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Markus Benzler Michael Brunner

As sustainability continues to gain prominence in financial markets, institutional investors are increasingly compelled to rethink their investment strategies. With frameworks like the Sustainable Finance Disclosure Regulation (SFDR) reshaping fund classifications in Europe, investors now have to navigate a new landscape of ESG-integrating and impact-focused funds. However, for institutional investors like pension funds, this presents a challenge when allocating capital, considering the level of ESG friendliness, investment universe and financial performance. In this article, we explore the key distinctions between these fund categories, performance trends, and how the evolving regulatory environment might influence investment choices.

ESG vs. impact investing – key differences

Understanding the distinctions between ESG integration and impact investing is crucial for institutional investors. As per Preqin’s methodology, for the purposes of this article we differentiate the two types of funds under the following:

  • ESG integration involves incorporating environmental, social, and governance factors into the investment process, but it’s primarily focused on financial performance. ESG funds may exclude harmful sectors, but their overarching goal is still profit maximization.
  • Impact investing in contrast, is explicitly focused on achieving measurable social or environmental outcomes. These funds often target sectors like renewable energy, education, or healthcare, where the primary goal is positive societal impact, with financial returns being secondary.

IRR and TVPI – A closer look

To understand the implications of different fund types, it’s important to look at their historical performance. For the purposes of this article, we have used Preqin’s definition of what constitutes ESG-integrating and impact funds. The data we analyzed indicates a noticeable gap in internal rate of return (IRR) and total value to paid-in (TVPI) between non-ESG funds, ESG-integrating funds, and impact funds. However, we need to take these results with caution given the small sample size of ESG-integration and impact funds that have registered their performance in the database, in addition the potential self-reporting bias of such a database.

Figure 1: IRR performance (%)*

Quartile ranking

Quartile ranking

Non-ESG funds

Non-ESG funds

ESG-integration funds

ESG-integration funds

Impact funds

Impact funds

Quartile ranking

1st Quartile

Non-ESG funds

21.60

ESG-integration funds

21.03

Impact funds

18.40

Quartile ranking

Median

Non-ESG funds

13.60

ESG-integration funds

15.30

Impact funds

9.30

Quartile ranking

3rd Quartile

Non-ESG funds

5.60

ESG-integration funds

7.30

Impact funds

-2.10

Figure 2: TVPI performance*

Quartile ranking

Quartile ranking

Non-ESG funds

Non-ESG funds

ESG-Integration funds

ESG-Integration funds

Impact funds

Impact funds

Quartile ranking

1st Quartile

Non-ESG funds

2.09x

ESG-Integration funds

1.66x

Impact funds

1.43x

Quartile ranking

Median

Non-ESG funds

1.59x

ESG-Integration funds

1.40x

Impact funds

1.09x

Quartile ranking

3rd Quartile

Non-ESG funds

1.15x

ESG-Integration funds

1.18x

Impact funds

0.90x

Source: Preqin, data as of 30 June 2024, since inception basis, vintages 2000-2021. For IRR, dataset includes 2,200 non-ESG funds, 13 ESG integration funds and 8 impact funds. For TVPI, dataset includes 2,309 non-ESG funds, 13 ESG integration funds and 7 impact funds that are registered in the Preqin database. Past performance is not a guarantee for future results. Tables for illustrative purposes only. ESG Integration defined as funds that consider environmental, social and governance principles in their investment strategies. These may encompass ESG as a whole or the E, S or G individually, with financial returns remaining the funds’ primary directive. Impact funds defined as funds focused on generating positive social or environmental effects. These funds are generally values-driven and pursue societal or environmental objectives complementary to financial performance as per Preqin’s methodology.

* This shows which quartile of the relevant peer group the fund falls into. When calculating the quartile ranking, equal weight is placed on IRR and multiple. Top-quartile funds are funds with an IRR or multiple equal to or above the upper-quartile benchmark; second-quartile funds are funds with an IRR or multiple equal to or above the median-quartile figures but below the upper-quartile figures, etc.

