Although it is a concept imported to China from the rest of the world, ESG investing has proven a huge success, particularly against the pandemic background. But now, a more proactive investment philosophy is taking hold: impact investing. We speak to several key market players to reveal how Chinese funds are implementing it, the problems it can lead to and the benefits it can have both for financial returns and achieving ESG goals.
“China’s aspiration towards clean energy is on the very top of its agenda,”
Jason Tu, Cofounder and CEO of MioTech
“Green technologies create industry value and also positive environmental impacts, providing double returns for impact-dedicated fund managers,”
Bai Bo, Chairman and CEO of Asia Green Fund.
“The social benefits of potential projects [are] an important criterion for selecting investment objects,”
Wang Weidong, Chairman of SDIC Chuangyi.
“Only commercial solutions with economies of scale can make themselves sustainable to deal with the severity of social and environmental problems,”
Luo Xiaomeng, Vice President of Ehong Capital.
Beginning at the End of the ESG Argument
It took the United States half a century to end the debate about whether ESG positively or negatively affects corporate financial returns until 2006, an influential study concluded that the two sides of the argument could be complementary (it propounded a curvilinear relationship between social responsibility and financial performance). In the same year, the United Nations Principles for Responsible Investment (UNPRI) was born, and ESG spread like wildfire as an array of investment companies specifically dealing with responsible investment and ESG-based portfolios began to spring up throughout the financial world.
As of April 2020, more than 2,700 financial institutions have joined UNPRI, representing assets under management (AUM) of over $10 trillion. Preqin data shows that between 2011 and October 2020, over 4,400 ESG-committed private equity (PE) funds closed successfully, bagging AUM of over $3 trillion. Even during crisis-hit 2020, ESG fundraising performed well, largely thanks to Blackstone, Apollo, Carlyle and other PE giants.
And the pandemic has only spurred ESG initiatives. After all, the practice can increase efficiency in the long run and mitigate risks.
For general partners (GPs) and limited partners (LPs) in the PE space, ESG investing is already self-explanatory, but ESG integration is a remaining challenge. For this, UNPRI has a detailed introduction in its ESG integration guide, including a model questionnaire for LPs to select aligned GPs. Tackling investment decision-making, the Global Sustainable Investment Alliance (GSIA) classifies ESG-committed investment strategies into several categories:
- Norms-based screening
- Negative/exclusionary screening
- Positive/best in practice screening
- ESG integration
- Sustainability-themed investment
- Corporate management and shareholder action
- Impact/community investing.
The precise strategy mix a fund manager employs indicates how passively or actively it is committed to ESG principles. And in China, the investment circle is increasingly leaning towards an active ESG commitment. As Jason Tu, CEO of MioTech, said in a special interview with FOF Weekly, “ESG investing is an imported concept, but it is very much promoted in China. I’ll give you one example: China has just surpassed the UK to become the largest offshore wind power farms installer in the world, so we can see that China’s aspiration towards clean energy is on the very top of its agenda.”
Top-Down ESG Investing
Despite the pandemic-caused shutdown and economic slowdown in 2020, China announced early in 2021 that it had eliminated absolute poverty. In this cause, SDIC Chuangyi has significantly contributed. The Chinese PE fund manager develops poor areas via industrial investment, and it has really moved the needle. Many people in the PE/VC circle remark that SDIC Chuangyi is practicing an ESG theory with Chinese characteristics. According to the GSIA classification above, SDIC Chuangyi has an investment strategy that belongs to positive screening, sustainability-themed investment, and impact/community investing.
FOF Weekly spoke to SDIC Chuangyi’s chairman, Wang Weidong, to find out more. He said, “SDIC Chuangyi regards the social benefits of potential projects as an important criterion for selecting investment objects. To this end, we entrust Peking University, Renmin University of China, Beijing Normal University and the Chinese Academy of Agricultural Sciences to conduct a comprehensive evaluation of the social benefits of investment projects. We have established a data collection and evaluation system for social benefits of investment projects, factoring poverty alleviation into all the stages of project initiation, investment and post investment management.”
SDIC Chuangyi manages more than CNY30 billion ($4.6 billion) in funds from the Ministry of Finance and all the state-owned enterprises. The fact tells us that China’s ESG wave takes a top-down approach.
Jason Tu, CEO of MioTech, also commented that China’s ESG investment boom is a market reaction brought about by the economic transformation occurring under enhanced supervision. By the end of 2019, MioTech’s Chinese clients roughly accounted for 30% of all its clients, the remainder coming from outside China. The number rose to 50% by the end of 2020 and is expected to climb even higher now that China has put peak emission before 2030 and carbon neutrality before 2060 on the agenda. That is, mainland China clients under ESG compliance will outnumber overseas ones for the first time in 2021.
