Category: Finance

Four Things No One Will Tell You About ESG Data

As the ESG finance field and the use of ESG data in investment decision-making continue to grow, our authors seek to shed light on several important aspects of ESG measurement and data. This article is intended to provide a useful guide for the rapidly rising number of people entering the field. The authors focus on the following:

    1. The sheer variety, and inconsistency, of the data and measures, and of how companies report them.  Listing more than 20 different ways companies report their employee health and safety data, the authors show how such inconsistencies lead to significantly different results when looking at the same group of companies.
    2. “Benchmarking,” or how data providers define companies’ peer groups, can be crucial in determining the performance ranking of a company. The lack of transparency among data providers about peer group components and observed ranges for ESG metrics creates market-wide inconsistencies and undermines their reliability.
    3. The differences in the imputation methods used by ESG researchers and analysts to deal with vast “data gaps” that span ranges of companies and time periods for different ESG metrics can cause large “disagreements” among the providers, with different gap-filling approaches leading to big discrepancies.
    4. The disagreements among ESG data providers are not only large, but actually increase with the quantity of publicly available information. Citing a recent study showing that companies that provide more ESG disclosure tend to have more variation in their ESG ratings, the authors interpret this finding as clear evidence of the need for “a clearer understanding of what different ESG metrics might tell us and how they might best be institutionalized for assessing corporate performance.”

What can be done to address these problems with ESG data? Companies should “take control of the ESG data narrative” by proactively shaping disclosure instead of being overwhelmed by survey requests. To that end, companies should “customize” their metrics to some extent, while at the same time seeking to self-regulate by reaching agreement with industry peers on a “reasonable baseline” of standardized ESG metrics designed to achieve comparability. Investors are urged to push for more meaningful ESG disclosure by narrowing the demand for ESG data into somewhat more standardized, but still manageable metrics. Stock exchanges should consider issuing—and perhaps even mandating—guidelines for ESG disclosures designed in collaboration with companies, investors, and regulators. And data providers should come to agreement on best practices and become as transparent as possible about their methodologies and the reliability of their data.

Authored by Sakis Kotsantonis and George Serafeim

ESG as a Value-Creation Tool for Active Investors: A Profile of Inherent Group

A growing number of investment managers claim to integrate environmental, social, and governance considerations into their investment strategy and processes, write Tony Davis and Beau Lescott in this Spring issue article, but few have described how they do so in depth. Even fewer reinforce the importance of sustainability within their own firms by becoming a certified “B Corporation.” This article offers a rare, inside look at how one such value-oriented manager uses ESG as a tool for differentiated investment sourcing, underwriting, and corporate engagement with the aim of achieving superior risk-adjusted returns.

One of the main arguments of the article—and a key principle of the firm’s investment approach—is that ESG, as applied to both corporate strategy and operations, is an important factor in determining a company’s cost of capital. The authors present specific examples of their investment process at work, highlighting how active engagement with management on ESG issues can catalyze progress that becomes valued by the capital markets.

Authored by Tony Davis and Beau Lescott

Private Equity 4.0: Using ESG to Create More Value with Less Risk

A growing number of private equity firms have responded to the increased focus on climate change, social issues, and technology disruption, write the authors in this Spring issue article, by broadening their corporate mission to encompass all important stakeholders, as well as their limited partners. And in the process, the management of ESG risks and pursuit of ESG opportunities have become increasingly fundamental to the staying power and value creation potential of PE firms by reducing the risk of their investments, discovering new sources of growth, and increasing their resilience to changes in the political and regulatory environment.

This article tells the story of how the Nordic PE firm, Summa Equity, has turned its ESG approach into a core competence and a source of competitive advantage that has enabled the firm to distinguish itself from its competitors and bring about significant improvements in the financial performance of its portfolio companies while providing benefits for their stakeholders. Using the U.N. Sustainable Development Goals to guide them, the firm invests in companies they perceive to be addressing major environmental or social challenges in an innovative and commercially successful way. This has led to investments in significant growth opportunities in areas such as health care, education, waste management, and acquaculture. And the firm’s returns to its investors have been high enough—and the perceived social benefits large enough—that the firm recently closed its second fund (which was significantly oversubscribed) for 650 million euros, and received the ESG award at the 2019 Private Equity Awards in London.

