Private assets have had a clear role in helping local government pension schemes (LGPS) navigate a decade beset with low yields and smooth out the public market volatility caused by Covid and other macro shocks. In fact, these factors often dominate the headlines when private assets are considered and discussed.

However, another advantage they can offer to LGPS is the ability to dial up responsible investing, if managed well. Arguably, the responsible characteristics of private assets are just as important as the financial benefits derived from the associated illiquidity premium. Private markets offer LGPS the ability to generate tangible, real-world impact, as opposed to the intangible portfolio-level impacts that can be achieved through public markets.

For example, infrastructure assets are developing increasingly efficient technologies to capture green energy in the real world, leading to reduced emissions. In contrast, public markets are reducing their portfolio-level carbon emissions by excluding high-emitting companies, without necessarily affecting any real-world change.

So how do they deliver this?

Engagement

Firstly, private market investments can offer excellent opportunities for engagement.

Such assets – from mid-cap corporate lending to owning renewable energy projects – are typically long-term investments, requiring long-term relationships. Moreover, these relationships are often also bilateral between the investor or lender and the underlying company. As such, engagement is critical.

For example, infrastructure investors may establish monitoring frameworks ranging from 100-day key ESG risk-mitigation plans – such as those in supply chains, based on questionnaires and discussions with underlying companies prior to investment – through to ongoing collaboration and measurement towards long-term ESG objectives, such as how to minimise waste from solar panels or wind turbines.

In some cases, the comparison with public market equities and bonds can be stark. While public market activity may be a short-term trade with thousands of investors, there is a choice to move on from engagement with the management team, disinvest and hand the problem to somebody else. Private market investors don’t have this option. The illiquidity and sheer length of their holding – with shorter-term consumer loans spanning of 1-3 years and some infrastructure investments lasting more than 25 years – means they are compelled to engage.

Best-in-class managers collaboratively engage with their portfolio companies throughout the entire investment lifecycle to achieve meaningful stewardship outcomes for each investment decision. This includes identifying key ESG engagement topics, establishing how to measure and monitor progress and, importantly, reporting on engagement – encompassing both the breadth of the business and depth of conversation.

Integration

In our experience, best-in-class fund management groups have integrated sustainability into their entire investment philosophy and process – also offering support and resource to smaller clients in defining and establishing their objectives.

Many of these leaders are private asset managers.

For example, infrastructure private equity, as an asset class, continues to lead the way in advancing and applying ESG objectives. This is largely due to there being an enormous opportunity to create, adapt and maintain sustainable infrastructure in developed and developing markets – particularly through greenfield renewable projects.

Moreover, we observe that most of the specialist infrastructure managers that look at LGPS money have factored the most relevant of the 17 UN Sustainable Development Goals into their investment theses.

Such a best-practice approach is borne out by our recent survey of sustainable investment practices of 112 asset managers. When we asked how often ESG considerations impact an analyst’s recommendations, 91% of private equity managers said “each time”. The other 9% responded with “sometimes”. The equivalent numbers in other asset classes are vastly different – for example, just 66% of public equity managers responded with “each time” and 12% with “most of the time”.

Focus

We also see an opportunity for LGPS to work with private asset managers to define and set completely new types of key performance indicators more closely aligned with ESG criteria.

For example, in private debt, we are seeing many LGPS setting triggers for a reduction in fees or a donation to charity if certain ESG targets are not met.

These targets could include defined, mile-stoned reductions in scope 1 and 2 carbon emissions, a commonly recognised example at a portfolio level, or increased reliance on green energy or improved board diversity at an investment level.

Investment-level metrics are established to be of direct relevance and challenge to each underlying portfolio company borrower, whereas portfolio-level metrics are often of greater benefit to the limited partners.

Achieving these objectives would typically lead to a reduction in the coupon rate of around 10 basis points. However, managers continue to innovate to make such incentive mechanisms more meaningful to portfolio companies, including shortening maturities on loans, for example.

Standardisation

However, the other side of this coin – and one area in which private markets could be said to lag public markets – is the limited standardisation of environmental, social and governance objectives.

This is partly to do with the massive diversity in asset types, ownership structures, lending terms and conditions and so on.

Yet even here, there are some areas where private markets can still come out on top.

For example, environmental objectives are typically focused on the energy transition within specific timeframes and other parameters. And governance forms a key part of due diligence in private credit, private equity and infrastructure markets. Some might say that only equity holders can influence the outcome of a portfolio company, but best-in-class private lenders structure clear and tailored documentation, terms, data standardisation, reporting covenants and collation to support sustainable objectives.

Private markets show how sustainable and impactful ESG practices enhance financial performance.

Of course, in some cases, the advantage of private over public assets is slim regarding responsible investment. In other areas, though, it can be significant.

If managers of LGPS assets continue to build their private allocations at the expense of public securities, then they are arming themselves with the tools to invest ever more responsibly.

Tricia Ward is director of private markets at Redington