When it comes to financing the energy transition, we are used to seeing two types of private fund: infrastructure funds that will build and deliver energy from renewable sources; and VC or growth funds that will back and scale up the emerging technology that will speed up the transition.
“A lot of money has been flowing towards green tech venture capital and towards green infrastructure (such as renewables),” says Jack Azoulay, senior partner at Argos Wityu, a Paris-based private equity firm that invests in Euroean small and medium-sized businesses. “But those are not the fields of competence for Argos. What we know best is to drive change in small and mid-size European companies… and we now want to do that with an environmental focus.”
Argos Wityu launched a climate buyout fund in September 2022 with a mandate to reduce the carbon intensity of European SMEs. Classified as Article 9 under the EU SFDR, the fund will invest between €20 and €40 million in 10 to 12 companies. It has set a target of reducing by at least 7.5 percent per year the intensity of portfolio companies’ greenhouse gas emissions. The firm is not commenting on specific target returns, but confirms it aims to deliver the same as its traditional buyout product.
The firm is one of a small handful of mid-market private equity firms that has tailored a strategy to help decarbonise industry from the bottom up. A 2022 survey from the European Commission found that just 24 percent of European SMEs have a concrete plan in place to reduce their carbon footprint, despite the market accounting for 63 percent of carbon emissions across Europe. The survey also found that the most significant barriers to going green were the complexity of administrative and legal procedures; and the cost of environmental action.
Adamantem is another GP with eyes on SMEs. In 2020, it became the first Australian private equity fund to adopt a “cradle to grave” approach to the emissions impact of its assets when it launched Adamantem Capital Fund II. The fund closed on A$795 million ($534 million; €505 million) in 2021 and targets mid-market companies in Australia and New Zealand. Acquired companies are required to implement emissions reduction targets that aim to either eliminate or offset their emissions within a decade. In addition, portfolio companies will be required to have an independent consultant undertake an energy and emissions baseline measurement covering Scope 1 and 2 emissions, in accordance with the International GHG Protocol. The firm declined to comment on returns.
The firm’s managing director of responsibility and impact, Natasha Morris, agrees that there is a lack of attention on the space. “There are investment opportunities at the infrastructure end of the spectrum, and you can see a lot of opportunities at the VC end of the spectrum,” she says. “But we are also seeing that there are opportunities in the mid-market PE space.”
The next wave?
Whether this type of fund – generalist private equity with a firm eye on decarbonisation – becomes the next big thing in climate investing is, in Europe, somewhat depedent on the regulatory environment. There is debate around whether a ‘grey to green’ strategy, which seeks to improve a potentially ‘dirty’ set of assets, should be classified as Article 9 under the EU Sustainable Finance Disclosure Regime.
“The fact that transition finance doesn’t have its own category [under SFDR] is a problem,” says Clara Cibrario Assereto, associate and sustainability regulation specialist at law firm Cleary Gottlieb.
Paula Langton, head of private markets adviser Campbell Lutyens’ sustainability practice, notes that, when it comes to decarbnisation, the real economy represents a “big void in that [PE] market”, but regulatory barriers make that void difficult to fill. “I’m not sure how you deal with SFDR, as you need to be investing in something sustainable,” she says.
Argos Wityu, having done its regulatory homework, is confident it can meet the requirements of Article 9. “If you really look at SFDR in detail, it says that to be an Article 9 fund, you need all your investments to be sustainable,” Azoulay explains. “Article 9.3 specifies that one of the ways for them to be sustainable is if they have as a main objective to mitigate climate change, namely by reducing carbon emissions. That’s specifically what we’re doing and why we are exactly in the spirit of article 9.3.”
Having overall control of the portfolio company is also key. According to Azoulay, it is difficult to prove additionality for the purposes of the Article 9 when taking minority stakes in businesses, but by buying them out “we can really prove that our action is what’s leading the acceleration in the decarbonisation of the company and that, by investing, we clearly have an additional impact on the company’s sustainability”.
Debt driving change
On the private debt side, French asset manager Tikehau Capital launched SG Tikehau Dette Privée, an Article 8 fund, earlier this month. The unit-linked fund enables private investors to invest in European SMEs committed to reducing their carbon emissions. Companies financed by the fund must commit to a Paris-aligned decarbonisation strategy based on the Science Based Targets initiative.
Throughout the financing period, borrowers’ compliance with the decarbonisation plans will be audited annually, with financing conditions adjusted depending on the results. The loans are all floating rate, with a current aim of 5 percent returns net of management fees.
The use of private credit as a means to promote decarbonisation (along with other sustainable behaviours) is catching on in the lower mid-market, as Kirsten Bode, co-head of European private debt at Muzinich & Co, told New Private Markets in October last year.
Another decisive factor in whether we see an explosion of transition-focused private equity funds is how quickly and how far incumbent managers adopt decarbonisation as a portfolio priority. In other words: to what extent will an emissions-reduction programme become a standard value creation lever to pull as a PE sponsor.
Carlyle, for example, announced last year that 75 percent of its portfolio companies’ Scopes 1 and 2 emissions will be covered by Paris-aligned climate goals by 2025, with all new majority-owned portfolio companies setting Paris-aligned climate goals within two years of ownership from 2025. The firm’s credit platform has also established a decarbonisation-linked financing programme that offers a pricing benefit tied to a borrower’s achievement of decarbonisation targets or other tailored climate-related KPIs.
PAI Partners told New Private Markets at the start of the year that a decarbonisation strategy at both the firm and fund level is a 2023 priority. We know from our discussions with other firms that many are currently focused on improving the quality and breadth of the data that portfolio companies are gathering.
For the moment, however, PE firms have been able to differentiate themselves through a focus on decarbonising the real economy. Says Azoulay: “Everything will need to be low carbon in 2030, and even more so in 2050. And you won’t be able to do that only with start-ups and innovations. You’ll have to also transform all the existing companies.”