ESG 2.0: Measuring & Managing Investor Risks Beyond the Enterprise Level
Do environmental, social, and governance (ESG) and impact investing practices in their current forms provide investors with sufficient tools to play a meaningful role in “Building Back Better” following the COVID-19 crisis? Many investors, including those who identify as “Universal Owners,” often seek to manage ESG risk and opportunity through corporate governance interventions. However, certain investment structures can also have negative impacts relating to ESG goals and management of systematic risk. Furthermore, they can undermine the positive impacts sought by investors at the portfolio company-level.
Currently, in practice, the negative impacts of weak capital structures are typically being addressed piecemeal through company-by-company interventions that focus on their operations, like a game of whack-a-mole; but key roots of the problems — the investment structures themselves — are left unaddressed. This paper outlines why it is important for institutional investors (asset owners and allocators) to consider risks stemming from asset allocation and portfolio construction and encourages investors to align the practices of their investment professional teams with ESG strategies. Regardless of whether an institutional investor includes a focus on ESG integration, understanding how allocations to high-risk asset classes can ultimately undermine long-term return goals can help fiduciaries fulfill their commitments to beneficiaries and manage accordingly.
In this paper, we review the issues and then propose several preliminary paths toward solutions that we intend to workshop and fine-tune with investors. Potential solutions focus on:
- Diversifying asset allocation to smaller, emerging, and more diverse fund managers and investment opportunities, including those with more regenerative investment structures in the middle of the risk-return spectrum (e.g. revenue based financing, equity redemptions, and worker/community ownership vehicles), as opposed to depending on large allocations at the very high and low ends of the risk-return spectrum (e.g. leveraged buyout private equity, high yield bonds, and leveraged loans);
- Building an internal enabling environment through adjustments to team incentive structures and performance reviews, as well as benchmarking and valuation methodologies (e.g. less focus on time-value-of-money metrics); and,
- Field-building (e.g. that supports expanded interpretations of financial materiality to address activities that contribute to systematic risk, as well as the evolution of existing ESG and impact investing frameworks to account for potential negative impacts from capital structures and investors’ influence in shaping them).