Authored by Reynir Indahl and Hannah Gunvor Jacobsen

Save the Buyback, Save Jobs

In the final article of our Winter issue, the authors explain the role of buybacks in increasing corporate productivity.

In response to a recent New York Times op-ed by Senators Schumer and Sanders deploring the effects of stock buybacks on workers and the economy, the authors explain the role of buybacks in increasing corporate productivity and in recycling “excess capital” from mature companies with limited growth and employment opportunities to the next generation of Apples and Amazons. Some companies, as Schumer and Sanders charge, are guilty of repurchasing shares in the name of “shareholder value maximization” instead of pursuing job-creating investments. But as the authors argue, well-run companies increase shareholder value not by boosting EPS through buybacks, but mainly by earning competitive returns on capital and investing in their long-run “earnings power.” And by paying out capital they have no productive uses for, such companies give their own shareholders the opportunity to reinvest in other companies with promising prospects for growth and jobs.

But the authors go on to note the tendency of companies to buy back shares not when their stock prices are low, but instead when the companies are flush with cash and nearer the top than the bottom of the business cycle. The result of this tendency, as research by Fortuna Advisors (the authors’ firm) shows, is that fully three quarters of companies doing large buybacks during the period 2013-2017 failed to produce an adequate “Buyback ROI,” a metric developed by Fortuna that indicates management’s effectiveness in “timing” its stock repurchases.

Given the usefulness of buybacks in recycling capital, the authors conclude that the most reliable solution to the corporate short termism and underinvestment problem is for companies to adopt better financial performance measures—including Buyback ROI—to guide their capital allocation. And when management determines that it has significantly more capital than value-adding investments, but wants to avoid committing to unsustainable dividend increases, it should consider buybacks—but only if management is convinced that its stock price has not outpaced performance.

Authored by Greg Milano and Michael Chew

The Economic Significance of Long-Term Plans

The third article of our Spring issue, is a summary of the findings of an event study of the capital market reactions to an inaugural set of 17 CEO presentations of their “long-term plans” to institutional investors. The findings show that, although sell-side analysts appear unresponsive to such plans, both trading volumes and stock prices exhibit significant abnormal reactions to the presentations, providing suggestive evidence that the communication of such plans conveys “value-relevant” information to investors with longer time horizons. Although based on an admittedly small sample, these findings shed light on the promise of long-term plans and have been corroborated by analysis of the market response to the presentations of 10 more companies since the study was conducted.

The authors also provide the outlines of a “content framework” designed to help companies put together effective corporate plans and other long-term disclosures. The framework is organized around nine main “themes,” including policies governing capital allocation, corporate governance, and human capital development, as well as the statement of corporate purpose. After applying this framework to the 17 CEO presentations, the authors find that the more specific and forward-looking the information disclosed in these long-term plans, the more positive the capital market reaction.

Authored by Sakis Kotsantonis, Christina Rehnberg, George Serafeim, Brian Tomlinson, and Bronagh Ward

Aptiv Becoming a More Sustainable Business

In “Aptiv Becoming a More Sustainable Business” in our Spring issue, the President and CEO of Aptiv presents and then discusses his progress in carrying out his “long-term plan” to transform an automotive parts supplier that was once part of General Motors into a “global technology company.” The company’s mission is to maintain and strengthen its current position as “a partner of choice” of the world’s largest automakers in designing and manufacturing “the brain and the nervous system of the vehicle”—and in so doing, to make vehicle transportation “safer, greener, and more connected.”

With 15 major tech centers and 126 manufacturing sites spread across 44 countries, and with over 160,000 employees, including 18,600 engineers and scientists, the company has the scale and resources to carry out that mission. And attesting to the resilience of its business model, in 2018, a year in which the global number of cars sold actually went down, the company increased its revenue by 10% and its operating cash flow by 50%.

