Impact investing is taking off in Europe in a big way as investors increasingly factor the environmental and societal impacts of their capital into allocation strategies. This shift has been so significant that Europe-focused impact funds raised €8.5 billion in 2022, more than quadrupling the 2021 total, according to Unquote. Moreover, 39 such funds registered or closed in 2022—almost doubling the previous year’s number.

Despite this strong showing in 2022, impact funds made a slower start in 2023. Only two funds, Planet A and Panakès Partners, have raised a combined €335 million for their impact vehicles—a steep drop-off from last year. This likely reflects the restraining denominator effect that has made investors more conservative in their private equity (PE) allocations in recent months. This occurs when the denominator, which represents the total value of an investor's portfolio, decreases due to market fluctuations. As a result, the relative proportion allocated to PE increases, surpassing the desired target allocation.

This appears to have caused a consolidation of capital with larger, more established PE managers. Last year, US$361.1 billion was raised across the industry globally, according to Pitchbook, almost matching the previous year’s US$362.9 billion haul. However, the number of funds raised was down 37% year-on-year to 497, with megafunds (above US$5 billion) accounting for 57% of global capital raised, according to Bain & Co.

Novel carry approaches

Even with these short-term pressures and the tilt toward large generalist funds, growth in the impact investing trend is gathering momentum. Large, established managers in Europe are offering limited partners sizable fund products with explicit impact mandates.

For example, Sweden’s EQT Partners’ €4 billion Future Fund—which is targeting companies with “market-shaping impact potential”—has a unique carried-interest model. Under the terms of the fund, the carry rate is 10% with a further 2.5% accruing to the GP should specific portfolio-wide sustainability goals be achieved related to reducing greenhouse gas emissions, improving employee wellbeing, and increasing gender diversity. London-headquartered Apax Partners, meanwhile, is raising US$1 billion for its Global Impact fund, which is taking the same approach of linking its carried interest structure to ESG targets.

Some smaller GPs are raising the stakes even further. Dutch PE firm Convent Capital, which held a €100 million second close for its €150 million AgriFood Growth Fund in April, has committed to forfeiting 100% of its carry if its impact objectives are not met. Similarly, UK firm Mirova and Swen Capital Partners in France, which are respectively targeting €300 million and €120 million, will forgo half of their carry for missed targets.

The ongoing impact of Article 9

The EU's Sustainable Finance Disclosure Regulation (SFDR), implemented in 2021, has been something of a game changer in this field. The classification of impact vehicles as Article 9 funds under the rules has led to both opportunities and challenges within the impact investing landscape. Article 9 designation requires the fund's objectives to align with "sustainable investment" or contribute to a "reduction in carbon emissions."

While this broad definition allows for a wide range of investment opportunities, it has also caused some frustration among limited partners (LPs). The flexibility provided by the broad definition means that many funds establish their own internal benchmarks to determine what qualifies as an impact investment. This subjective approach risks producing inconsistencies and varying interpretations of what constitutes a genuine impact investment.

LPs are also closely monitoring the potential downgrading of Article 9 funds, which could negatively affect the funds’ perceived quality and credibility. This underscores the importance of maintaining transparency and adhering to clear impact measurement and reporting standards to maintain investor confidence and trust.

However, the broad scope of Article 9 funds has clear advantages. It is creating significant pools of capital that will flow into a wide range of sectors including healthcare, climate technology, agricultural technology, energy transition, cybersecurity and education. This diversity allows for the allocation of capital to address pressing societal and environmental challenges from various angles.

Provided GPs are transparent in their impact measurement and portfolio reporting, the SFDR is likely to be a net benefit for LPs, particularly where fund managers are willing to link their performance incentives to clearly established goals.

Fruits of labor

As ethically minded as investors are becoming, they still expect their PE investments to perform. Given the long-term nature of PE funds and the relative nascence of dedicated impact funds, it can be hard to benchmark the strategy.

However, the idea that a trade-off exists between returns and impact does not seem to be well founded. Generally, even where companies lack explicitly ESG-aligned credentials, management teams that integrate these factors build businesses with more sustainable long-term value.

The cost of debt in leveraged buyouts can also be brought down by setting achievable ESG-related goals, improving funds’ financial returns. While ESG ratchets are a relatively new development in the loan market, they are becoming increasingly common as investors seek to encourage borrowers to improve their ESG performance and are fast becoming a powerful tool for driving change.

Recent exits in the European PE market suggest that there has been no compromise on returns. In February, ECI Partners sold low-emission vehicle leasing company Tusker to Lloyds Banking Group for a 6.2x return, while in the same month Tikehau successfully floated EuroGroup Laminations in a moribund IPO market, making a 3x return on its partial realization from its T2 Energy Transition Fund.

These are all positive signs. This year may not have had the strongest start for European impact fundraising but returns like these will likely entice investors to reconsider their allocation targets as new funds continue to be brought to market.