Difference Between Impact Vs ESG Investing In Private Markets -

What’s the Difference Between Impact vs ESG Investing in Private Markets? Impact investing intentionally targets companies and funds delivering specific positive social or environmental impacts, like affordable housing, clean energy or education access.

The primary goal is achieving measurable real-world outcomes alongside financial returns.

As a conscious investor, I vividly remember the day I realized my capital could be a driving force for good.

It was reading about a solar startup bringing renewable electricity to remote rural villages, illuminating homes and powering opportunity. From that moment, I was determined to align my investments with creating positive change, not just profit.

In this guide, I’ll explain the key distinctions between impact and ESG investing philosophies when navigating private markets.

We’ll explore strategies for maximizing your intentional impacts while generating strong performance.

What is Impact Investing?

Impact investing aims to generate positive, measurable social and environmental impacts alongside financial returns. The core focus is actively creating beneficial outcomes.

Intentionally targets companies/funds working on solutions for global issues like clean energy, affordable housing, healthcare access, etc.
Prioritizes measurable positive impacts as a principal investment criterion
Focuses on generating competitive financial returns aligned with impact goals
Common in private equity, venture capital, debt and real assets

Impact Investing in Action

Acumen invests in innovative companies delivering affordable services like clean water, health, housing and agriculture to low-income communities.
DBL Partners provides venture capital for companies with positive social impacts and commercial growth potential.

What is ESG Investing?

ESG investing incorporates environmental, social and governance factors into the investment process and portfolio construction. The emphasis is on risk management and ethical oversight.

Evaluates companies based on ESG criteria like carbon footprint, labor practices, board diversity, etc.
Aims to invest in more responsible/sustainable companies and avoid controversial ones
Focus is more on managing ESG risks and aligning with ethical values
Common approach for public equity and debt investments

ESG in Private Markets

KKR Global Impact Fund looks for commercial businesses contributing to solutions for global challenges
TPG Rise Funds invest in high-growth companies driving measurable social and environmental benefits

Comparison of Impact vs ESG Investing

Factor	Impact Investing	ESG Investing
Primary Goal	Generate positive measurable impacts	Evaluate ESG risks & ethics
Impact Approach	Proactive & Intentional	Incorporate ESG factors
Areas of Focus	Targeted solutions (e.g. clean tech, healthcare)	Broad range of ESG issues
Impact Measurement	Central requirement	Often lacking consistency
Asset Classes	Private equity, VC, debt, real assets	Public equities & debt
Financial Returns	Competitive, market-rate expected	Variable return expectations

While both philosophies consider social/environmental factors, impact investing is more proactive in driving specific positive outcomes as a primary objective. ESG is more focused on managing risks and investing responsibly.

Advantages of Impact Investing

Driving Tangible Change

By intentionally targeting companies delivering solutions to global challenges, impact investors can directly support progress on issues like:

Expanding access to affordable basic services (water, health, education, housing)
Mitigating climate change and promoting renewable energy
Improving food security and sustainable agriculture
Generating quality jobs and economic opportunity

Potential for Competitive Returns

Contrary to previous assumptions, studies show impact investments can achieve market-rate returns comparable to traditional investments across private markets.

A Morgan Stanley report found:

Private equity/venture capital impact funds matched conventional fund performance
Impact companies often disrupt underserved markets ripe for growth

Unlike ESG, impact investing mandates measurement and reporting of specific positive outcomes generated. This data allows investors to evaluate and compare the tangible impacts achieved.

Tools like the Impact Management Project provide standardized metrics, enabling greater accountability and insight into impact performance.

Tax Advantages

Investments in certain qualified opportunity zones, renewable energy projects or social enterprises may provide tax credits or other incentives for impact investors.

Challenges of Impact Investing

Limited Investment Options

While the impact investing market is growing rapidly, it still represents a small subset of the overall private investment landscape. Fund/company options can be more limited.

Higher Due Diligence

Evaluating both financial potential and impact integrity requires additional operational and impact due diligence, which can be resource-intensive.

Impact Measurement Complexities

Quantifying and comparing social/environmental impacts across diverse areas like health, education or clean tech is inherently challenging. Standardized metrics and impact ratings are still evolving.

Perceived Below-Market Returns

Some investors still perceive impact investing as requiring a financial sacrifice, despite growing evidence of competitive returns. This perception persists as a barrier.

Advantages of ESG Investing

Managing Financial Risks

By considering ESG factors like environmental impacts, labor practices and corporate governance, ESG analysis helps identify and mitigate potential operational, legal or reputational risks.

Broad Investment Universe

ESG strategies can be applied across a wide range of public and private market investments globally. More funds/companies qualify under basic ESG criteria.

Alignment with Values

For investors with specific ethical, religious or political motivations, ESG investing provides a way to align their portfolio with personal values and moral principles.