In the area of safety, the company is helping its customers build vehicles that move the industry closer to its goal of zero traffic fatalities and accidents by delivering the building blocks of active safety systems—which include perception and vision systems, and the high-speed and high-reliability networks that connect them. (And promising even greater gains in safety, the company’s advances in fully automated vehicles are helping make self-driving cars a reality.) In terms of green initiatives, the company is focused on minimizing the vehicles’ “total lifecycle impact on the environment” by providing the high-voltage distribution and connection systems for electric cars, while also using “smarter” vehicle architectures to achieve significant reductions in weight and mass. Finally, the company is helping the industry incorporate the increased connectivity that aims to provide a seamless integration between the passenger, the vehicle, and the Internet of Things.

The company’s commitment to corporate social responsibility goes well beyond its products and solutions. As an important part of its disciplined approach to creating sustainable long-term value for its shareholders, the company tracks a range of key performance indicators designed to ensure that “we devote the right amount of time and attention to each of our key stakeholders.” Along with its stakeholder programs and ongoing investment in human capital, which have helped the company win the designation “one of the world’s most ethical companies” in seven consecutive years, the CEO also cites the important roles played by its highly collaborative and engaged board of directors, and by a long-term incentive pay plan for its senior management team that, along with standard financial measures, uses a “strategic results modifier” that reflects the company’s success in meeting “non-financial goals that are related to talent, culture, and product quality.”

Authored by Kevin P. Clark

A Fireside Chat with Raj Gupta (or What It Takes to Create Long-Term Value)

Starting off our Spring issue, the chairman of two public companies (and former chair and CEO of Rohm and Haas) draws on his experience as a director of five private and 15 public companies in discussing the challenges and opportunities facing today’s corporate boards.

Perhaps the most formidable challenge is the pace of technological change, which is making business models “in all industries and countries” obsolete and forcing companies to adapt much more quickly than in the past. Along with the risk of obsolescence is the increase in “reputational risk” associated with an “information age” in which companies are forced to monitor the nearly continuous flow of fact, hearsay, and outright fabrication.

The author recommends that public company boards adopt a new “partnership” model. Besides ensuring an “ethical tone at the top,” corporate directors should aim to become partners with the senior management team by playing more active roles in strategic planning, risk management, and the design of performance evaluation and incentive pay systems. In the most striking departure from current practice, the author urges directors to seize the opportunity created by the “reconcentration” of ownership of U.S. public companies by actively engaging large institutional investors in a strategic dialogue about the companies’ strengths and vulnerabilities. In so doing, proactive directors can help their management teams preempt shareholder activists and create long-run value by creating a more effective two-way channel of communication, one with the potential to give management more confidence when undertaking large strategic investments with longer-run payoffs.

A conversation with Raj Gupta with Mark Tulay

Do Large Blockholders Reduce Risk?

In the sixth article of our Winter issue, the authors review the role and influence of companies with “blockholders” — shareholders with large positions in a particular company

The conventional assumption in the asset pricing literature is that the identity of a company’s owners is largely irrelevant, but studies of companies with “blockholders”—shareholders with large positions in a particular company—provide grounds for questioning this assumption.  Unlike the well-diversified investors of modern portfolio theory, blockholders have strong incentives to monitor corporate performance and, when necessary, to exert control over ineffective managements and boards. The findings of many studies support the idea that blockholders have a positive effect on rates of return.

The authors of this article report the findings of their recent investigation of whether blockholders might also have a positive effect on shareholder value by reducing the risk of the companies in which their holdings are concentrated. After distinguishing between companies with individual as opposed to corporate blockholders, and those with one share, one vote as opposed to those with dual-class shares, the authors find that ownership of large positions by individuals—but not corporations—was associated with lower systematic risk (when using both Fama-French multiple factor and CAPM models). At the same time, they find that the firm-specific risk of such companies was higher, but “biased” toward positive outcomes—that is, smaller downsides with larger upsides. What’s more, this upward shift in performance and risk-profile was achieved at least partly through increases in productivity as reflected in higher profit margins, profitability, profit per employee, and operating leverage, and lower costs of goods sold, SGA, and cash holdings. By contrast, in the case of blockholders in companies with dual-class share structures, all of these positive associations with blockholders were either significantly weaker, or reversed. That is, whereas the presence of individual blockholders appears to increase productivity and value under a one share, one vote governance regime, blockholders in companies with dual-class structures were associated with higher systematic risk and reduced productivity and value.

