A decade ago, few institutional investors believed that their environmental, social, and governance (ESG) funds could generate meaningful alpha—at least not in comparison with other classes of funds. But that mindset has changed. According to BCG research, institutional investors increasingly recognize that impact investing is not simply a philanthropic vehicle, but one that can produce attractive returns. A major catalyst for that shift has been climate change.
With up to 20% of gross domestic product globally at risk from carbon emissions, the E in ESG has gone from an abstract notion to a concrete business challenge—with specific solutions that financiers can fund. In the past couple of years, commercial private equity firms have entered the green space at scale, with ten times as many funds launching in 2018 as in 2000. In addition, numerous boutique firms have sprouted up, focusing exclusively on clean tech, alternative energy, and climate change. This funding-fueled innovation has delivered impressive returns, with the first generation of clean energy and clean-tech superstars already rivaling Big Tech leaders in total shareholder returns.
Having seen the value of financing positive environmental change, investors should approach the S of ESG with similar resolve—but with much greater speed. Neither they nor society can afford to follow the same decade-long learning curve as in the past.
The need to improve diversity, equity, and inclusion (DEI) in the workplace has taken on greater urgency. Although private-sector pledges to support marginalized communities gained momentum in the US in 2020 after the death of George Floyd and the racial reckoning that followed, women and communities of color continue to face obstacles worldwide in their efforts to acquire development investment, business financing, and employment.
COVID-19 has been an exacerbating factor. Globally, 64 million women left or lost their jobs in 2020 as a result of the pandemic, departures that collectively extracted roughly $800 billion in income from the economy. Additional hurdles confront people of color. In the US, for example, Hispanics and Blacks represent less than one-third of the female labor force, but they accounted for about 46% of job losses among women over the past two years. Racial disparities in health outcomes and health access persist among men and women of color, and the pandemic has made those inequalities more acute. Essential workers, whose jobs put them at higher risk of COVID-19 infection, are disproportionately people of color.
Concrete areas for developing solutions have emerged. They include greater access to childcare, more flexible workplace arrangements, improved skills training, and more effective on-ramping. Innovations that allow underrepresented groups to contribute their talent and participate in the labor force could inject trillions of dollars into the global economy by 2050. But these solutions require significant investment, and the level of financing today is nowhere near where it needs to be.
Although philanthropic and development finance institutions contribute upward of $150 billion globally in support of ESG initiatives, this figure falls far short of the roughly $3 trillion required to meet the United Nations’ Sustainable Development Goals (SDGs). The Corporation for Enterprise Development calculates that without changes to existing policies to improve capital access and opportunities for people of color in the US, it would take up to 228 years for Black families and 84 years for Latino families to accumulate the same level of wealth as white families. And the World Economic Forum estimates that without greater investment in gender equity, it will take more than 267 years to close the economic participation and opportunity gap between men and women globally.
Only institutional investors have the capital resources to effect change at the scale needed. To date, however, their contributions represent a relatively small share of the total impact investing pool—funding that is intended to generate positive, measurable social and environmental impact alongside a financial return. (See Exhibit 1.) And in interviews conducted with a global cadre of institutional investors, we found that many continue to rely more on shareholder activism and saber rattling in the boardroom and less on deploying their capital to force improvements in DEI.
One key reason for the relatively low level of institutional investor funding is that many pension funds, insurers, and sovereign wealth funds apply the same conventions about ticket size and track record to social impact funding as they do to their large-scale portfolio investments. But social impact is a very different space. Deal sizes are necessarily smaller, the data on outcomes is less mature, and accurately gauging the benefits of addressing factors such as financial inclusion, poverty alleviation, and affordable housing may require examining second- and third-order effects that can also financially benefit the invested companies. By attempting to conform small-fund dynamics to big-fund hurdles, institutional investors deny communities and themselves the impact and yields they might otherwise generate.
That’s a huge missed opportunity. Attracting more institutional capital could allow social impact funds to significantly extend their reach and increase economic inclusion. In return, pension funds, insurance companies, and sovereign wealth funds could gain access to high-quality investment opportunities in growth markets, enabled by the differentiated deal access and expertise that equity-focused impact fund managers can provide. BCG’s research has found a strong correlation between gender and racial equity and business performance, with leaders seeing higher rates of revenue growth, stronger innovation, and greater employee and customer satisfaction.
By focusing on three core steps, pension funds, insurance companies, and sovereign wealth funds can transform the scale and reach of their social impact while maintaining their fiduciary responsibilities:
The need for social impact investing has never been greater, and as the triple-bottom-line benefits from engaging in this space become clearer, institutional investors have the opportunity and the imperative to step up their funding and catalyze growth. Those that seize this opportunity have the chance to take the lead in a space likely to become the next frontier in generating alpha.