Challenges of ESG Investing

Greenwashing Concerns

With increased popularity, some criticize “ESG-washing”—companies superficially meeting minimum criteria without making substantive commitments. Rigorous analysis is required.

Inconsistent Standards

Unlike impact investing, there are limited universal standards for evaluating, measuring and reporting ESG performance, creating ambiguity across funds/ratings.

Financial Underperformance

Unlike impact funds, ESG funds may be intentionally constructed with a values-based approach that could sacrifice maximum returns. The performance implications require scrutiny.

Comparing Impact vs ESG in Private Markets

Focus Areas

Impact funds concentrate on specific solutions driving progress in areas like:

Renewable energy/clean technology
Healthcare/life sciences
Education and workforce development
Sustainable food/agriculture
Affordable housing/community development
Financial inclusion

ESG strategies take a more broad-based approach, evaluating companies across environmental, social and governance metrics like:

Environmental: Carbon footprint, pollution, resource usage
Social: Workplace safety, employee treatment, community impact
Governance: Board diversity, executive compensation, business ethics

Impact Measurement

Measuring and reporting positive impacts is a core requirement of impact investing. Common metrics include:

Carbon emissions reduced
Patients treated
Affordable housing units created
Jobs created in underserved areas
Gallons of water purified/saved

Standardized measurement frameworks like IRIS+ from the Global Impact Investing Network provide guidance.

While ESG strategies consider environmental and social impacts, consistent impact measurement and reporting has lagged in private markets.

Financial Performance

Research indicates impact private equity and venture funds can generate competitive, market-rate returns comparable to conventional funds. Impact real asset funds have also demonstrated strong performance.

Performance across ESG funds in private markets has been more mixed, as ESG criteria may influence portfolio construction in ways that diverge from pure return maximization strategies.

Investment Process

For impact investors, rigorous operational and impact due diligence is critical to assess:

Financial viability and return potential
Ability to deliver projected impact(s)
Impact measurement and management capacity

ESG investors must carefully scrutinize ESG practices, policies and risk exposures, but investment processes are generally more aligned with traditional approaches.

Combining Impact & ESG: The Best of Both Worlds

Many investors are adopting a blended approach that melds elements of impact and ESG philosophies.

This entails:

ESG Integration: Using ESG criteria to identify ethical leaders and manage risks across all investments
Impact Allocations: Dedicating a portion of the portfolio to proactive impact investments driving measurable positive change

ESG Integration

Even for investors focused primarily on impact, incorporating baseline ESG analysis across the entire portfolio is prudent risk management. This helps:

Avoid investments in companies with poor ESG practices that could create legal, reputational or operational risks
Identify corporate leaders demonstrating responsible environmental stewardship, ethical practices and good governance
Align the portfolio with personal values and sustainability principles

ESG integration provides a ethical foundation while impact allocations enable concentrated efforts towards specific impact goals.

Impact Allocations

After applying ESG safeguards, investors can allocate a portion of their capital (e.g. 5-20%) towards private funds and companies intentionally delivering impact solutions. Some approaches include:

Dedicated impact fund allocations (e.g. renewable energy, affordable housing funds)
Direct investments in individual impact companies
Diversified multi-strategy impact fund of funds
Program-related investments (PRIs) by foundations

This enables investors to actively support progress on the environmental or social issues most aligned with their priorities and values.

The Integrated Portfolio

The end result is a portfolio that incorporates both impact and ESG best practices:

Core holdings analyze and mitigate ESG risks via ESG integration
Carve-outs actively drive positive impact through targeted allocations
Ability to track both impact metrics and ESG performance

This approach provides intentionality in impact areas of focus while maintaining ethical integrity across all investments.

Investor Case Study: Aligning Values and Vision

To illustrate this integrated impact + ESG philosophy, consider this hypothetical case study:

The Alvarez Family Office is guided by multigenerational values rooted in environmental sustainability, community empowerment and business ethics. Their mission:

“Grow our family’s wealth in a way that generates positive social and environmental impacts while upholding responsible business practices.”

To achieve this, their private markets portfolio takes a multi-pronged approach:

ESG Integration (100% of portfolio)

The family office has investment policies explicitly prohibiting investments in companies involved in areas like:

Fossil fuel extraction or reserves
Tobacco or controversial weapons
Exploitative labor or human rights violations
Corporate bribery or corruption scandals

All prospective investments undergo ESG due diligence reviewing policies, practices and controversies related to environmental impacts, social responsibility and governance ethics.

Impact Investments (20% of portfolio)

To proactively support their vision, the Alvarez family allocates 20% of their total investment capital towards impact funds and direct investments, including:

A diversified impact private equity fund of funds (8% allocation)
Investments in sustainable food & agriculture funds (5% allocation)
A renewable energy infrastructure fund (4% allocation)
A direct investment in an affordable housing REIT (3% allocation)

These investments all have clear impact theses, strategies and measurement frameworks aligned with the family’s priorities like:

Reducing greenhouse gas emissions and promoting clean energy
Increasing access to healthy, sustainably produced food
Expanding affordable housing and economic opportunity

Comprehensive Reporting

Through this hybrid approach, the family office can comprehensively report on the environmental, social and governance integrity of 100% of their investments, while also highlighting the specific positive impacts generated by their 20% impact allocation.

