ESG OPPORTUNITIES & RISKS IN PRIVATE MARKETS

Financial markets—both public and private—have a critical role to play in this movement. How we view our role, or the attitudes we bring to the table; how we construct portfolios, or the expression of those attitudes; and how we measure that data, or understand the impact of each expression—all adds up to the chemical make-up, the DNA, the imprint that will help shape the health of global ecosystems and where investment management has contributed to that progress.

After all, climate risk is investment risk.

And from an investment perspective, our clients are focused on many of the trends that are shaping the climate conversation—and not as constraints, but as profitable investment opportunities and growth drivers. Trends like: renewable methods of traveling, working, and collaborating; the proliferation of alternative and green materials, and a dramatic shift to a more resource-efficient, circular economy.

Providing capital to innovate in these trends, and grow the businesses that underpin them, is where private equity, too, has a role. For instance, among those that specialize in infrastructure investments, private market managers are also recognizing the value creation that comes with energy-efficient and green projects. And when they evaluate those opportunities, fund managers are using data to gain a holistic view of the ESG outcomes that each investment generates across the value chain. This is the bird’s eye view that provides a critical perspective, the map—from effort to impact.

And it is this data, and the ability to collect and measure it, that informs us how the private markets, as a whole, lends itself particularly well to ESG integration and impact investing.

Consider even just the following.

Studies have shown that private equity ownership leads to a significant reduction in use of toxic chemicals for extraction and CO2 emissions from flaring¹.

The private markets have encouraged and rewarded scalable businesses (in the real asset sector) that build resilience among coastal ecosystems—creating sustainable economic growth and securing the livelihoods of the people in those communities².

And, private capital³ has supported projects committed to extraction and prevention of plastic pollutions and the ocean clean-up. But behind each of these examples is also a radical shift in investor attitudes—expressed by both investment decisions and investor mandates—towards environmentally and socially responsible investments. And whether these attitudes are more acutely exhibited in diversified portfolios or dedicated to applying financial instruments to a whole new vision of the world—they are growing, evolving, and being measured in unique ways.

At the same time, in today’s market environment, we see investors allocating more of their investments to private markets-seeking to amplify portfolio performance and leverage new methods of diversification to build resilience in their portfolios.

We are witnessing the transition from the traditional 60/40 split—between stocks and fixed income—to an almost equally balanced allocation between stocks, bonds, and alternative investments. Research shows that, going into 2022, institutional investors (most notably pension funds and SWFs) are expected to increase their target allocations to alternatives to close to 30% of their total AUM primarily because of the reliable income stream and diversification benefits of this asset class. Once considered a ‘nice to have’, the ability to support public and private assets on a single platform is becoming a ‘must-have’, in our view.

That’s why we decided to fill in the gap and give our clients a whole portfolio solution that enables them to manage both public and private asset classes simultaneously, and to quantify the common factors among client portfolio exposures, project cashflows, and unify the risk metrics for both public and private markets—all while tackling the greatest challenge of our generation.

But it’s also about the sheer amount of data—the volume—that makes measurement a challenge.

As private markets have developed and grown in size, so too has the appetite for information—across the board. Both asset owners and asset managers are looking for actionable information that can often be hidden in unstructured data or require major time commitments to parse through—like financial documents. This can undermine the efficiency and scalability of these operations and creates the demand for solutions that automate the information extraction process.

And it’s not just about the volume of data, but asset class coverage, increased investor demand, and financing the transition. I could add regulation to the list, but let’s just call it “mutually agreed standards” for today. As you may have heard, reporting standards are inconsistent. And as corporate disclosures become more practiced, when it comes to sustainability in particular, the volume of data will increase vastly. For investors to get a complete picture of their portfolios—estimating that data and making it transparent will be key.

Meanwhile, the complexity of even tracking the well-represented investments—structured products, real estate, private credit, and infrastructure—will become more of a challenge—especially from an ESG lens. Compounding this: investor demand for companies to demonstrate their transition or contributions to a net-zero economy.

As Larry Fink said in his annual letter to shareholders, with additional focus and scrutiny on carbon-intensive assets in the public markets, there is a risk of companies divesting so-called “dirty” assets to the private sector.

This only exacerbates the need to understand what you own and foster a set of standards in the private markets for companies to report on, and for asset owners and asset managers to hold them accountable. What can be measured can be managed. Already, the SFDR and TCFD rules, particularly in Europe, are helping to codify how participants measure their impact, and communicate that impact back to investors.

Nordic investors have historically been at the forefront of sustainability, and you know that you need to be serious about data if you want to be serious about sustainability. All of this ties in together: again, climate risk is investment risk, and the only way that we can measure and manage that risk is through high-quality data. In 2020, we launched Aladdin Climate to help clients understand risks how the physical toll of climate change and how the transition to a low-carbon economy impacts risk and returns, across portfolios.

