between the short period of March and May double the number of LPs (now 25%) state they plan to attend GP AGMs via video conference going forward. 21% say they will do more remote due diligence using video conference.

Private Equity Wire’s ‘Technology Innovations in Focus’ report published this July is a ClearlySo recommended read for LPs, offering an insight into how top-tier GPs are integrating technology into their processes and back office systems. This is one area we suggest LPs include in their due diligence, as an understanding of how effectively the manager is managing data collection and processing all whilst maintaining high standards of cyber security can be a hidden yet real driver of returns.

I learnt recently in a conversation with an insurance group’s Asset Liability Matching manager that every mobile phone is attacked by automated hacking scripts every few minutes. More targeting attacks are also prevalent. Just this May Private Equity Wire reported that private equity firms are having to double down on cyber risks in the current climate, as hackers exploit the chaos caused by COVID-19 to target PE-backed companies with ransomware attacks.

With notable improvements to operational efficiency achievable, investment firms must embrace new ways of working to remain ahead of the game. We are seeing that top-tier investment firms are using new cloud-based infrastructure, and integration with portfolio companies’ systems, to best effect along with a thorough understanding of the risks and required security measures.


Regardless of challenges faced by the private equity industry, the macro picture from past years is that PE outperformed its public market equivalents by most measures over the past decade. On a micro level, asset manager’s variability in performance remains substantial and the enduring challenge for LPs is manager selection. Selecting the right funds strategies is paramount to realising the boosted returns that PE offers over more liquid investments.

When re-evaluating allocation and fund selection strategies in this environment, LPs should bear in mind McKinsey’s analysis that indicates GPs with dedicated value creation teams outperformed those without them by an average of five percentage points during the last recession.