As predicted by theory, increased investor demand has resulted in higher returns for public stocks with good environmental, social and governance (ESG) characteristics. Unfortunately, that means future returns will be lower for those stocks. New research confirms that this is also the case for private “impact” investments.
ESG investing in its various forms (such as SRI, or socially responsible investing, sustainable investing, and impact investing) now accounts for one out of every four dollars under professional management in the United States and one out of every two dollars in Europe[1]. The trend is poised to continue.
While economic theory posits that if a large enough proportion of investors chooses to favor companies with high sustainability ratings and avoid those with low sustainability ratings (“sin” businesses), the favored company’s share prices will be elevated, and the sin stock shares will be depressed. Specifically, in equilibrium, the screening out of certain assets based on investors’ taste should lead to a return premium on the screened assets.
The result is that the favored companies will have a lower cost of capital because they will trade at a higher price-to-earnings (P/E) ratio. The flip side of a lower cost of capital is a lower expected return to the providers of that capital (shareholders). Conversely, the sin companies will have a higher cost of capital because they will trade at a lower P/E ratio. The flip side of a company’s higher cost of capital is a higher expected return to the providers of that capital. The hypothesis is that the higher expected returns (a premium above the market’s required return) are required as compensation for the emotional cost of exposure to offensive companies. On the other hand, investors in companies with higher sustainability ratings are willing to accept the lower returns as the “cost” of expressing their values.
There is also a risk-based hypothesis for the “sin” premium. It is logical to hypothesize that companies neglecting to manage their ESG exposures could be subject to greater risk (that is, a wider range of potential outcomes) than their more ESG-focused counterparts. The hypothesis is that companies with high sustainability scores have better risk management and better compliance standards. The stronger controls lead to fewer extreme events such as environmental disasters, fraud, corruption and litigation (and their negative consequences). The result is a reduction in tail risk in high-scoring firms relative to the lowest-scoring firms. The greater tail risk creates the sin premium.
While keeping the economic theory in mind, investor preferences can lead to different short- and long-term impacts on asset prices and returns. For example, if investor demand increases for firms with high sustainable investing scores, that could lead to short-term capital gains for their stocks – realized returns rise temporarily. However, the long-term effect is that the higher valuations reduce expected long-term returns. The result can be an increase in “green” asset returns even though “brown” assets earn higher expected returns. In other words, there can be an ambiguous relationship between carbon risk and returns in the short term.
Returns on public ESG investments
In general, the research on returns to publicly available securities confirms financial theory. Studies such as, “The Contributions of Betas versus Characteristics to the ESG Premium,” “A Sustainable Capital Asset Pricing Model (S-CAPM): Evidence from Green Investing and Sin Stock Exclusion,” “Outperformance through Investing in ESG in Need” and “Is ESG an Equity Factor or Just an Investment Guide?” have found that firms with lower ESG scores exhibit higher expected returns. However, as the authors of the study “Sustainable Investing in Equilibrium” noted, the heightened interest in ESG investing has led to firms with high ESG scores having rising portfolio weights, leading to short-term capital gains for their stocks – realized returns may rise temporarily, though expected long-run returns fall. Thus, investors have to be careful how they interpret research findings – at least until an equilibrium has been reached.
We now turn to new research on returns to private impact investing.
Returns to private impact investing
Brad M. Barber, Adair Morse and Ayako Yasuda contribute to the literature on sustainable investing with their study, “Impact Investing,” published in the January 2021 issue of the Journal of Financial Economics. The focus of their research was on venture capital (VC) and growth equity funds that are structured as traditional private equity funds but with the intentionality that is the hallmark of impact investing – to generate both positive social or environmental returns and positive financial returns.
Using Preqin data, they constructed a sample of 24,000 investments by about 3,500 investors over the period 1995-2014. These investments reflected 4,659 funds – the combination of traditional VC and impact VC funds. From this sample they isolated 159 as being impact funds using a strict criterion that the fund must state dual objectives in its motivation. They then constructed six impact categories: environmental impact (28%), minority and women funding (11%), poverty alleviation (43%), social infrastructure development (e.g., health, education and mainstream infrastructure, 16%), small and medium enterprises (SMEs) funding (42%), and focused regional development (jobs creation and economic development funds in a specific region, 33%). Following is a summary of their findings:
- Traditional funds had a mean (median) internal rate of return (IRR) of 11.6% (7.4%), while impact funds had a mean (median) IRR of 3.7% (6.4%). The same pattern emerged for value multiples and imputed public market equivalents. After controlling for fund characteristics, the ex-post financial returns earned by impact funds were 4.7 percentage points lower than those earned by traditional VC funds.
- From 2000 onward, the standard deviation of IRRs for traditional and impact funds was similar (16.8% versus 14.7%).
- In random utility/willingness-to-pay (WTP) models, investors accepted 2.5-3.7 percentage points (ppts) lower IRRs ex ante for impact funds.
- Development organizations, public pensions (which may be subject to political pressures), Europeans and United Nations Principles of Responsible Investment signatories had high WTP.
- Financial institutions – banks and insurance companies – had high WTP, likely reflecting their incentives to invest in local communities, either to comply with the Community Reinvestment Act (CRA) and/or to garner goodwill from the community or politicians/regulators.
- Mission focus (i.e., development organizations and foundations) was associated with a positive WTP of 3.4-6.2 ppts in expected excess IRR.
- Political or regulatory pressure was associated with a positive WTP of 2.3-3.3 ppts in expected excess IRR.
- Those subject to legal restrictions (e.g., Employee Retirement Income Security Act) exhibited low WTP.
- Impact funds focused on environmental impact, poverty alleviation, and women or minorities generated the highest WTP estimates. In contrast, impact funds focused on small- and medium-sized enterprises and social infrastructure (e.g., health, education and mainstream infrastructure) funds did not generate investment rates that reliably differed from those of traditional VC funds.
Summarizing their findings, Barber, Morse and Yasuda concluded: “Our results provide compelling evidence that investors are willing to pay for nonpecuniary characteristics of investments.” They noted that this is consistent with research findings that SRI mutual fund flows are less sensitive to performance than non-SRI flows. They added: “This result indicates that the capital allocation decisions, though certainly governed by the linchpin risk-return tradeoff of wealth maximization in standard utility models, are also shaped by the real-world consequences of the investments that people make.”
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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[1] Depending on how you identify ESG assets, those numbers are considerably less.
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As predicted by theory, increased investor demand has resulted in higher returns for public stocks with good environmental, social and governance (ESG) characteristics. Unfortunately, that means future returns will be lower for those stocks. New research confirms that this is also the case for private “impact” investments.
