As we emerge from the COVID-19 pandemic, the importance of responsible business and sustainability has never been so clear. From the growing efforts worldwide to avert the climate emergency to public action on racial injustice, society at large is increasingly focused on confronting a broad range of environmental and social issues. And for many of our private equity clients, the importance of, and the opportunities presented by, ESG and impact investing are becoming a key focus. Private investment in renewable energy, innovative climate technologies and natural capital can all play a key role in meeting the accelerated need for progress and are increasingly recognised as being aligned with financial return.

Of course, specialist impact investors (such as Actis, with its focus on emerging markets) have been in existence for some time and continue to be active, but it is no longer a niche market. As part of the wider trend towards greater diversification of investment strategy that we are currently seeing among asset managers, many of our mainstream private equity clients are either considering or are already in the process of establishing funds dedicated to impact investing, following the lead of big players like TPG and KKR. Recent data published by Unquote shows significant capital inflows - European GPs raised €4.1bn in 2021 for vehicles focusing on impact-driven investments, and a further €2.56bn was raised in January 2022 alone, reflecting a rapidly growing appetite for responsible investment strategies.

This is a promising sign that much needed private capital is and will continue to be allocated to achieving net zero and other sustainability goals. A recent report by McKinsey highlighted the staggering cost of the transition to net zero and the vital part private capital has to play in achieving this. It is clear that the climate emergency in particular requires more than government pledges – action is required from a broad range of stakeholders and a significant amount of public and private financing. With specialist impact investors already making waves in targeting disruptive environmental technologies, it will be interesting to see how additional capital from the world's biggest asset managers will be invested to scale those breakthroughs.

But what does a move into the impact investing market mean for mainstream private equity firms? It's a development that takes us beyond the traditional focus on downside risks associated with ESG concerns, to an investment strategy that has positive contribution to society and/or the environment at its core. ESG comes from thinking about how to minimise or mitigate harm, whereas impact has a positive focus – it involves investing with a pre-identified impact focus in mind, whether that be mitigation of global warming, poverty alleviation or something else – but there has to be intentionality. To quote the Global Impact Investing Network (GIIN), impact investment is about "investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return". This requires a change in attitude and a need for GPs to adopt a rigorous and verifiable approach for generating impact alongside financial returns.

A survey carried out by GIIN in 2020 identified impact-washing as one of the greatest challenges facing the market over the next few years. Fortunately, widely accepted standards now exist for how GPs should embed impact considerations into each stage of the investment process. Increased legal and regulatory controls and intervention for asset managers and their portfolios (including the EU SFDR and TCFD and forthcoming SDR in the UK and requirements to report on alignment with green taxonomies) will play a key part in guiding best practice and holding GPs and their portfolio companies to account.

As pressure increases to manage regulatory compliance and social and environmental impact, due diligence processes will become more sophisticated – not just focused on downside risk, but also aimed at spotting opportunities. Our tailored legal and regulatory ESG due diligence processes and post-acquisition health check are designed to help companies and their investors take a considered and proactive approach to ensure reputational and commercial demands are balanced against compliance and legal liabilities.

LPs and GPs are also thinking creatively of ways to achieve alignment and a genuine commitment towards impact – for example, Trill Impact has said that it will forfeit 10 per cent of its carried interest if the fund does not meet certain impact targets. Capza also recently announced that the carried interest structure of its sixth private debt fund will be linked to ESG KPIs. There is also growing appetite to include ESG or impact-linked targets in equity ratchet structures at the portfolio company level. We recently worked with the Chancery Lane Project to create "Bella's clause", a template equity ratchet provision designed to incentivise management teams to meet targets which are linked to climate change and environmental issues.

It is encouraging to see ESG and impact related KPIs increasingly featuring in legal documents, in an effort to drive behavioural change at the fund and asset levels, but as the trend continues to grow and develop, care is needed to avoid superficially attractive targets that do not deliver meaningful change. There are different approaches to monitoring and reporting against a wide range of KPIs, some of which are more easily measurable than others. The key is to ensure that KPIs are accurately and clearly defined in legal documents, with reference to percentages or specific amounts and clear methodology where calculations are required. It is also encouraging that we are now seeing a move towards standardisation, with a number of industry bodies publishing guidelines and frameworks for a more standardised approach to the collection and reporting of ESG data and market terms.