Are Positive Environmental and Social Outcomes in Investing Reserved for Philanthropists?

Executive Summary: Sustainable and Impact Investing Is Evolving

• Sustainable and impact investing is cross-asset class, and can be underpinned by several investment themes, making both broad asset class coverage and deep sector expertise paramount. Expert partners can help navigate this nuanced investment strategy.
• Investors may gain outperformance benefits from sustainable and impact funds. Thematic private markets investments funds aligned with the United Nations Sustainable Development Goals (“SDG”)¹, which can include healthcare, energy and environment, community development and financial empowerment themes, amongst others, have been outperforming their non-SDG aligned peers since 2018, and there is no difference between performance and risk of realized SDG-aligned funds and non-SDG aligned funds. 
• Thematic, sustainable and impact investing does not automatically lead to attractive performance, but thoughtful portfolio construction may help investors realize positive, long-term returns.

Some investors hold a view that you’re not a ‘real’ impact investor if you’re not concessionary enough in your approach, messaging a flawed belief to private markets that investing in sustainable or impact opportunities is necessarily a financial compromise. This is naturally a self-fulfilling and self-validating approach. Other investors hold the opposite view – that sustainable and impact investing is a silver bullet for attractive returns, throwing investment fundamentals to the wind to ride thematic tailwinds. They may be riding those tailwinds too close to the sun. 

Neither of these polarized fringes serve the development of a healthy ecosystem that is suitable enough to attract capital at scale and meaningfully accelerate the desired environmental and social outcomes. The reality as we see it is that most investors today are seeking to pursue non-concessionary financial performance aligned with their mission and values in a thoughtful and disciplined manner. Too much to ask? Our experience and data say otherwise. 

Maturing Cross Asset-Class Opportunity 

First things first: For the last six years or so, SDG-aligned funds have outperformed non-SDG aligned funds. This is a step change the market shouldn’t ignore, and we believe it’s driven in part by the diversification and maturation of an ecosystem focused on disrupting the status quo to deliver better long-term outcomes for all. For those new to private markets, the polarized sentiment around sustainable themes may come as a surprise given the recent performance data, but there is a history to overcome. 

From the aughts to the mid-2010s, SDG-aligned fund performance lagged non-SDG alternatives. Digging into the data in two ways, both 5-Year Rolling TWRs and Fund Net IRRs by Vintage Year, this period is a tale of two halves – in the first half, the sustainable ecosystem was dominated by natural resources, a lower performing strategy with a propensity for some degree of volatility given commodity exposure, and in the second half, the losses of Clean Tech 1.0 and early renewables plagued investors. (Clean Tech 1.0 is generally viewed as the first wave of clean technology development, investment and deployment, which occurred primarily in the 2000s, focused on technologies to increase performance, productivity and/or efficiency of production while minimizing negative impacts on the environment). Asset owners and investors have long memories and the lessons learned from this period will be remembered well into the future to avoid repeating, or as we at Hamilton Lane like to say, ‘rhyming history’.  

Rolling Fund Performance
Five Year TWRs

Fund Net IRRs
By Vintage Year

Despite the retrenchment of clean tech, strategies and assets driving positive non-financial outcomes continued to diversify and mature. In private equity and venture capital, health and community, place-based, double bottom line investing, financial inclusion and efficiency themes continued to produce actionable opportunities. Infrastructure investors applied lessons learnt and continued to lean into renewables, and this time more successfully. Over the last few years, the addressable market has further diversified, with energy transition and climate opportunities emerging at pace. Is this Clean Tech 2.0? We don’t think so. Will investors need to remain selective to achieve returns? Absolutely. 

The combination of improved return potential and increasing investor appetite to drive positive outcomes – both financially and non-financially – has led to emerging managers, platform extensions and select re-positioning of mature managers to address this market segment. As of Q2 2024, our investment team has identified approximately 1,650 fund managers pursuing strategies serving positive environmental or social outcomes. Depending on the lens, market and individual investor, these funds may be referred to as thematic, SDG-aligned, sustainable or impact. 

Managers with Funds Raised Since 2000
18,500+ Funds | 9,500+ Fund Families

Fundamentals Are More Relevant than Labels 

At the asset level, SDG-aligned, and non-SDG aligned realized deals deliver parallel performance with no statistical difference in risk profile, as demonstrated by the near parallel dispersion of returns. In other words, these are just ‘good investments,’ where private market investment fundamentals remain relevant regardless of label. For further evidence, we need to look no further than the proportion of SDG-aligned assets in mainstream funds, which based on our data sample is just shy of 30%.   

