Stepstone Group: The evolution of impact investing

The face of impact investing has evolved – now it offers a variety of compelling opportunities for investors seeking to align their financial and environmental or social objectives, say StepStone Group’s Suzanne Tavill and Bhavika Vyas.

This article is sponsored by Stepstone Group.

What changes are you seeing with regard to investor appetite for impact and what strategies are proving most popular?

Suzanne Tavill: We are seeing notable growth in investor appetite, but that appetite is manifesting in different ways. LPs view impact as a way to reflect the objectives of their stakeholders. They want to align their impact programme with their stakeholders’ interests. As a result, there is variation in the way these programmes are being built around the world, particularly in terms of the impact objectives being targeted. The one area where we are seeing a coalescence of demand, however, is climate. 

Suzanne Tavill, Stepstone Group

The composition of funds available in the impact space has changed materially over the past decade. Initially, the sector was dominated by emerging markets strategies with an emphasis on social issues. However, the investment landscape today is weighted towards developed markets with a substantial portion of those focused on climate. Further, the false notion that impact investing is always associated with concessionary returns is being dispelled with the strategies now available. All of this has meant that impact investing has broadened in appeal.

In terms of popularity, I would say that climate ranks as number one across all private markets asset classes, from infrastructure to private equity, private debt and real estate. This is followed by diversity strategies, or strategies focused on empowering diverse individuals. Finally, we see interest in broader strategies aligned with the UN Sustainable Development Goals, which may cover a range of social and environmental issues.

How are investors integrating impact considerations into their allocation decisions and how does this vary by investor type and geography?

ST: There is no single approach being adopted by investors, but perhaps the most common is the creation of a dedicated impact allocation. We see dedicated allocations around climate and dedicated allocations around impact more broadly. 

In terms of which types of investors are most forward leaning, I would have to say high-net-worth individuals and foundations. However, we are also seeing increased demand from pensions, endowments and even sovereign wealth funds. With respect to geography, Europe has typically led the way but we are also noting a lot of activity out of Australia. Australia has traditionally been very progressive when it comes to ESG, and this enthusiasm is flowing into the impact arena.

How do you distinguish between ESG and impact, and how do investors view that distinction? 

ST: In our view, ESG is more focused on process, whereas impact is focused on outcomes. Having said that, impact is still a relatively new concept for many investors, and we do see some confusion around these terms. Indeed, we see the term ESG being used widely in certain regions, and in some cases, they mean to say impact. It is important to make sure everyone is talking about the same thing. 

Another area where we still see a lack of clarity is this idea that impact is associated with concessionary returns. There is a segment of the impact market where this is true, certainly, but there is also an extremely large component of the impact universe that is delivering commercial returns and impact, without any trade-off.

What types of questions are investors asking of impact managers in due diligence?

Bhavika Vyas, Stepstone Group

Bhavika Vyas: The first area that investors explore in due diligence is whether a fund’s objectives align with the investment themes that they are looking to address. Specifically, they want to know that the manager is creating intentional impact in the areas of climate or diversity, for example, as opposed to any incidental impact that their strategy may produce. 

Then, investors want to see that a manager is truly integrating those impact considerations into its diligence and underwriting processes. They also want to understand how engaged the manager is in bringing value to its portfolio. Last, but not least, they look at their monitoring, reporting and transparency. It is expected that managers will provide impact metrics alongside financial metrics. To that end, StepStone has created ESG and impact score cards, which we use in all our diligence, to ensure we approach these factors consistently.

How are impact investors differentiating themselves?

BV: In our experience, specialist managers tend to outperform generalists. They have networks, experience, value-add capabilities and, importantly, reputations in the specific areas where they invest, which supports origination and ultimately performance. 

We have seen first-hand that management teams can distinguish between different types of capital. They recognise impact capital that is intentional and where the investor has real value-add to offer. Specialist managers tend to identify interesting off-market opportunities; they also know where and when to pick their entry points. In terms of the nature of that specialisation, it is a wide range within climate, including everything from energy efficiency and storage, electric mobility, industrial decarbonisation to plant-based food and ag tech.

How should managers approach verifying impact processes and performance?

ST: Verification is a relatively new concept to many impact investors that have only entered the space over the past few years. There are also new groups entering the verification space itself. That is raising questions about the qualifications of these verification service providers. Who will check the checkers? That is always a concern implicit when “quasi” rating agencies start to emerge. All those concerns are fair and relevant and need to be worked out. 

Verification is important, however. It holds practitioners to account and gives the LP universe confidence that what is being delivered is authentic. There is widespread scepticism around greenwashing today, which is to be expected in a new focus area for investors that is growing rapidly and attracting a lot of new entrants. Groups that are prepared to hold themselves to account by going through a verification process can use this to address some of those greenwashing concerns. 

Looking ahead, how do you expect impact investing to evolve in the context of the broader PE industry?

BV: As Suzanne mentioned, we have seen impact evolve from concessionary investment, primarily focused on emerging markets, to a far broader opportunity set where there is now a recognition that impact can be achieved in tandem with strong financial returns. I think we will see that proven out over the years to come.

Climate will remain an exciting area for investment given the pressing need to tackle this global problem, and I think the evolution of impact will be heavily influenced by this particular opportunity. It is increasingly well understood that climate investment represents an attractive investment proposition, quite independently of its positive impact, and so climate-related strategies are proliferating across multiple asset classes. 

Historically, much of the impact universe had been more credit focused, with the heavy involvement of development finance institutions. The early impact equity investing pioneers were focused on early-stage investments. But I think we will see a larger variety of offerings as the industry continues to evolve. We, for example, are primarily focused on mid to late-stage venture and growth equity with our climate investments today, coupled with a handful of interesting buyout managers. We are starting to see more small and mid-market buyout impact strategies emerge. 

Given our vantage point, we also look at climate as an opportunity across asset classes, and see interesting investments across private equity, infrastructure and real assets. 

We also expect the volume of impact secondaries opportunities to grow and diversify as the industry matures, just as has been the case in other private markets asset classes. Lastly, we expect to see increased convergence around data, reporting, transparency and monitoring as the swell of regulations comes into effect and gets more widely understood and adopted. In short, I expect to see a more sophisticated impact investment environment generally, tracking the well-worn path of other asset classes in the private markets space.

How would you describe the impact opportunity set today, particularly as it relates to climate?

BV: Climate is widely accepted to be the most pressing issue of our time. It also represents a very large and diverse opportunity set. Furthermore, there are a number of tailwinds that mean it is becoming an even more attractive investment proposition than it has been in the past.

First, the sector is maturing, which is leading to cost efficiencies in the underlying technologies. That is important because it makes it possible for companies to break even faster. It also makes the economic decision for the end customer easier, thereby increasing the addressable market.

Second, we are noting increasing sophistication among both investment managers and asset-level management teams. There is now a significant group of individuals that have real experience in deploying capital in this area, starting companies and successfully exiting them. That is encouraging.

Sovereign and corporate net-zero commitments and the shifting consumer appetite towards sustainable choices are providing additional support for climate-related products and services today. In addition, regulations that are driving innovation, adoption and disclosure are leading to a more robust opportunity set, while ensuring authenticity by combatting greenwashing.

Suzanne Tavill is a partner and global head of responsible investment at StepStone Group, while Bhavika Vyas is a managing director and leads the firm’s impact investing effort