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Looking back a few years, the respective reputations could not have been further apart. While the private equity sector has grown in 40 years from cottage industry to $20 trillion giant, the image of corporate raiders defined by the seminal 1989 book, Barbarians at the Gate has lingered.

In contrast, impact investing as recently as the mid-2010s represented the furthest reach of progressive finance, with common good trumping hard returns in a niche with its roots in development finance, charitable investing and social enterprise. If the larger field of ESG-screened investment was already comfortably admitted in traditional finance, impact, with its central focus on measurable social or environmental progress, operated in a distinct world with a purer vision.

Such clean distinctions are increasingly historic with the impact sector seeing explosive growth in recent years, a shift helped by the entrance of some of private equity's biggest names, among them pioneering funds from TPG, as well as Bain, Carlyle and KKR.

Many factors have driven this wider change – among them increasing state action to decarbonise the global economy, changing social expectations on business and the rise of regulatory and tax incentives to support investments with a positive real-world impact. But while such shifts and the recent influx of institutional investors will be welcomed, questions remain, especially regarding how the bottom-line driven world of private equity can mesh with the progressive agenda of impact. And if controversy rages still over how to credibly define and measure mainstream ESG-aligned or sustainable investments, that challenge is far more acute in the less developed field of impact.

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This area has seen massive growth in a very short space of time. Impact used to be a niche investment strategy. What we've seen over the last six years is institutional money has started to be deployed.

Rebecca Perlman
Partner, London

But such unresolved debates reflect impact's increasing relevance. "This is an area that has seen massive growth in a very short space of time," says Herbert Smith Freehills' (HSF) corporate partner Rebecca Perlman, whose practice focuses on ESG and sustainable investing. "Impact investing used to be a niche investment strategy that was predominately adopted and driven by development finance institutions and charitable organisations. What we've seen over the last six or so years is institutional money has started to be deployed."

And the prospects for private equity in the field attract such attention because, despite a culture gap, the hands-on approach of such financial sponsors appears in many regards perfectly geared towards driving change at scale. As HSF corporate partner Heike Schmitz puts it: "I would say private equity is naturally born to make an impact."

This goes beyond only gauging how far this union can run; the fortunes of private equity in the arena look a reliable bellwether of whether impact investing can continue its broader meteoric rise and sustain credible returns – both financial and for people and planet – to establish itself in the mainstream.

A pretty good fit

If it is not obvious why private equity entered the impact space, sheer momentum plays some part. The Global Impact Investing Network (GIIN) has valued the impact market at about $1.2 trillion. Impact as such helped private equity address substantial demand from investors, increasingly progressive outlooks from their own professionals and the need to polish the image of a sector that is now consistently – and not always comfortably – held in the spotlight.

"Impact is becoming increasingly mainstream," notes HSF corporate partner Shantanu Naravane, a funds and asset management specialist. "There was a sense that impact was focused on areas of the market where mainstream players were not interested – that is not the case now. You now have big houses all looking at this area seriously."

TPG, Apollo, KKR and Blackstone all have sizeable funds dedicated to impact. The Texas-based TPG has been the acknowledged pioneer since launching its impact strategy in 2016, including a record-breaking $7.3 billion capital raising in 2022 for its dedicated climate fund, TPG Rise Climate. It was this fund which in October announced a deal to acquire testing, inspection and certification company AmSpec Group, a specialist in energy commodities and fuels. According to the firm, the wider impact platform has $18 billion in assets under management (AUM) spread across separate funds with different impact objectives. Other investments to date across the platform range from medication and education to dairy farming in India.

Elsewhere, Apollo's Impact Investment Platform has $1.6 billion in AUM. The US firm says its approach is centred on "collinearity" – essentially investing in mature companies where positive non-financial results are part of the business strategy, making profit and impact mutually reinforcing. KKR states that it has $30 billion invested in wider climate and environmental sustainability projects since 2010 while its first dedicated fund for impact investment launched in 2018, raising $1.1 billion.

