ESG Table Stakes for Investors

(An excerpt from my book coming in fall 2023 — Table Stakes | Why ESG Matters To Stakeholders, and Why Every Company Needs It)

Globally, many investors have made the big shift to ESG investing. But what in the big, big ESG thicket appeals to them? And what class of investors are we talking about anyway?

While looking at companies through an ESG lens is growing globally as a way to analyze their financial prospects, all investors haven’t moved in lockstep in adopting it. In this post, I explore some investor groups and what ESG looks like for them. 

Private Equity

Private equity (PE) is a class of corporate ownership in a company not listed on a public stock exchange, and PE investors seek this investment flavor because of the possibility of earning outsize returns compared to owning shares in public companies.

In a 2022 survey of more than 100 limited and general partners in private capital markets, 90 percent of general partners said folding ESG strategies into their investing leads to higher returns, and 82 percent have an ESG policy in place. Both partner groups are moved by intertwined motivations – demonstrating societally beneficent investing and creating highest-and-best returns for the long term.

In 2021, PE held $6.3 trillion (7 percent) of global assets under management (AUM) with the expectation that that number doubles by 2026. General partners are overwhelmingly driving the ESG investment bus, though limited partners are catching on and catching up. While PE takeovers can unearth hairy ESG problems that might not be a good look in the public light, PE has a stealth, off-the-radar advantage to be able to rectify investee problems quietly. PE also has the sway, the data access, longer time horizons and greater investment sophistication to successfully right and onboard ESG strategies.

Venture Capitalists

Like PEs, venture capitalists (VCs) are fairly new to ESG. Yet as VCs are often first in with capital to help a company grow, they’re also in a unique position to mold and shape it, including its ESG initiatives. In addition to being first in, they decide which companies get funding and which don’t, so if there are biases in VC firms and the industry as a whole (algorithmic or otherwise), these can color funding choices. And while VCs fund companies in a range of sectors, they dominate in tech, having funded companies like Amazon, Google, Facebook and Apple. The ubiquity of these companies shapes modern life as we know it.

There are several impediments that VCs must overcome in order to have ESG evaluation and integration be a well-oiled part of the machine. First, they need to be able to assess value creation and risk management quickly. Second, VCs must walk their talk about ESG by including incentives, processes and structures for their own ESG integration. These can change the orientation of their own firms’ internal systems, tipping VCs to spot and act on external ESG opportunities they fund. And firms need to do whatever they can to help their investees standardize ESG so that measuring and adapting it to inevitable business iterations, especially in early company stages, isn’t such a lift.

Institutional Investors

Institutional investors are known as the “whales of Wall Street” because of their outsize impact and influence on global stock exchanges. Their trading equals 90 percent of all trading activity, and 80 percent of institutional investors comprise 80 percent of the S&P 500’s total market capitalization. Wall Street’s whales have made a hard turn toward ESG, and that moves global markets.

Institutional investing comes in all shapes and sizes, including pension, mutual, hedge and endowment funds, insurance companies and commercial banks. Despite political crosscurrents buffeting ESG in some places, 75 percent of institutional investors believe ESG is a part of fiduciary duty, and 72 percent said they set ESG goals for their asset managers. Ninety percent of asset managers say that ESG is an accelerant for long-term returns. Sixty percent of institutional investors are already experiencing higher yields on ESG investments than non-ESG comparables. And more than half say that ESG outperforms in fewer than three years – not necessarily a quarterly timeline but not a long-term one either.

Retail Investors

Retail investors are non-professional, individual investors who buy and sell corporate shares and debt in money-market funds or ETFs – exchange-traded funds. While retail investors typically invest smaller amounts of money than their professional-class peers, retail investors matter because collectively, these Main Street investors own $38 trillion worth of equities  more than 59 percent of the U.S. equity market according to the SEC (including those in accounts managed by investment pros). Retail investors also flavor the market with their attitudes and outlook.

Fifty-seven percent of retail investors recently surveyed say that investment and money flows can change the world for the better, and 77 percent say that if they could invest in SRI funds, those would align somewhat with their values. Unlike institutional investors and even PE, retail investors have a big information gap about what ESG even is. Only 28 percent say they’re familiar with it, 24 percent can define it and 21 percent know what the ESG acronym even stands for. Only 9 percent of the respondents have ESG-identified investments, and 36 percent don’t even know if it’s represented in their portfolios or not.

Historically underrepresented groups say they’re most familiar with ESG: African-Americans (44 percent say yes), those with annual incomes below $30,000 (40 percent) and investors below age 30 (37 percent). In fact, 8 percent of white investors hold ESG investments while other races and ethnicities hold them more frequently (12 percent). As the United States skews younger and less white, these numbers point to groups of investors who will seek ownership in companies doing well by doing good – a burgeoning business opportunity for fund managers and companies that are paying attention.

Short-Timers

There is a class of retail investors who buy into ESG at their own risk – those who churn and burn trades, focused on short-term gains.

One meta-study (study of studies) looked at over 1,000 research papers written between 2015 and 2020 and found that the relationship between ESG and corporate financial performance (CFP) got stronger over the longer term. With everything else held constant, studies with (implied) long-term focuses were 76 more likely to have positive or neutral results. And companies with strong ESG ratings outperformed those without by 3.8 percent in the mid- and long-term.

At root, ESG creates mid- and long-term value through strategy formation and transformation. Investors looking for a quick turn on ESG assets miss the point that ESG is about longer-term value creation, not a one and done. When done well, those things can take time and create big value.

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