Key observations

  • ESG-integrating funds perform similarly to non-ESG funds, with IRR and TVPI values remaining competitive.
  • Impact funds show a clear underperformance, especially in the third quartile where the IRR is notably lower (-2.1%). For institutional investors, this suggests that while impact investing aligns with broader sustainability goals, it tends to offer reduced financial returns.
  • The median IRR for ESG-integrating funds exceeds that of non-ESG funds, signaling that incorporating ESG factors may not necessarily compromise performance and in some cases could even potentially enhance it.

For pension funds and other institutional investors, the performance discrepancy between ESG-integrating and impact funds offers a compelling reason to prioritize ESG-integrating funds over impact funds, at least from a return-oriented perspective.

SFDR and its 2025 revisions – uncertainty on the horizon

The Sustainable Finance Disclosure Regulation (SFDR), which divides funds into Article 6, Article 8, and Article 9 categories, has reshaped the way European investors assess sustainability. Article 8 funds can have a promotion characteristic or seek to invest a portion of the portfolio in sustainable investments, whereas Article 9 funds mainly focus on sustainable investing and achieving an environmental or societal impact. However, it’s important to note that the SFDR framework is under revision, with major changes expected by 2025. This revision leaves a considerable amount of uncertainty:

  • It's unclear whether compliance with Article 8 or Article 9 requirements will become more difficult, potentially reducing the number of qualifying funds.
  • What will the regulatory impact be? Non-European funds, especially those in the US or Asia, are not bound by SFDR regulations, allowing them to market themselves as impact funds without facing the stringent requirements imposed on European funds.

For institutional investors, particularly those with global portfolios, this creates an additional layer of complexity. Whilst many non-European private equity funds may brand themselves as impact, they might not adhere to the same rigorous SFDR standards, making it harder to compare them directly with European funds.

Impact funds – growing in number but it's still early days

Based on our findings and experience, whilst we do see a growing number of impact private equity funds being launched every year, in our view it’s still too early to judge whether these funds represent a good investment or not.

As shown in Figure 3, in recent vintage years, worldwide, the number of funds labelling1 themselves as impact has grown from 36 in 2018, to 129 funds in 2023. As of September 2024, so far 72 private equity funds in vintage 2024 have labelled themselves as impact and we expect this upward trend to continue. That being said, the average size2 of these impact funds ranges from USD 73‒317 million, with many impact funds failing to exceed USD 150 million in client commitments.

Figure 3: Average closing size of impact funds vs. number of impact funds launched per year

Average closing size of impact funds vs. number of impact funds launched per year

This chart shows how in recent vintage years, worldwide, the number of funds labelling themselves as impact has grown from 36 in 2018, to 129 funds in 2023. As of September 2024, so far 72 private equity funds in vintage 2024 have labelled themselves as impact and we expect this upward trend to continue.

The sectors in which the companies in the portfolios of these impact funds are also an aspect to be considered. Many sectors such as Agritech and climate-tech are unproven, and it remains to be seen if companies in these sectors can be exited by these impact funds in coming years and still return exit multiples similar to other sectors favored by private equity.

The Agritech sector is a good example of this. If we look at all funds which have (i) labelled themselves as impact, and (ii) drill down a level further to include those funds which are stated to have Agritech firms in their portfolio, then we see that the vast majority of such funds have only been launched in the last three to four years. According to Preqin, historically speaking, since 2018 only 43 impact funds in total have been launched that include Agritech in their portfolio, of which 90.8% of said funds were launched in the vintages 2020‒2024 (see Figure 4). In our view, this indicates that the vast majority of these impact funds are very young and their portfolio companies are still within the J-curve.

Figure 4: Number of impact funds known to invest in Agritech– by vintage year

Number of impact funds known to invest in Agritech– by vintage year

This chart shows how historically speaking, since 2018 only 43 impact funds in total have been launched that include Agritech in their portfolio, of which 90.8% of said funds were launched in the vintages 2020‒2024.

