It is no secret that the rise of private markets and ESG/impact investing were two of the most defining trends in asset management over the last decade. Private markets AUM reached a record $13.1 trillion in mid-2024, according to research by McKinsey, while impact strategies have grown by 10x over the last ten years. However, both impact investing and PE have recently encountered headwinds; perhaps a union of the two may help to overcome them. Impact investing can be defined as profit-seeking investments that have positive externalities. The idiosyncrasies of PE strategies can synergize well with this approach. The control that these funds exert over companies can serve as a mechanism for transmitting the positive externalities of impact investing throughout their portfolios, and their ability to take a long term view can help overcome some of the growing pains that have plagued certain ESG sectors. Furthermore, PE managers have recently set their sights on the mass affluent market. Impact strategies may prove useful in courting these assets.
After enjoying over a decade of eye-watering growth, the PE industry has become saturated with capital and managers who seek to deploy it, making the most profitable deals more difficult to access. In the early days, GPs generated over 80 percent of their alpha from optimizing their target companies’ capital structures or exiting them at higher multiples. Today, operational improvements account for almost half of value creation.
This shift towards an intrinsically harder to implement strategy, combined with the current macro environment, has resulted in a slowdown in PE. 2023 saw declines in fundraising and IRRs (especially in infrastructure, VC, and real estate), as well the ninth consecutive year of increasing dry powder.
To maintain its growth, the industry is attempting to tap into mass affluent investors ($100,000 and $1,000,000 in assets), who have historically been locked out of alternatives by regulation. This market represents assets worth $7.2 trillion in the United States, according to estimates by Capco. However, if PE is going to thrive in this new environment, it is going to have to adapt to its preferences.
Millennials (those born between 1981 and 1997) and gen-Z (those born between 1998 and 2012) are much more widely represented in the mass affluent market than in the high net worth segments, or for that matter, institutional investment committees. Research by the Federal Reserve found that Americans aged 35 to 44 had an average net worth of $549,600 in 2022, while those 35 and under were worth $183,500. Data from Capco reveals that 40 percent of the mass affluent market and 62% of the mass market, are comprised of people under the age of 55.
The younger generations view impact investing and ESG much differently than their older counterparts. While older and/or wealthier investors do tend to be very impact oriented, they have historically treated their return generating assets and impact-driven philanthropy as two separate buckets of capital. This is in stark contrast to millennials and gen-Z who prefer for the two to work together as a single entity. The PE funds that adapt to these preferences will be at a significant advantage when attracting AUM from mass affluent investors.
While impact investments represent an economic opportunity of about $12 trillion, they are fraught with near term uncertainty. Take climate infrastructure, a classic example of an impact investment. In Europe, an evolving patchwork of regulations has made clean energy investors uneasy, increasing the cost of debt and stalling new projects. In 2022, the Spanish government’s auction system set ceiling prices too low, turning bidders away. Instead, many of them chose to bypass national energy markets altogether. This regulatory uncertainty, combined with clean energy’s high upfront capital costs and long path to profitability, has spooked public market investors. Earlier this year, BP announced that it was dramatically cutting back on renewables due to pressure from shareholders. At around the same time, leading French energy distributor Rubis saw activist investor Ronald Sämann win a seat on its board following his criticism of the firm’s large solar investments. While these specific issues do not apply to all types of impact investments, they are emblematic of the intrinsically nascent nature of many of these opportunities.
PE firms are well positioned to navigate the aforementioned challenges. Returning to the clean energy example, PE funds’ ability to lock up capital over prolonged periods insulates them from the public markets’ short term jitters, allowing value to fully crystalize. Furthermore, buyout firms’ controlling ownership over a multitude of companies (either within a single fund or across several) gives their managers unique value creation opportunities: the ability to make decisions quickly and to create synergies between assets. For instance, a GP could overcome an unfavorable energy auction system by entering into a power purchasing agreement with another portfolio company, or use an affordable housing development project to support the workforce of another company during a restructuring. Essentially, PE funds can create network effects through which the positive externalities associated with impact investing can quickly spread throughout their portfolios. This dovetails well with the industry’s increasing focus on operational changes to drive returns. Of course, managers will have to ensure that this approach does not result in firms cannibalizing each other’s profitability, but if it is executed right, it may prove both profitable and an excellent method for attracting AUM from the mass affluent market.
The industry will have to overcome some significant challenges to fully embrace impact investing. One of the biggest hurdles for the marriage of PE and impact funds will be their ability to show that they are able to generate returns. A major stumbling block for the ESG movement has been its inability to quantitatively link non-financial metrics to risk and return. While many people who I have spoken to within this space are able to clearly articulate the causal links between say, climate risk and insurance costs, many investors still feel that pursuing impact-oriented goals comes at the expense of returns. Research comparing the performance of impact and non-impact funds, which was conducted by Cambridge Associates and the Global Impact Investing Network, showed mixed results. The relative IRRs of the two fund types varied significantly depending on vintage year and geography. Perhaps performance will be less of a concern in the mass affluent market if the utility that its members get from the knowledge that their investments positively impact society outweighs the lost utility from potentially lower returns. Then again, psychologists would call this wishful thinking as people usually feel loses more strongly than gains.
Of course, the very premise of attracting mass affluent AUM with impact strategies depends upon the PE industry successfully convincing policy makers to let non-accredited investors access their funds. No one knows whether or not this will happen. However, it is possible that the networks effects described earlier could be enough to make PE impact investing the industry’s next big thing.