Perspectives on Ethical Real Estate Finance
ESG-friendly lending: A threat or an opportunity for Real Estate Impact Funds?
March 24, 2023 9 Minute Read
Over the last two decades there has been steady growth in UK ‘Impact Funds’ lending money on real estate projects. In this article we explore how these funds might be affected by the more recent growth in ‘sustainable’ or ‘ESG-friendly’ investment funds and lending.
What is an Impact Fund?
In the UK context, an Impact Fund aims to lend money, usually for development projects:
- In ways which generate a purposeful, measurable, social or environmental benefit alongside a benchmark (but not necessarily outperforming) financial return; and
- Where access to finance in the first place is the key barrier. Impact Funds aim to lend in circumstances where no other lender is willing or available, despite the underlying project being viable
An example of this growth may be found in the £150m North West Evergreen Fund, a key regeneration development lending programme managed by CBRE. This fund is now three times as large as when it was created.
The rise of ‘ethical’ lending
There has, in parallel, been a growth in ESG-friendly lending, including ‘green lending’ which we cover in other articles within this series.
This growth has, in part, been delivered by pressure from the underlying providers of long-term capital to invest in assets more likely to withstand future risks arising from climate change or social change.
It has also been driven by new regulatory requirements, in particular new international mandatory corporate reporting and disclosure requirements such as TCFD.
Will impact funds be overtaken by wider ESG-friendly lending practices?
Despite this growth in ethical lending activity, we do not believe that Impact Funds will be ‘swallowed up’ by it. It is not evident that all mainstream lending will henceforth pay the same attention to achieving social and environmental benefits as Impact Funds have historically done.
Many Impact Funds relate their lending rates to market standard pricing, reflecting what a conventional lender might want, which ensures a fair level of commercial return whilst enabling the development. As others have argued, Impact investors assess the risk of an investment on its own merits, and charge an appropriate rate.
Impact Funds have a niche that private funds can’t and won’t reach
Instead, the future of Impact Funds seems secure for four other reasons.
Firstly, Impact Funds have, by definition, had ethical considerations ‘designed in’ from the start. They thus have significantly broader coverage, and more advanced reporting, than even some of the leading mainstream ‘ethical’ funds. This isn’t to say that more mainstream funds won’t catch up in due course, but Impact Funds certainly have a head start. They now need to maintain that lead, by continually improving the quality and standards that they work to.
Secondly, because the underlying investors are usually public sector or third sector funds, including pension funds. Return is a consideration, but Impact Funds aim to have impact over and beyond achieving a financial return, and it’s that impact that the investors want.
While private investors can and do invest in Impact Funds, the principle of Impact Funds is to invest where the private sector otherwise doesn’t. While private lending is being forced to become more conscious of its impact, this differentiating principle makes it unlikely that private lending will ever attract all of the capital available from public sector investors. Nor does it mean that private sector money will become as preoccupied with social and environmental benefits as public sector money.
Thirdly, private sector lending is also (for now) heavily focused on the ‘E’ of ESG, with much less focus on the ‘S’, where Impact Funds have a much stronger focus. There is some emerging regulatory pressure on the capital markets relating to social issues (not least the EU Social Taxonomy); but this is much less developed than in the environmental sphere, giving Impact Funds a compelling lead on social issues for now.
Fourthly, Impact Funds are often geographically focused. Regionally concentrated lending might lack diversification and thus carry too much risk for a private sector lender, but is the main focus for some regional or local government funds. For these funds, the benefits of supporting ‘levelling up’ or regeneration are weighed against the loss of diversification. Generic UK-wide ethical funds regeneration areas completely.
Will new regulation affect Impact Funds?
As noted above, regulation has been a key driver of the growth in ESG-friendly lending. Regulators are now clamping down further on unsubstantiated claims which funds make about their ethical and ESG credentials.
For example, the EU’s Sustainable Finance Disclosure Directive (SFDR) and the UK Financial Conduct Authority’s proposed Sustainability Disclosure Requirements (SDRs) introduce new reporting and labelling requirements.
Following Brexit, SFDR is now only indirectly relevant to UK Impact Funds. However, it will affect cross-border flows of capital if investors feel they need to comply with both EU and UK requirements.
Unlike the SFDR, the SDRs aim to protect retail investors and end consumers, rather than institutional or professional investors. The FCA does propose to ban the use of the word ‘impact’ to describe funds and investments unless they can substantiate claims that they do actually have an environmental or social impact, and are labelled as such. But for as long as UK Impact Funds continue to seek capital only from institutional investors, these labelling rules will not affect them.
Even if these new requirements do apply to Impact Funds, they will arguably be easier to comply with, given the wider scope of the existing reporting frameworks which Impact Funds use. More traditional funds will have work to do to catch up.
Conclusion: convergence, not coalescence
Impact Funds will continue to enjoy a particular niche within the mix of lending for development projects.
While the overlap between the objectives of Impact Funds and the objectives of ‘ethical’ private investment appears to be growing, it will take many years before there is no longer any need to distinguish between them. Indeed, the distinctive features of each category suggest that this potential merger may never happen at all.
One further intriguing possibility is that, if Impact Funds begin to articulate and structure their offering in ways which are compliant with the SFDR and SDRs, we may perhaps see a ‘reverse takeover’ in which Impact Funds begin to attract capital which otherwise would have been allocated to more conventional lenders.
This in turn could change the character of Impact Funds, potentially diluting their focus on projects that otherwise no-one else will fund; but in the meantime, their niche appears secure.
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