As Jason explains, “Regulatory compliance has been the top one urgent challenge for China’s financial institutions when the government is gaining awareness of sustainable development, climate change and others, because financial institutions are directly regulated, and the whole financial industry is an industry under heavy regulation. The second big challenge is decision-making: what kind of companies to invest in or to lend money to under the ESG compliance. And GPs should align with LPs’ needs and values.”
Upgrading ESG: How Impact Investing Is Taking Root
Similar to ESG investing, impact investing also focuses on the social and environmental benefits of investments. But there are fundamental differences between them. “The difference between impact investment and ESG investment is that the former involves active behavior and the latter more passive, like not investing in something on a negative list,” says Bai Bo, chairman and CEO of Asia Green Fund, in an exclusive interview with FOF Weekly.
Lin Yigu, director of the China Social Enterprise and Impact Investing Forum, explains that under the ESG framework which involves negative screening, best in class screening and other tactics, impact investment is the most active strategy. Impact investors try to directly create positive social and environmental impact as much as possible through active investment, rather than just avoiding investment in “bad” companies.
The International Finance Corporation (IFC) has clearly defined impact investment as “investments made in companies or organizations with the intent to contribute measurable positive social or environmental impact, alongside a financial return”, which highlights intent and contribution measurement.
But some doubt that impact investing deserves recognition. “Inside or outside the impact investing circle, people believe that any investment has its own impact. Why should we allocate a separate sector to impact investment? Some LPs even deny the existence of this industry,” Luo Xiaomeng, Vice President of Ehong Capital, explained in an exclusive interview with FOF Weekly. Ehong Capital is a pioneer of impact investment in China, with Narada Foundation and data service provider Wind among its LPs. Its second impact fund size has increased from CNY200 million ($30.7 million) in 2018 to CNY1 billion ($153.7 million) this year.
Chinese LPs are divisible into four categories by their attitudes towards impact investing.
A: Highly advocate impact investment and give concrete financial support. E.g., Narada Foundation.
B: Put impact investing in its three-to-five-year plan. Investment targets will be fund managers making impact investments in small sums. E.g., family offices.
C: Recognize this concept, but currently lacks an investment plan. Most investors belong to this type.
D: Deny the sector’s existence.
So, is impact investment real? The key lies in the theory of change. If a certain project presents a complete evidence chain and a logic chain with industry research and academic papers to demonstrate the change brought by impact investment into it, it is an impact investment target.
If a project is purely invested in for financial purposes but happens to fall into the education or the healthcare industry, you can’t say it’s also eligible to impact investors. At present, impact investment in China is in its infancy, and there is no organization like the Global Impact Investing Network (GIIN) active there which can accommodate all the evidence bases on one single platform. Therefore, Chinese LPs worry about impact washing – much in the same way that greenwashing is an issue for ESG.
Chen Qinruo, founder of AvantFaire, the only signatory to IFC’s impact principles in Greater China, advises that GPs should have a consistent professional team for the full-cycle process, including project sourcing, pre-investment research, post-investment management and exit, to avoid falling into a greenwashing trap at any step.
Chinese GPs and LPs have little experience in impact investment so far, leading to difficulties in project screening and impact measuring and management (IMM). However, as Luo Xiaomeng of Ehong Capital explains, “The more you invest, the better you get at IMM; the better your IMM system is, the better you get at impact investing – it is complementary.”
In 2016, TPG launched The Rise Fund, the world’s largest global impact platform committed to achieving measurable, positive social and environmental outcomes alongside competitive financial returns. The Rise Fund has created a methodology called Impact Multiple of Money (IMM) to assess impact.
Why Do We Need Impact Investment? Is Charity Better?
Some who deny the value of impact investing propose that it is better to make donations. However, Ehong Capital, in pursuit of a normal market rate of return, believes that “only commercial solutions with economies of scale can make themselves sustainable to deal with the severity of social and environmental problems”. Even foundations need to preserve the wealth and add value through investment.
Luo Xiaomeng says, “Impact investment was originally proposed by the Rockefeller Foundation. The reason why we need impact investors is that to achieve the 17 sustainable development goals (SDGs) by 2030, the private sector must invest $2.5 trillion a year, on top of the government, international organizations and public welfare institutions.”
Ehong Capital emphasizes that underlying projects should really be “investable”. Ehong Capital follows a 4-pronged approach in target sourcing: aligning UN SDGs with Chinese context; addressing the key concerns for a considerable number of people; positive impact significantly outweighing its potential negative impact on the society; and a clear exit path for investors.
Impact investment is not a byword for relinquishing financial returns. On the contrary, it is beneficial to the interests of LPs. Preqin examined the funds set up in 2010-2017, including 160 impact funds, 767 ESG-committed funds and 873 other funds. Among the three, impact funds have the highest average median return rate of 14.7%, while the lowest dispersion of 8.7%. IFC statistics as of 2019 concluded that the total AUM of impact investment in the private equity market has exceeded $2 trillion, with $415 billion from private equity funds and $1,657 billion from financial development institutions respectively.
