Future Bright LLC is well versed in the evolving landscape of Impact – ESG standards and reporting and can assist with integration in the portfolio management process. Below is a conceptual standard for integration.
The field of Responsible Investing (RI), including ESG and Impact investing, is growing rapidly and quickly evolving from an operational headache to a source of opportunity and alpha. RI has applications across the investment spectrum from Private Equity to Liquid Investments. The latter is the largest segment of adoption of the $22 trillion + in global assets reported to be managed utilizing as least some form of RI/ESG strategy. The reported number is large, ¼ of all AUM, however, wide differences exist in implementation. Few investors have integrated ESG and impact analysis fully into the portfolio construction, sourcing, and risk management process. Our view is asset managers that fully incorporate impact and ESG analysis into the investment process can create and capture significant value for their firms and LP’s. We discuss some of these opportunities and the market in this brief as they pertain to Private Equity strategies and Liquid Investing.
Private Equity Investors incorporating an ESG lens can create and capture more value by:
- Gaining a more complete picture of risk. Would any investor think it is prudent to ignore an increased focus on factors like carbon emissions, water intensity, customer health and safety policy, or sexual harassment policy. The answer is obviously no. By incorporating the vast and growing subset of ESG factors into portfolio construction, selection, and risk management, GP’s gain a better understanding of risks and can avoid costly lawsuits, product recalls, or scrutiny on a portfolio companies’ energy & water footprint.
- Identification of new and emerging opportunities. At the center of the ESG universe, whole industries are emerging geared towards both economic performance and social and environmental stewardship. These industries are diverse and range from renewable energy to controlled environment agriculture, big data and fintech-based RI platforms. Incorporating ESG strategy into the investment process illuminates a new sleeve of early investment opportunities.
- Economically accretive opportunity for existing portfolio companies. When the owners of a Made in the US textiles company procure on-site renewable energy for their manufacturing process, they fix the energy cost base for the long-term and provide security from outage.
- The ability to lower cost of capital for portfolio companies. Responsible companies have access to the growing green bond and social investment markets, which often sport a lower cost of capital when compared with traditional investment pools.
- Widening of the investor base. An increasing number of investors, and especially millennial investors, will not investment in strategies that do not incorporate ESG into the investment process.
ESG and Impact strategy offers value through both integration (operational efficiency and management) and sourcing of new opportunities. Below is a list of some categories that are ripe for both selection and can offer value through the integration of their products with existing portfolio companies.
The Performance Myth
Recent data is debunking the idea that ESG and Impact investments come with an inherent performance trade-off. In fact, many studies are showing that these investments can generate better risk adjusted returns. A better handle on risk and growing demand for both equity and end products of responsible companies helps explain the performance.
Highlights
- Investors factoring in ESG since 2008 would have avoided 90% of bankruptcies (BofA)
- Sustainability Indexes experience fewer bubbles than the S&P500 (Pax)
- Hypo L/S portfolios buying carbon efficiency and selling carbon inefficient companies generated 3.5-5% excess return over 2005-2015 (Monk 2017)
- ESG Indices tend to have lower volatility than their non-ESG counterparts. Outperformance in recent years has been a high as 243 basis points for EM LO strategies
Factor Integration
Our view is that ESG factor integration in liquid strategies will add significant value going forward. One way to approach this is to categorize non-overlapping ESG factors in an additional grouping alongside traditional factors like momentum and valuation. One Future Bright segmentation included Human Capital (internal customers) split out from Social Capital (external customers) and includes a separate category for Innovation given its importance in business longevity. Some factors are displayed below. It should be noted that industry evolution is still challenged by incomplete data sets, timing mismatches, and other problems. Many of these challenges are no different than those faced by traditional stat-arb strategies. Future Bright feels the biggest advantage to ESG factor integration in liquid strategy comes in catastrophic risk avoidance firstly then in the ability to spot emerging opportunities (examples include shorting the Bayer-Monsanto merger, long Lithium on the back of growth in batteries, and long solar component provider Solar Edge (NASDAQ:SEDG).
Future Bright LLC looks forward to helping you build a world-class ESG and Impact Investing effort.