Compared with other asset classes, private equity can move quickly in identifying sustainability-orientated investment opportunities. It can also use majority- or substantial minority-ownership positions to encourage existing portfolio companies towards the net zero global economy: rather than simply divesting more carbon-intensive sectors, PE funds can steer investee companies to adapt their business models.
The transition to net zero also presents considerable opportunities for the PE sector – or, for those funds able to demonstrate a credible net zero strategy – to tap cheaper funding. Capital providers are keen to deploy debt to sustainable purposes, both to meet their own sustainable finance targets and because they recognise the correlation between corporate ESG performance and financial performance.
The market in sustainability-linked loans has exploded, reaching $700 billion in 2021 – up 300 percent on the prior year – according to Refinitiv data. A key feature of these loans is the linking of coupons to ESG targets: if sustainability targets are met, the coupon steps down, allowing the lender to demonstrate that their financing has delivered environmental and social impact while reducing the cost of capital for strong ESG performers. The GP, meanwhile, can reduce its funding costs – a win-win for all involved.
Approaching the market
So, how should PE funds respond to the opportunities – and risks – presented by the net zero transition?
Such funds should be in a position to present a clear climate strategy and vision for net zero portfolio emissions in line with science-based targets. To do so, fund managers should understand, and be able to disclose, where portfolio companies sit in terms of climate risk and opportunities, and their positioning in relation to a net zero global economy.
As part of delivering this strategy, PE firms should be working closely with existing portfolio companies to ensure they understand the implications of the transition, and that they are, where applicable, adjusting their strategies and business models in the context of decarbonisation. They are likely to benefit from support from third parties: while some of the largest PE funds are building in-house capacity to ensure they can manage the transition, partnerships will be the most efficient means to operationalise a net zero strategy.
As for the sustainable debt market, it is vital that borrowers agree material, challenging and impactful environmental targets to qualify for step-downs. Ideally, these should be assessed and, if necessary, challenged by a third-party consultant or verifier. Setting the bar too low risks accusations of greenwashing.
Indeed, sincerity and ambition should be at the centre of any climate action strategy. As the race to net zero accelerates, civil society groups, investors and regulators are – quite rightly – applying growing scrutiny to claims made and impact delivered. Disclosure is necessary, but not sufficient: they want to see measurable progress towards science-based targets, rather than broad aspirations and long-term goals.
Fundamentally, the net-zero transition is creating enormous investment opportunities that the PE sector is well positioned to seize. Attempts that are half-baked, opportunistic or fail to go beyond box-ticking could potentially do more harm than good for PE funds and end investors alike.
Deniz Harut is executive director and Gavin Templeton is a partner at specialist climate change investment and advisory firm Pollination