Green landscape with sustainability symbols

Private market funds may soon need to open their books to scrutiny regarding their ESG performance, and many industry players are welcoming the change.

“I’m looking forward to seeing more disclosure and transparency in the private markets,” said Bonnie Foley-Wong, Canada sustainable investment leader with Mercer (Canada) Ltd. in Toronto. “Investors are asking for that and it will certainly help in terms of whole-portfolio management.”

Ray Punn, vice-president with Guelph, Ont.-based Skyline Wealth Management Inc., believes investment giants such as the Canada Pension Plan Investment Board and the Ontario Teachers’ Pension Plan are influencing the trend toward openness.

Pensions and endowments, influenced by the Yale Model, helped dispel the belief that 60% equities, 40% fixed-income was an ideal allocation by adding private-equity funds to their portfolios a few decades ago.

“The smart money has mixed in private alternatives,” Punn said. “As the institutional guys made the switch, we’ve slowly seen retail investors coming in after that.”

Institutional investors are once again acting as trendsetters as ESG has become a focus in private market investing, said Foley-Wong: “This focus on ESG has become more sophisticated. In the last five to 10 years, there’s been an attention toward impact, but increasingly we’re seeing that attention toward ESG integration in the private markets, and how it supports enhanced risk-adjusted returns.”

U.S. investment manager State Street Corp. found in a 2023 study that half of asset managers and asset owners believe private markets provide better opportunities for ESG impact than public markets, while 61% identified ESG investing as a key driver for retail adoption of the asset class.

Still, Foley-Wong said, disclosure requirements for private markets pale in comparison to those of their public counterparts, presenting a significant problem for investors — whatever their size or level of sophistication.

While several credible third-party ESG rating firms, such as MSCI Inc. and Sustainalytics, operate in the public markets, Foley-Wong said, there are large gaps in the quality and consistency of ESG data in the private markets. Investors must try to fill these gaps themselves.

“There’s still a lot of primary data collection,” Foley-Wong said, “so we gather data or engage with managers on behalf of our clients, because there isn’t necessarily a central data reporting portal or conduit. It’s time-consuming.”

However, Foley-Wong is encouraged by initiatives such as the ESG Data Convergence Project, a joint effort by the California Public Employees Retirement System and Washington, D.C.-based Carlyle Group Inc. that’s aimed at generating reliable ESG data in the private equity industry. Launched in 2021, the project has expanded its membership to more than 375 general partners (GP) and limited partners, with a combined US$28 trillion in assets under management.

“That was a meaningful signal in terms of bringing more rigour to ESG disclosures and reporting to the private markets,” Foley-Wong said.

In the past two years, BDC Capital — the Business Development Bank of Canada’s specialized financing arm —has shone light on its own corner of the private asset industry. The Crown corporation released the second set of results from its diversity, equity and inclusion and ESG reporting templates in 2023, which were distributed to all 72 of its GPs, as well as more than 1,000 of the GPs’ underlying portfolio companies.

The responses suggest diversity is lacking in the senior ranks of GPs, with results showing 48% were owned entirely by men, while 8% were entirely owned by visible minorities and just 2% were owned by women or Indigenous people.

However, hiring figures suggested that both women and visible minorities accounted for at least half of the new recruits at the bulk of GPs.

Participation in the reporting was up among both GPs and portfolio companies. Alison Nankivell, BDC Capital’s senior vice-president, said she was impressed by the level of engagement and thoughtfulness demonstrated in answers.

“When we started this exercise a couple of years ago, a lot of investment companies and GPs thought this was irrelevant and wondered why we were bothering,” Nankivell said. “But the reality has caught up very quickly and they can see that they need to be investing in building out that data collection and reporting capacity.”

In addition to investors, regulators may have a role in improving transparency by helping to standardize ESG data in private markets, said Francis Sabourin, portfolio manager with Richardson Wealth Ltd. in Montreal.

“Europe is way ahead on this issue,” he said. The European Union’s sustainable finance disclosure regulation has used a graduated structure to designate funds as “green” since 2021. Managers of private equity funds must meet strict criteria to qualify as an Article 8 or “light green” fund; tougher requirements are set for the Article 9 or “dark green” fund accreditation.

In the U.S., the Securities and Exchange Commission (SEC) is cracking down on greenwashing. The regulator recently updated its “names rule,” which requires that at least 80% of a public fund’s assets fall under the investment focus suggested by the fund’s name. Amendments announced in late 2023 extend the rule’s reach to explicitly cover ESG terms in fund names.

Although this rule affects only registered investment companies, the SEC also has signalled its willingness to enhance transparency in the private markets.

Around the same time as the regulator updated its names rule, it released a separate rule requiring private fund advisers to report certain information regarding fund fees, expenses and performance to all investors on a quarterly basis.

Steve Balaban, chief investment officer with Mink Capital Inc. in Toronto, said the onus is on investors and their financial advisors to ensure they understand what they are getting into when investing in private markets. His firm has developed a due diligence checklist that encourages investors to question private equity funds on the role of ESG factors and targets in their investment and operational decisions.

“If you’re going to invest in the private markets or a private equity fund, you should meet the people from the private equity fund and ask them questions,” Balaban said. “And in the event you don’t have access to those people, my recommendation is that you don’t invest in the fund.”

This article appears in the March issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.