And in the Nordics and beyond, the demand from LPs for quantifiable ESG data is increasing quickly. But the challenge now is that there are a lot of GPs that are not reporting ESG information to LPs—and when it is reported, it is very inconsistent. In addition, because there are so many different ESG reporting frameworks in place globally, it becomes very cumbersome for LPs—even if they get the data—to make sense of it.

The lack of unified metrics, combined with low adoption, prevents the creation of a benchmark that allows either GPs or LPs to assess whether an ESG number is necessarily good or bad. So, we also need technology to help deliver benchmarks and also help establish a standard of relativity for improvement or decline.

Technology is vital, when it comes to measuring and managing risk in private markets—whether it’s across specific portfolio goals (like ESG) or to bring balance to investment strategies at a time where there is less liquidity and more volatility—like the era we are in currently.

Every sound policy starts with quantifying the variables. In the private markets, we have seen two ways of quantifying the environmental impact of a company. The first is an inside-out angle: enabling portfolio companies to easily report on standard metrics in a way that can be aggregated at an asset owner and asset manager level. Another angle is to be more outside-in: using advanced machine learning technologies to scan thousands of media sources and publications for risks about a company (i.e.what is the market saying about a particular company).

Meanwhile, we are seeing many players in the industry, including us, develop models to quantify the potential impacts of climate change. They are as wide-ranging, as they are needed. And they help answer questions like: how exposed is my property to natural disasters? How will the valuation of my asset change with the advent of carbon pricing and other regulations? Or, based on the Paris Agreement, what will be the impact to my asset’s value if we keep warming at or below 1.5 degrees? What happens if we exceed 2 degrees? Which industries and geographies would we expect to outperform or underperform?

The metrics that answer these questions are kinetic. They change as the world changes. That means that interoperability and open systems are a must-have—so that there is consistent, real-time coverage across equities and fixed income, with dynamic analysis and reporting capabilities, and seamless integrations with data partners—big and small.

All of this, and more, is needed to help translate climate risk into investment terms—combining climate and transition forecast scenarios, with those models, and company-specific transition data: the targets, plans, and CapEx dedicated to achieving it all. It’s not about predicting the future—it’s about scenario building and driving that kinetic energy from analysis to insights to performance—and ultimately to impact.

And as I mentioned, the private markets have a unique role in that impact; one that is nuanced; and one that is also kinetic.

Across the board, investors and managers, alike, are increasingly asking to better understand the impact on environmental, social, and governance matters related to their investment targets. We must all work together to accelerate the availability of ESG data, while simultaneously creating a benchmark of ESG metrics.

At large, BlackRock’s sustainability commitments are anchored in access, stewardship, and integration. We are tackling the barriers that exist in private markets ESG reporting by providing a universal solution to streamline and standardize ESG data—no matter how far along a company is in its ESG journey. And for Aladdin (inclusive of eFront), we’ve put ESG and climate analysis at the heart—with a clear focus on physical risk, climate risk, transition risk, climate scenario analysis, net-zero strategy alignment, and workflow integrations across the platform.

For private markets specifically, BlackRock has dedicated resources to develop a unique flavor of natural language processing technology—to help derive meaning from unstructured documents and to automate the process of relevant data extraction.

We can now automate the quarterly reporting process for our clients, increase the precision of relevant investment data capture, and do those things faster and at scale, while freeing up more productive time for clients—so that they can focus on core business strategies and tactics. These types of tactics will potentially become more and more important as ESG data volume increases. Tactics that will become ever-more important as ESG data becomes ever-more manifold.

Our eFront Insight Sustainability module has also been created to enable our clients to manage and monitor their alternative investments based on ESG risk incidents and ratings for private companies, self-disclosed asset level ESG metrics sourced from GPs, public proxies, and more.

Institutional investors—regardless of whether they are public-markets heavy or private-markets focused—have to navigate the same forces that retail investors and the public at large read about in the news, tighten their wallets at home about, or have concerns over how it all will impact their retirement and financial well-being in the long term. What I’m talking about is: a major war in Europe, continued supply chain disruption, inflationary pressures, fragmented liquidity, pervasive volatility, and of course the overall health of our planet.

This is the stage on which market participants must generate alpha on. And that translates into new methods of diversification and portfolio construction.

But like in the natural world, so too in the economic world and financial markets, it will take ecosystems of participants: public and private, sovereign and commercial, retail and institutional, GPs, LPs, and PortCos—all working together to make sense of the data, build a baseline, and encourage a robust and credible reporting system that not only keeps account of ESG outcomes, but keeps each of us, human beings, ever-more accountable for our footprint on this Earth.

Thank you.

¹Bellon (2021), Does Private Equity Ownership Make Firms Cleaner? The Role Of Environmental Liability Risks.
²14 Capital, Indico Capital, BlueSwell business incubator, etc.
³Ocean Cleanup Project