Bai Bo, chairman and CEO of Asia Green Fund, believes that green development can become a new driving force when technological innovation, entrepreneurship and business models are combined.
“We focus on Industrials and B2B Business Services. We call it IBS strategy. With the economic transformation of China, the next 5-10 years will be a golden investment period of IBS. Green technologies create industry value and also positive environmental impacts, providing double returns for impact-dedicated fund managers. Devoted to environmental impacts, Asia Green Fund looks for technologies that can bring double returns, excellent entrepreneurs who understand these technologies and suitable local business models, before it allocates responsible capital to promote the growth of these companies to achieve profitability and environmental protection.”
Clearly, Bai Bo’s philosophy has been working. Asia Green Fund is formerly the 2016-established US-China Green Fund. Through four years of exploration, it has an AUM of CNY15 billion ($2.3 billion), of which CNY3.7 billion ($568.5 million) is under direct management and CNY12.9 billion ($2.0 billion) is co-managed.
Key Opportunities for Impact Investing
Chang Sun, Managing Partner of TPG China, is a pioneer in advocating and practicing social impact investment in China. He has said on many occasions: “PE houses can play a significant role in impact investing. Impact investments can help promote social and economic inclusiveness and advance the 17 UN Sustainability Development Goals. TPG will continue to look for investment opportunities in sectors such as inclusive education, healthcare and inclusive finance.”
Bai Bo also mentioned in the exclusive interview with FOF Weekly that there are huge opportunities for new materials and industrial Internet of things (IIoT), with the application of new materials and digital technology. Obvious efficiency improvement is visible in new energy, transportation and logistics, advanced manufacturing and other sectors, delivering both financial and environmental benefits.
So far, Asia Green Fund has made an investment in the overlap area of IIoT and pharmaceutical industry, which links the ERP system of about 80,000 pharmacies and insurance companies through SaaS, connecting the largest market-based waste drug recycling network in China. In addition, Asia Green Fund also invested in a company producing recyclable packaging materials, and IIoT played a significant role in improving its efficiency.
Bai Bo also believes that data centers are another lucrative sector. Automobile data centers are highly in-demand in first-tier cities, though slight oversupply will occur in other parts of China in the beginning two-to-three years. As a part of China’s new infrastructure construction plan, the data center sector will have an annual growth rate of between 20% and 30% on the demand side and will continue to see strong demand growth in the next 5-10 years.
Compared to Asia Green Fund who is good at sourcing targets with environmental impact, Ehong Capital does well in the social impact side. “Powers is an Ehong-invested education service provider for children with learning disabilities. Its solution is to focus on the family, including both parents or even all seven members of a family. Through child cognitive training, family education guidance and psychological counseling, it aims to relieve family anxiety and improve the education environment. This kind of Group Therapy is where their theory of change depends.
From Ehong Capital’s perspective, it’s not investable projects but impact investors that are really in short supply. Our wish at this point is that the growing LP base will eventually divert the tide: if we can invest all the CNY1 billion in the next year, and raise another CNY3 billion for the next fund to channel more funds to try impact investment, that’s one step closer to our wish.”
China’s Leapfrog Advantage in Impact Investing
From ESG to impact investing, social/environmental factors are deeply written into the DNA of capitalism across the world. TPG, Hillhouse and other giants are among the first to enter the market; mechanisms are taking shape and maturing in western countries; and greenwashing, while a problem to be solved, at least shows that enterprises and society are gaining awareness.
China was late to impact investment, but the ‘leapfrog advantage’ is that China can avoid the chaotic period when the concept originated in developed countries. At the outset of its impact investment practice, China has gathered the most professional elites. Moreover, given its size, the Chinese market provides an opportunity to verify the business model. Also, compared with developed countries, China creates a space where financial return and environmental return are better connected.
In the future, it is not enough for China to bring in foreign mechanisms and experience if it wants impact investment to take root and flourish. The Chinese market has social and economic peculiarities. Hence, impact investment talents who are familiar with this market are needed.
Amanda Zheng, founder of Impact Bread, holds that since impact investment has the mission to fill the gap in the entire investment value chain and is often specialized in highly impactful vertical sectors such as energy innovation, sustainable mobility, food tech, smart agriculture, ocean health, etc., talents with corresponding industry knowledge and know-how will have a scarcity value on the market. Fund managers need talents to be sharp on both industrial insights and business acumen.
However, Ehong Capital ingeniously stresses that the skillset is just one aspect of talent recruitment, while value and belief alignment is another hard-and-fast rule.
As one of the major countries in the world, a small change from China can have a significant global impact. If impact investment can truly take root, China will doubtless lead the way in addressing the world’s most challenging difficulties.