Dispersion of Gross Deal IRRs

The broad nature of investment themes serving positive environmental and social outcomes has led to a higher degree of cross-asset class sourcing, where a deal may be sourced in one asset class but carries the risk profile and investment fundamentals of another, and any combination in between. As an example, infrastructure investing has not jumped in return profile to a 3x MOIC and 30% IRR, despite what some energy transition deal flow might lead an investor to believe, and just because it says venture capital or growth on the cover, doesn’t mean consideration of project costs and/or yield profile won’t be critical to underwriting the investment. So, what is an investor to do? 

One approach would be to wait for the global industry to agree on definitions, though, we wouldn’t advise holding your breath here. Mainstream investing makes our point for us, where the definition of growth equity in North America and Europe started converging only in the last five years. Also, there are still multiple acceptable definitions for middle-market buyout. And funding round names in venture capital can be misleading relative to company maturity. If we didn’t have you on board yet, here’s another: Infrastructure funds can call themselves “infrastructure” whilst allocating some portion of capital to infrastructure-related growth and buyout investments. (And for those of you on the infra conference circuit, you’ve undoubtedly heard “the definition of infra is expanding”). If we wait for industry alignment on definitions (also referred to as taxonomy), we may be waiting forever.    

Another approach could be to rely on regulators and enhanced labelling and disclosure regimes to drive selection. For the avoidance of doubt, we are fully supportive of regulation that protects investors and prevents greenwashing. And to be sure, for some investors, particularly those investing within a single regulatory framework, regulations can lead to simplification. For global investors, however, aligning to a country or regional regime can add complexity, and we observe that many investors would rather their own mission and values lead decision-making, with regulatory compliance as a necessity rather than a driver of an investment decisions. 

Instead, what we strive to do, and recommend investors should too, is focus on underwriting fundamentals without prejudice, in addition to fund or investment labels. Do the work bottom-up to define the risks and attributes of an investment opportunity on both financial and non-financial bases. We believe that rigorous underwriting and disciplined asset selection can contribute to long term achievement of attractive financial return and secondary objectives, but they are not the only contributors of success in investing for positive non-financial outcomes… 

Thoughtful Portfolio Construction is Critical 

If you have bought into the performance profile of SDG-aligned investments, you may be wondering how to think about your existing exposure (recall, just shy of 30% assets in mainstream funds were SDG-aligned) or adding exposure to your portfolio. Equally likely, you may not have private markets exposure yet and are actively assessing whether changing that would contribute to your broader objectives, be they financial or non-financial. Regardless of your starting point, portfolio strategy and thoughtful construction are critical to delivering against target returns and objectives, especially if you are restricting your target market in any capacity. 

Venture capital and healthcare currently represent a large proportion of the addressable market relative to overall market share. If the ecosystem continues to deliver attractive performance, we expect further diversification and growth in the market. Investors seeking large exposures in the meantime should build intentional strategies to address these differences and any investor-specific restrictions that further restrict the addressable market. 

Addressable Market

Data and Technology Lead to Better Decisions 

From reporting on ESG risk factors, required metrics to comply with various regulatory regimes around sustainability and impact, or metrics to assess performance against non-financial objectives, collection of high-quality data is critical. This is why in 2021, alongside a consortium of investors, Hamilton Lane helped found Novata, a certified B Corp with presence in the US, Europe, and Asia. We also led Novata’s Series-B funding round and have implemented Novata solutions across our business. But this is just part of the picture. The ability to connect performance data to a variety of investment frameworks and operational metrics can allow for more advanced insights as the data quality improves, which can ultimately lead to better investment and portfolio strategy. 

Simply put: Data and technology serve to simplify an ecosystem predicated on additional complexity and can lead to better feedback loops and decision-making. Our hope is that by leveraging our performance data to demonstrate that we have not found evidence that SDG-aligned investing leads to a degradation of returns in private markets, we can move the dialogue forward.  

What’s Next 

Looking forward, we expect that there will be continued growth and diversification of the addressable market generating positive non-financial outcomes in addition to financial return. Improvements in data quality and availability will lead to a broader spectrum of frameworks and strategies, although we expect total alignment on definitions and goals to remain an unlikely outcome. Improvements are about defining, communicating and optimizing individual investor goals, so each investor knows that achieving non-financial goals does not mean sacrificing returns. While a one-definition-fits-all outlook currently remains out of reach, we believe there is a clear path forward in the long term. What is viewed as sustainable, SDG-aligned or impactful today will become mainstream, and the cycle will start again.