Figure 5: Percentage of impact funds known to include Agritech companies in their portfolio – by vintage year

Percentage of impact funds known to include Agritech companies in their portfolio – by vintage year

This chart shows how the percentage of impact funds that are known to include Agritech companies in their portfolio, by vintage year, for 2018-2024.

In our view, at this point in time it’s simply too early to tell whether these impact funds will turn out to be ‘good’ investments. Many impact funds are typically small, sub-scale venture capital funds, investing in companies operating in sectors that are largely unproven such as agtech and climate-tech, and realistically we’ll need another 5‒10 years in order to adequately judge this.

The growing trend in SFDR fund launches

As sustainable investing gains momentum, the number of Article 8 and Article 9 private equity funds launched each year has increased. The following tables break down the number of funds launched per vintage year based on fund strategy.

Figure 6: Number of SFDR Article 8 funds launched per vintage year

Number of SFDR Article 8 funds launched per vintage year

The chart shows how the numbers of SFDR Article 8 funds launched per vintage year are distributed from 2019-2024.

Figure 7: Number of SFDR Article 9 funds launched per vintage year

Number of SFDR Article 9 funds launched per vintage year

This chart shows how the number of SFDR Article 9 funds launched per vintage year are distributed from 2019-2024.

Summary:

  • The data indicates that Article 8 funds have seen a significant increase in launches across all strategies, particularly in buyout and venture capital categories. This aligns with the data showing strong financial performance for these funds. Notably there are only a small number of private equity fund-of-funds which are stated to comply with Article 8 according to Preqin. Such fund-of-funds may represent an opportunity for institutional investors looking to enjoy the benefits of a well-diversified multi-managers portfolio, whilst at the same time being invested in an ESG Article 8 portfolio.
  • The data indicates that Article 9 funds, while growing, remains more limited. The Article 9 investment universe is dominated by growth and venture funds, with very few buyout or fund- of-funds labelling themselves as Article 9 compliant, according to Preqin. For institutional investors looking to gain exposure to impact private equity funds, in the current environment they will have to limit themselves to venture and growth funds, which are typically below USD 300 million in terms of commitment size.

Similarities between ESG integration and Sharia investing

One underexplored area is the alignment between ESG integration investing and Sharia-compliant investments. Both strategies share common exclusion criteria:

  • No alcohol, tobacco, gambling, adult entertainment: Like ESG-integrating funds, Sharia-compliant investments avoid these sectors.
  • No leverage: Sharia investing prohibits the use of leverage, a requirement that does not exist for ESG-integration funds. However, this can add a unique layer of financial stability to Sharia investments, aligning with certain long-term, risk-averse institutional mandates.

For institutional investors, especially those with a global or multi-faith clientele, considering Sharia-compliant funds alongside ESG funds could offer another ethical investment option, diversifying the portfolio while adhering to strict Sharia ethical criteria.

Final thoughts: A balanced approach for institutional investors

For institutional investors, particularly pension funds, the growing demand for sustainable and impact investing presents both an opportunity and a challenge. ESG-integrating funds offer a balanced approach, considering ESG factors, while maintaining competitive financial returns. The more stringent impact funds, whilst seeking to achieve a greater level of environmental or societal impact, may not always meet the financial return targets of a pension fund. Given the relatively small investment universe of impact funds, it may be impractical to shift a large portion of the portfolio toward impact-focused investments. This is mainly due to the typical lifespan (ca. 10-15 years) of private equity funds. Furthermore, such statistical comparisons must be viewed with caution, due to the relatively small sample size of impact and ESG-integration funds listed in such databases and the potential for self-reporting bias.

In the view of the writers of this article, institutional investors wishing to satisfy both financial obligations and the increasing demand for sustainable investing, may be best served by adopting a balanced approach to portfolio construction by:

  • Focusing on ESG-integrating and Article 8 funds, which consider ESG aspects and focus financial performance.
  • Gradually allocating a smaller portion of the portfolio to impact or Article 9 funds for their mission-driven impact, while managing expectations regarding potentially lower financial returns.

The views and opinions expressed in this article are those of the authors and do not reflect the views of UBS or the UBS Framework on sustainability.

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