The arrival of new players certainly reflects increased investor demand but where is the money going? Naravane comments: "There's a bifurcation in strategies at the moment. You have big private equity houses looking at energy transition or decarbonisation projects that have the ability to absorb large amounts of capital. Meanwhile, you have the traditional impact players who have smaller pools of capital who are pursuing broader societal goals, such as improvements to marine life or biodiversity strategies. But they are up-and-coming strategies; you can't pour $1.5 billion into a strategy like that."

And while private equity investments in the space have been dominated by decarbonisation, there are signs of a broader pool of projects, with regenerative agriculture, nature-based climate solutions and socially-geared ventures beginning to emerge.

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With impact funds, we're seeing more talk of people having their carry linked to non-financial performance. Either they forgo some carry if they don't hit certain metrics or they get extra if they hit impact targets.

Stephen Newby
Partner, London

Of course, the energy transition's increasing relevance across the global economy could also prove a challenge for private equity in search of attractive returns, with the wall of capital chasing renewable energy and the relative maturity of low-risk fields like solar and wind power depressing returns. Most significant is the Biden administration's Inflation Reduction Act and its $369 billion stimulus package for green investment in the US. But the hope among impact proponents is investment in the energy transition will unlock funds which will eventually pour into areas such as sustainable agriculture and fledgling social projects, as well as educating more investors in the sector.

While purists sometimes lament the dilution of impact's societal focus, the scale and sophistication that leading buyout houses bring to the sector carry unquestioned benefits. Moreover, private equity's relatively long investment cycles and model of close involvement with portfolio companies has obvious common ground with impact. In a similar vein, the due diligence that sponsors routinely conduct on potential acquisitions offers a natural point to accommodate assessments geared towards impact criteria.

"Sometimes people think it won't mesh," says Schmitz, whose practice focuses on advising funds and asset managers on investments, strategy and ESG. "But private equity's pitch is around long-term value creation and impact is a good model – it doesn't fit in every case but it's a pretty good fit in general."

In a sign of that convergence, some buyout houses are experimenting with tailoring the traditional industry carrots to reflect the impact ethos. "Normally, managers get paid a percentage of profit, usually about 20% of profit as their carried interest, which acts as their performance alignment. With impact funds, we're seeing more talk of people having their carry linked to non-financial performance as well," says HSF corporate partner Stephen Newby. "Either they forgo some carry if they don't hit certain impact metrics or they get extra if they hit impact targets."

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Private equity's pitch is around long-term value creation and impact is a good model – it doesn't fit in every case but it's a pretty good fit in general.

Heike Schmitz
Partner, Germany

Regulatory catch-up

If the investment ethos of impact and private equity share much common ground, many see the potential emergence of more established regulatory regimes as being another key factor in deciding how strong the appeal of impact will ultimately be to generalist institutions like private equity.

For one the corporate and investing worlds are increasingly wary of allegations of greenwashing – both from the perspective of reputation management as well as more immediate regulatory or legal risks. As a result, sceptics are asking probing questions: what does impact mean? How is it benchmarked? And, who measures it? Lack of clarity increases exposure.

This is where things get hazy in many market discussions. Impact aims to make tangible social or environmental benefits via an actively managed strategy through incentives and remedial actions. A key element of the methodology – and one which regulators are largely yet to adopt – is the intentional focus on impact as a core goal, as opposed to measuring improvements in narrow outcomes, such as falling carbon emissions. Intention is all.

Moreover, impact has yet to see as thoroughly developed standards as for ESG and sustainability, which have benefitted from a series of disclosure and labelling regimes in major markets in recent years. The possibility of fitting impact into such regimes – or creating bespoke arrangements within them geared to impact's proactive ethos – has only just emerged on policymakers' agendas.

Specialist industry bodies have so far made the most progress towards setting out coherent frameworks. The World Bank's International Finance Corporation has developed its Operating Principles for Impact Management with the intention of "establishing a common discipline around the management of investments for impact" and promoting "transparency and credibility by requiring annual disclosures of impact management processes with periodic independent verification". Currently, the principles are followed by several big players, including TPG, KKR and Apollo. GIIN's definition of impact is also being drawn upon by regulators who are beginning to scrutinise the space, a notable example being the European Securities and Markets Authority.