This exemplifies using an ESG foundation to maintain ethical integrity across a portfolio, with dedicated impact capital driving measurable change in prioritized areas.

The flexibility to combine impact and ESG strategies makes it easier for investors to simultaneously uphold their principles and proactively support their vision for a better world.

FAQs

What Is The Difference Between Impact And ESG Investing?

Impact investing proactively targets solutions to global challenges like affordable housing, clean energy, or education access. The primary goal is to generate measurable positive impacts alongside financial returns.

Can I Achieve Market-Rate Returns With Impact Investments?

Absolutely. Contrary to old misconceptions, numerous studies show impact funds can generate competitive, market-rate returns comparable to traditional investments across asset classes like private equity, venture capital, and real assets.

By targeting innovative companies disrupting underserved markets, impact funds can capitalize on major growth opportunities while driving social progress. An integrated portfolio with ESG foundations and dedicated impact allocations can pursue both values alignment and performance.

Measuring positive impacts is a core requirement of impact investing. Organizations like the Global Impact Investing Network (GIIN) provide standardized metrics and frameworks like IRIS+ for consistent impact measurement and reporting across areas like:

Carbon emissions or pollution reduced
Patients provided affordable healthcare
Jobs created in underserved communities
Gallons of water purified or saved
Affordable housing units created

This data allows investors to evaluate and compare the real-world outcomes achieved.

What Asset Classes Can I Access For Impact Investing?

Impact investment opportunities span numerous private market asset classes including private equity, venture capital, private debt, and real assets like infrastructure or real estate. Some common areas of focus include:

Renewable energy/clean technology
Healthcare/life sciences
Education and workforce development
Sustainable food and agriculture
Affordable housing and community development
Financial inclusion for underserved populations

Public equity impact funds also exist, but private markets enable more direct impact through earlier-stage investments.

Why Do Some Investors Still Avoid Impact Investing?

While evidence shows competitive impact investing performance, some investors still harbor outdated perceptions of concessionary “sacrifice” returns. This philosophical hurdle persists despite data.

Other challenges include the relatively limited set of impact fund options currently available, the additional operational and impact due diligence required, and the complexities of quantifying diverse social/environmental impacts.

However, the impact investing market is rapidly growing as conscious capital allocations increase.

How Can I Combine Impact And ESG Investing Approaches?

Many investors blend impact and ESG principles for a comprehensive solution:

1) Apply baseline ESG integration across the entire portfolio to uphold ethical principles, manage risks, and avoid controversial investments.

2) Allocate a dedicated portion (e.g. 10-20%) towards proactive impact investments generating measurable positive outcomes aligned with priorities like renewable energy or affordable housing.

This allows investors to maintain ESG integrity while concentrating efforts towards specific solutions and measuring achieved impacts.

What Are The Main Challenges With ESG Investing?

Key challenges for ESG investors include “greenwashing” concerns about companies merely meeting perfunctory ESG criteria, a lack of standardized metrics and reporting requirements, and potential financial underperformance since ESG funds may forgo certain opportunities on ethical grounds.

Additionally, while ESG analysis considers impacts, it does not mandate rigorously measuring and optimizing for positive environmental or social outcomes like impact investing does.

Is Sustainable Investing Just A Trend Or Here To Stay?

Sustainable investing is rapidly becoming mainstream and institutionalized rather than a passing trend. Drivers propelling long-term momentum include:

Heightened stakeholder expectations and pressure around corporate responsibility
Evidence that sustainable practices are materiality drivers of operational risks and financial performance
Economic fundamentals like demographic shifts prioritizing ethical values
Regulatory tailwinds incentivizing sustainable business models and disclosures

Both impact and ESG investing are integral parts of the sustainable finance landscape shaping the future of capital markets.

Conclusion

In closing our exploration of impact vs ESG investing in private markets, it’s clear these philosophies represent two powerful paths toward conscious capital allocation. While ESG provides ethical risk management by analyzing environmental, social and governance factors, impact investing takes this a step further.

The key takeaways? Impact investments intentionally target and measure specific positive real-world outcomes like reducing emissions, expanding healthcare access or creating affordable housing.

By combining ESG foundations with dedicated impact allocations, investors can uphold their principles while proactively supporting solutions to global challenges.

If driving measurable change in areas you’re passionate about like renewable energy, sustainable food systems or community empowerment is a priority, I encourage evaluating impact investing options.

Find the right partner to integrate positive impacts into your investment strategy and portfolio.

Image: Credit Wirestock

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