Why now is the time for European pensions to fully embrace impact investing

Europe has long positioned itself as one of the leaders of the sustainability transition, highlighted by efforts to harmonize corporate sustainability disclosures and implement new sustainability-oriented regulations for different types of market actors.

One key player in the sustainability transition are European pensions, which collectively control $3.5 trillion in assets. Despite growing interest, a culture of caution persists among pensions when it comes to adoption of impact investing, leading to missed opportunities to fulfill both financial and impact objectives.

According to the GIIN’s 2022 market-sizing study, pensions and retirement funds represented just 2% of the 896 organizations that the GIIN identified as participating in the impact investing market. Furthermore, capital commitments from institutional investors like pension funds and insurance companies make up 23% of the estimated €80 billion of direct impact investments in Europe.

This slow drip of capital stands in sharp contrast to overwhelming demand for these types of impact investments among pension beneficiaries, many of whom want to see their retirement income used to help further sustainability objectives.

A recent study by the Morgan Stanley Institute for Sustainable Investing found that 77% of individual investors are interested in “investing in companies or funds that aim to achieve market-rate financial returns while also considering positive social and/or environmental impact,” while 54% said they anticipate boosting their allocations to sustainable investments in the next year. These figures mirror what we’ve seen in similar studies of investor preferences, a clear sign that the ongoing $30 trillion wealth transfer from Baby Boomers to younger generations will fundamentally reshape the investment landscape.

Fortunately, there are reasons to be optimistic. Several of Europe’s biggest pension funds – including those overseen in countries like the Netherlands (APG and PGGM), Sweden (AP funds) and UK (Big Society Capital, The Access Pool) – have made sizable commitments to the impact investing market. The question is how to best learn from their experiences and help more European pensions pursue impact investments more aggressively.

In this article we discuss three concerns that pension funds have raised as reasons for their cautious approach, along with recent developments and research that serve to allay those perceived concerns.

Impact know-how 

Impact investing requires a different skill set than the one employed by traditional investors, given the dual objectives of achieving both financial and impact performance. However, many European pension funds today lack the dedicated or appropriate expertise on their investment teams to manage both of these elements with discipline.

Understandably, traditional pension fund professionals may lack a comprehensive awareness of best practices in impact measurement and management. This creates the risks of ill-informed decision-making and/or ineffective and inefficient engagement with prospective GPs. Many impact fund managers express frustration with the challenges of interacting with pension funds new to the market, especially when it comes to aligning on those aspects of their impact strategy and performance that are most material and relevant.

This challenge is exacerbated by the lack of standardized impact metrics and reporting frameworks, which can make it more difficult for pension funds to evaluate and compare the impact of different investments. This is especially true of impacts or outcomes related to social issues, which can be much trickier to measure than those metrics used to assess progress on climate issues.

However, there are several resources for pension funds looking to wrap their heads around the fast-evolving impact investing market. A great first step is to download the BlueMark x CASE at Duke University Field Guide, which covers the key considerations LPs should acknowledge both pre- and post-investment. The guide also offers tools and tips for allocators during due diligence and as part of their ongoing management of impact funds, as well as potential red flags that could signal a lack of rigor, capacity, or intentionality on the part of these managers.

In 2023, the GIIN published a similar study designed to help institutional asset owners apply an impact lens to holistic portfolio construction. The report outlines the steps that asset owners like pension funds can take to incorporate impact considerations, “starting with planning and conceptualization and moving toward the ultimate goal of an impact lens applied across an entire portfolio.”

Another helpful reference is the Operating Principles for Impact Management, which were introduced in April 2019 to provide a framework for how impact considerations should be integrated throughout the investment lifecycle, from due diligence to portfolio monitoring to exit. Already, more than 180 impact investors with a combined impact AUM of $518 billion have signed onto the Impact Principles.

These and other resources are readily available for pension funds looking to familiarize themselves with the impact investing market.

Fiduciary duty and return expectations

Another concern raised by many European pension funds is uncertainty about whether impact investing is compatible with their fiduciary responsibility to pursue maximum risk-adjusted returns. For some, there is still a perception that impact investing necessitates a financial return trade-off. However, evidence is accumulating that demonstrates impact funds perform just as well as non-impact funds.

A 2023 analysis by PitchBook found that impact funds that started deploying capital in 2019 or 2020 generated a similar IRR as non-impact funds for funds with a similar vintage year, with competitive returns for top quartile funds as well. Another 2023 study published by Impact Capital Managers (ICM) and Morrison Foerster showed that 65% of impact exits met or exceeded financial objectives, based on a sample size of 230 exits from ICM members, each of which manages a market-rate fund. A 2023 study of the UK pension market conducted by Pensions for Purpose showed that pension funds can achieve their impact objectives without sacrificing financial returns, thereby fulfilling their fiduciary responsibilities. A group of UK financial market lawyers also recently published a paper, Pension Fund Trustees and Fiduciary Duties, in which they argued that pension fund trustees have a fiduciary duty to consider sustainability factors.

Impact investing returns will always exist on a spectrum, ranging from concessionary strategies to market-rate impact funds. But as the market has matured, a growing number of impact investors are pursuing strategies with financial return targets competitive with non-impact strategies.

Indeed, a 2023 survey of impact investors conducted by the GIIN revealed that 74% of respondents are seeking risk-adjusted, market-rate returns and an impressive 79% met or exceeded their financial expectations. These and other studies should overturn the myth that impact investing requires concessionary returns.

The right ticket size

Another common issue we hear from pension funds is their need to make large-ticket investments. This requirement inevitably limits the potential pool of investments, including many impact investments which tend to require a smaller ticket-size. Pensions understandably want to avoid becoming the dominant source of capital for any one fund manager.

Fortunately, billion-dollar impact funds are no longer a rarity in the market. Indeed, several recently launched impact funds have eclipsed the $1 billion mark, including those managed by Brookfield ($15 billion), TPG ($7.3 billion), General Atlantic ($3.5 billion), EQT ($3.3 billion), and KKR ($2.8 billion). Recent research by the GIIN shows this is part of a continuing trend, with the average investment portfolio across a subset of 1,289 impact investing organizations holding $485 million in impact AUM, a far cry from the early days of the industry when many allocations to impact could be measured in the tens of millions.

The impact investing industry is only continuing to grow, with many first-time funds now coming to a close and the second or third generations of funds beginning to enter the market. With each generation of funds, the market is maturing and achieving more scale and institutional buy-in.

Ultimately, pension funds represent an important piece of the sustainability puzzle given they are among the largest holders of capital in the world. Even a 1% allocation to impact investments would dramatically increase the size of the European impact investing market overnight. Imagine the transformative impact on the European economy and Europe’s efforts to lead the sustainability transition if pensions joined in.