The possibility that the EU's Sustainable Finance Disclosure Regulation (SFDR) could carve out a specific category for impact is currently gaining much attention as it would confer wide acceptance and go a long way towards establishing a globally credible standard for impact investments. SFDR was ushered in March 2021 as a cornerstone of the EU's sustainable finance agenda to improve transparency and rigour in the market for sustainable investments. While SFDR's Article 9 already picks up some of the impact methodology, it is generally considered a poor fit given its focus on outcomes over intent but the European Commission has this year floated creating a more bespoke arrangement.

The UK Financial Conduct Authority (FCA) has gone further, putting forward a proposed impact label under its Sustainability Disclosure Requirements regime. The FCA says the label applies to "products with an explicit objective to achieve a positive, measurable contribution to sustainable outcomes". Under the SDR, companies will need to provide information to show the impact of their investment, including evidence of "a robust method to measure and demonstrate that its investment activities have had a positive environmental and/or social sustainability impact".

While the evolution of global regimes will be closely watched, the prospect of more sophisticated frameworks to accommodate impact looks likely to widen the pool of investors and institutions targeting the sector. "The first thing to keep an eye on is regulatory divergence across all of these things," notes Perlman. "The next thing to consider is: do we really have people sitting within regulatory bodies that have the understanding in impact specifically to be designing labelling rules and disclosure and classification frameworks? And what does the impact investing industry have to do to engage with that process?"

There are critics who say now large private equity houses are involved the purity of impact has been lost but the sophistication and capital they bring is a positive. They can channel much more into impact.

Shantanu Naravane
Partner, London

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Making good

If many issues remain unresolved in what is a marriage of contrasts, ultimately the future for private equity in impact investing looks upbeat. One reason why these new entrants have been (largely) welcomed into the fold is that the arrival of such unsentimental players acts as a powerful sign that impact investing has matured into a credible discipline that can command commercial returns alongside its societal mission.

As Perlman sums up: "You're getting market rate returns. You've got pension funds developing impact strategies, you've got the biggest private equity houses developing impact strategies and they aren't doing that in any areas that generate less than market rate returns. The debate around trade-offs is not something you commonly hear anymore – that's been one of the big changes over the last two to three years."

If private equity looks here to stay, sponsors themselves have a way to go to persuade the sceptics. Investors have grown more wary of funds throwing around terms like impact with little to back it up, while gyrations in markets and surging interest rates mean higher returns can be found in some more traditional areas.

"A lot of people expected more from the impact fund raising than they have currently seen," concedes Schmitz. "Some of that is due to the current market environment but some are also finding that it takes more than flaunting the word impact to unlock the money; investors themselves still need a lot of education on what impact means."

As such comments suggest, there will be challenges ahead. In an environment in which private equity is expected to face several more challenging years after a long boom fuelled by cheap debt, there will be pressure to bring more substance to the impact sales pitch. Other trends to watch in the future include a further pivot from impact's origins in emerging markets towards developed economies, as well as the extent that institutional backers diversify away from decarbonisation to a wider set of projects.

If there has been a sense of some funds riding the short-term of investing fashion, now will come a period when results and rigour come to the fore. Yet few doubt the ultimate dividends to come from this somewhat unlikely union. As Naravane sums up: "There are critics who say that now large private equity houses are involved the purity of impact has been lost because originally it wasn't about pumping large amounts of capital into something for financial returns, it was about finding good causes and investing in them. There's a debate to be had there. But the sophistication and capital they bring is a positive. They can channel much more into impact. They're adding value in that way."

Key contacts

Shantanu Naravane photo

Shantanu Naravane

Partner, London

Shantanu Naravane
Stephen Newby photo

Stephen Newby

Partner, London

Stephen Newby
Heike Schmitz photo

Heike Schmitz

Partner, Co-Head ESG EMEA, Germany

Heike Schmitz

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London ESG, Sustainability and Responsible Business Impact Investment Private Capital ESG Geopolitics and Business Private Capital Impact investment Shareholder Activism Shantanu Naravane Stephen Newby Heike Schmitz