Environmental, social and governance-related (ESG) criteria have come to be seen as mainstays of the investment process recently, as greater numbers of investors look beyond the immediate term and expand their venture horizons. The reasons for this are clear: the headwinds of the global economy point to a future when sustainability is embedded more deeply than in years past, and as much as returns are foremost in investors’ minds, there is more of an appetite for investments that extend their benefits to society and the environment.
No longer a niche corner of the market, ESG investing – as with most new movements – is experiencing growing pains. Namely, the range of investment jargon used to describe it has become a hindrance, and some have seized upon the confusion to dilute the content. As a result of this and other factors, many are at a loss as how best to approach investment with a social or environmental slant, while changes in policy, technology and physical risk mean definitions are constantly shifting.
Bank of England Governor Mark Carney spoke in September 2015 about the “tragedy of the horizons”, describing a situation in which investors know full well they are looking over the edge of a cliff in five, 10 or 20 years’ time, yet are without the institutional frameworks to manage the transition.
To ensure the cause is not diminished further, experts in the field have tended towards the catchall term of ‘impact investing’, which encompasses any investment made into a company, organisation or fund with the intention of generating social and environmental impact alongside financial return.
Ben Goldsmith of Menhaden Capital defined impact investing “quite simply as investing in companies, projects and other entities that, as well as representing significant investment opportunities, deliver sustainability benefits, such as helping to reduce environmental and/or social harm”. Like this new breed of investor, Menhaden takes a long-term, patient approach and invests across asset classes.
‘Impact investing’ encompasses any investment made with the intention of generating social and environmental impact alongside financial return
WHEB Asset Management, meanwhile, was among the first listed equity strategies to be recognised on the GIIN’s ImpactBase database of funds qualified as Impact Funds, and was the first listed equity manager to produce an impact report. Asked to specify what impact investing means to him, Ted Franks, Partner at WHEB and Fund Manager for the FP WHEB Sustainability Fund, said there were two key parts.
The first, he said, “is mapping and defining outcomes. What social or environmental problem or challenge is the company solving and how do the products or services it makes do that?” For instance, many of the challenges we see today are a result of growing, ageing and increasingly middle-class populations that just well happen to put a tremendous strain on society, resources and the environment. In answer to these problems, WHEB has identified positive impact companies in health, water management, resource efficiency, safety, clean energy and education (nine social and environmental themes in all).
The second part is assessing the intensity of the beneficial impact of these products and services. He told World Finance: “For instance, in cleaner energy we can measure the degree of CO2 reduction, which is relatively straightforward. In health, it is a more complex issue, but we see companies like Novo Nordisk leading the way through treating diabetes and obesity. The way it goes about raising awareness and reporting this in a clear, consistent and transparent way helps to set high corporate standards.”
To lay it out more simply, positive impact is the holistic outcome of the whole process, where key criteria are sustainability as a source of growth, analysis that integrates ESG as a route to quality, and a disciplined approach to valuation in a long-term investment context.
Where impactors invest
Both Menhaden and WHEB are part of a powerful new movement to tout the importance of ESG in investment; their expertise on the subject of impact investing is essential if we are to dispel old assumptions about impact and profitability.
The former invests in companies, both large and small, helping to build a new global, green economy and taking a long-term, patient approach across asset classes. According to Goldsmith: “We are building a portfolio of investments that include sectors ranging from smart grid software to pollution prevention, water savings and waste reduction, using a longer-term approach to investment that is good for society, the environment and investment returns.”
The latter is a specialist boutique built around a single global equity strategy focused on investing in sustainability themes. According to Franks: “What makes us really different from many other fund managers is that our investment philosophy is reflected in the way the business is organised, and vice versa. Our philosophy is based on investing in companies that are making a positive contribution to society and the environment through the products and services they provide, as well as being good corporate citizens.”
For WHEB, this meant becoming a B Corporation, where the legal structure of the business and its organisation is designed to meet high standards of social and environmental performance, accountability and transparency. “In other words”, said Franks, “our company is good by design”.
ESG and impact
The success of both Menhaden and WHEB means the two are ideally positioned to pass comment on how the concept of impact investing itself is different to an ESG box-ticking style of analysis. WHEB considers ESG analysis to be an input, while the ‘impact’ relates to outcomes. According to Franks: “Understanding how a business manages the environmental, social and governance risks and opportunities it faces helps us to understand better the quality of a business and how it is managed, and gives us a more holistic view of its future growth potential than if we simply looked at the figures in the report and accounts alone.”
He argued most traditional analysts are only observing a small part of the picture, using a narrow window of analysis. By understanding the ESG analysis of a company, WHEB is able to take a broader view, and often one that is more forward-looking. He continued: “ESG analysis on its own only tells a part of the story, and is usually focused on the operational management of a business, and is often applied in a best-in-class or sector-neutral way.”
Franks stressed that this should not be confused with the overall sustainability of a company, which takes ESG into account in combination with the nature of the product or service the company is selling. “Impact investing incorporates ESG as an input, but more comprehensively addresses the positive intentionality and outcomes of an investment.”
Good sustainability and environmental management are an integral part of any investment that is set for long-term outperformance
As much as ESG elements are a part of the decision-making process in investment circles, there is a sense that positive environmental or social change requires concessions in terms of returns. Going back to Goldsmith, his and Menhaden’s stance on the matter is that good sustainability and environmental management are an integral part of any investment that is set for long-term outperformance.
“The headwinds of the global economy”, he said, “point to a transition to a low-carbon economy. For example, as the cost of equipment tumbles – especially of solar photovoltaic panels – there is a fast-growing list of situations and places in which renewables are the cheapest option for power generation, and this creates many positive investment opportunities.”
Franks and WHEB echo this sentiment, again casting off any assertions sustainability need necessarily come at the expense of returns. At the heart of WHEB’s investment proposition, Franks said, is a strong conviction that sustainability performance leads to strong financial performance: “In the words of our mission statement, we ‘create prosperity through positive impact investments’. This is not about ‘balancing’ the two elements, or trading off one for the other, but a clear alignment between sustainability and financial performance, each reinforcing the other.”
While it’s imperative investors ask rigorous questions where they can, it’s important they also challenge assumptions, particularly any they have held for a long time that might be considered ‘conventional wisdom’.
Franks maintains impactful and positive environmental change is happening across the global economy and is recognised by business, academic and political leaders in the US, UK, Europe, China and across the rest of Asia. The issue, he said, lies in creating a framework that encourages investors to challenge the status quo, particularly in moving beyond a short-term profit mindset and onto a long-term wealth creation approach that spans the economic and social value chain.
The way to address this challenge is to ensure any company touted as an impact investment firm has a sound business model with the right market fundamentals, regulations and standards to succeed. According to Franks: “In our view, sustainability is so fundamental to a well-functioning economy that the growth opportunities will continue over decades-long periods, and new ones will emerge. Organisations that pay lip service to this change are potentially the ones that will get left behind.”