Authored by David Newton and Imants Paeglis

How Has Takeover Competition Changed Over Time?

The fifth article of our Winter issue, examines how, since the boom in takeovers in the 1980s, research in both law and financial economics has debated the role of takeover impediments such as poison pills, staggered boards, and state antitakeover laws. Have these impediments entrenched target management to the detriment of shareholders? Or have they increased the bargaining power of target boards of directors and left shareholders, if not better off, then at least unharmed?

In their study published recently in the Journal of Corporate Finance, the authors provide new answers to these questions with a detailed analysis of takeover competition during the period 1981 through 2014. Using a random sample of 388 completed and withdrawn deals from this 34-year period, the authors begin by confirming the already well-documented increase in the use of takeover impediments over time. They then report evidence that takeover competition has not declined during this period.

First of all, takeover premiums—the average percentage over market paid by acquirers to consummate transactions—have remained steady over time. Second, and the most striking of the authors’ findings, is that the corporate auction process has “gone underground” since the 1980s. Although we now see fewer hostile attempts and publicly reported takeover bidding contests, the amount of competition for targets has remained largely unchanged when one takes account of “private” as well as public auctions—that is, contests that, as the authors discovered, included unidentified bidders.

The authors view such a fundamental change in the takeover auction process as a response to the widespread growth of takeover impediments. In this sense, as Bill Schwert commented years ago, “hostile takeovers are less about shirking target management than about the bargaining tactics of targets and bidders.” Or as the authors put it, “the greater bargaining power provided by state laws and other takeover impediments has changed the manner in which takeover auctions are conducted,” but without greatly affecting the goal of economic efficiency that such transactions are designed to help bring about.

Authored by Tingting Liu and Harold Mulherin

The Early Returns to International Hedge Fund Activism: 2000-2010

In the fourth article of our Winter issue,the authors summarize their recent article in the Review of Financial Studies,. They provide an overview of the methods and findings of the first comprehensive study of worldwide hedge fund activism—one that examined the effectiveness of some 1,740 separate “engagements” of public companies by 330 different hedge funds operating in 23 countries in Asia, Europe, and North America during the period 2000-2010.

The study reports, first of all, that the incidence of shareholder activism is greatest in companies and countries with high institutional ownership, particularly U.S. institutions. In virtually all countries, with the possible exception of Japan, large holdings by institutional investors increased the probability that companies would be targeted by activists. Nevertheless, in all countries (except for the United States), foreign institutions—especially U.S. funds investing in non-U.S. companies—have played a more important role than domestic institutional investors in supporting activism.

The authors also report that those engagements that succeeded in producing “outcomes” were accompanied by positive and significant abnormal stock returns, not only upon the announcement of the activist’s block purchase, but throughout the entire holding period. “Outcomes” were identified as taking one of four forms: (1) increases in dividends or stock buybacks; (2) replacement of board members; (3) corporate restructurings such as sales or spinoffs of businesses; and (4) takeover (or sale) of the entire company. But if such outcomes were associated with high shareholder returns, in the many cases where there were no such outcomes, the eventual, holding-period returns to shareholders, even after taking account of the initially positive market reaction to news of the engagement, were indistinguishable from zero.

The authors found that activists succeeded in achieving at least one of their proposed outcomes in roughly one out of two (53%) of the 1,740 engagements. But this success rate varied considerably across countries, ranging from a high of 61% for North American companies, to 50% for European companies, but only 18% engagements of Asian companies—with Japan, again, a country of high disclosure returns but unfulfilled expectations and disappointing outcomes. Outcomes also tended to be strongly associated with the roughly 25% of the total engagements that involved two or more activists (referred to as “wolfpacks”) and produced very high returns.

Authored by Marco Becht, Julian Franks, Jeremy Grant, and Hannes F. Wagner