The myths vs. the truth
Megan Starr, Head of Impact at The Carlyle Group, told SuperReturn Asia that one of the biggest challenges in understanding ESG was that the space had become an “alphabet soup” in which there were a variety of different investment tools that had different applications and investment theses behind them.
There were three broad categories that ESG fell into, namely alignment, ESG integration and impact investing. She explained that alignment involved investors screening things out of their portfolios or reducing their exposures to certain things, such as carbon intensity, and it was done in a very risk-managed way.
Starr described ESG integration as being a form of good active investing. “It is the idea that you can’t just look at cashflows to understand the future value of a company, but you have to think more holistically."
She added that the third category, impact investing, was the idea that there were certain sectors in the market where there were strong drivers of growth and profitability for businesses that were solving environmental and social challenges.
“It is market rate return investing into private companies whose core business model is solving these issues,” she said.
The panel agreed that one of the biggest misconceptions about ESG investing was that it led to lower investment returns.
Starr said: “One of the things we see the most is the misconception that if you spend any time focusing on impact you are not spending time on maximising risk-adjusted returns.”
But she pointed out that the opposite could actually be true and there were some macro themes that had created markets where there were strong drivers of growth and profitability that converged with impact themes.
Raj Pai, Partner, GEF Capital Partners at Global Environment Fund, said another big concern investors had was that ESG would limit their scope of investment and lead to them missing out on good deals.
But he said: “What we have seen in some cases is that because we had an ESG understanding, we were able to do deals which otherwise we would not have done.”
There was one company he looked at which had a lot of issues, such as not having labour policies or waste disposal policies. “The easy and lazy decision for us would have been to walk away, but because we had ESG in place, we could actually ring-fence the risks around these gaps and put a plan in place to make sure the company addressed them.”
He added that it was also possible to buy companies at a discount if they had ESG issues that needed addressing.
Divgi said many investors thought ESG was relatively new, when in reality it had always been there, even if it was not labelled ESG.
“It is what you have always been looking at, and most likely have within your investment due diligence framework, especially with governance,” she said.
Starr agreed, saying: “When things are stripped away, it is still about good investment discipline and rigor.”
Pai pointed out that when they looked at ESG in developing markets, it was more from a risk motivation, adding that in emerging markets it was extremely important to do due diligence on the environmental impacts, and social and governance aspects of a company.
“The number one reason for companies not returning capital in emerging markets is governance,” he said.
Vikram Raju, Head of Emerging Markets at Morgan Stanley Alternative Investment Partners, pointed out that ESG not only helped to prevent value destruction, but it also enabled companies to gain better reputations, and if a company had a better reputation, it tended to get a better valuation.
“We make sure all the risks have been addressed to the best possible extent. It is like any other risk management. When you do things right, a buyer will pay you one, two, three times higher in valuation because they don’t have to spend time fixing problems,” he said.
Starr pointed out that there was sometimes a misconception that ESG was separate from investment and a business model. “Actually, it is the same tools that you use as a private investor to make sure a company is on track,” she said.
Pai agreed that active management was a big part of ESG. “ESG is part of the shareholder agreement, so for any breach of that, there is a penalty. It is an approach of working actively on a continuous basis,” he said.
While a number of misconceptions still surround ESG, the panel was clear that not only did it not have a negative impact on returns, but it could actually boost them.