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The State of Financial Performance in Impact Investing, Part One

Anisa Dougherty, Impact Analyst

Even as impact investing moves into the mainstream, the perception—whether true or imagined—of a financial trade-off remains a barrier. We at Threshold Group are often asked by first time impact investors: will I have to sacrifice financial return for impact?

Our answer? Not necessarily.

Here we explore the evidence showing that we need not sacrifice financial returns to generate positive social or environmental impact.

In part one of this two-part series, we will focus on public market investments. Part two will discuss private markets and what all of this means for the newly minted impact investor.

Public Market Investments

There is a growing body of research showing that companies that perform well on environmental, social or governance (“ESG”) metrics tend to perform better financially than their traditional counterparts – exhibiting lower volatility, better operational performance and lower costs of capital. Below is a small sample of recent reports:

  • A 2015 study by Deutsche Bank reviewed 2,200 studies and found that 90% show a non-negative relationship between ESG and corporate financial performance, suggesting that at the very least ESG does not detract from performance. The study also found that a large majority of the 2,200 studies demonstrate a positive relationship between ESG and financial performance, suggesting that ESG can benefit performance.[1]
  • A 2015 report by Morgan Stanley found that sustainable investing has performed as well—and often outperformed—comparable traditional investments on both an absolute and risk-adjusted basis, across asset classes and over time. For example, the study reviewed 7 years of performance data for 10,228 open-end mutual funds. Their sample of sustainable mutual funds showed equal or higher median returns and equal or lower median volatility for 64% of the periods when compared to their traditional counterparts.[2] 
  • A 2015 meta-analysis by Oxford University assessed 200 studies. Roughly 90% of the studies on the cost of capital show that strong sustainability standards lower the cost of capital, suggesting that the market perceives these companies as lower risk. Likewise, 88% of the studies show that companies with sound ESG practices exhibit better operational performance by more efficiently translating resources into revenue.[3]
  • A 2011 Harvard Business School study compared the stock performance of 180 large U.S. firms, classifying 90 as high sustainability and 90 as low sustainability. Both sets of companies operated in the same sectors and exhibited identical size, capital structure, operating performance and growth opportunities. The study found that high sustainability firms outperformed their counterparts. Given a $1 investment in 1993 in a value-weighted portfolio of high sustainability versus low sustainability firms, the high sustainability portfolio would have grown to $22.60 by 2010, while the low sustainability portfolio would have reached $15.40, a 46% difference.[4]

So why do ESG investments tend to fare as well or better than their mainstream counterparts?

Risk management

ESG data can help companies and investors identify long-term risks that sit outside the balance sheet but still affect value. For example, climate change, water scarcity, and poor labor conditions can adversely impact business operations. Likewise, poor workplace policies or unsustainable business practices can pose reputational as well as regulatory risks, potentially leading to declining sales and lower valuations. In an era where 84% of the value of the S&P 500 is concentrated in “intangibles”–such as intellectual property, human talent and public goodwill—understanding ESG risk equates to understanding other dimensions of financial risk.[5] 

Value creation

The smart use of ESG data can also help investors identify companies that are building a competitive advantage through enhanced environmental and social practices. First, companies have the opportunity to reduce operating cost and expand margins by improving resource management (e.g. water, energy, carbon, waste, etc.) in their supply chains. Second, companies making products with strong environmental or social components may be tapping into under-appreciated sources of value creation.

An information edge

Finally, ESG is emerging at a time when it has become difficult for investors to capture an informational advantage. In contrast to financial information—which is standardized, mandatory and rapidly integrated into stock and bond prices—ESG information is voluntary, selective and slow to be priced into the market. Furthermore, few investment managers have the expertise to sift through ESG data to understand what is value-relevant. Today, less than a quarter of investment professionals consider extra-financial information in their investment decisions[6] and just 10% receive formal training on how to consider ESG in their investment analysis[7]. These information asymmetries present a window of opportunity to identify investments that are under-appreciated.

In summary, ESG can augment traditional financing analysis by helping investors and companies manage risk and identify opportunities that mainstream markets may not readily perceive.

[1] Friede, G., Busch, T., and Bassen, A. ESG and financial performance: aggregated evidence from more than 2000 empirical studies. Journal of Sustainable Finance & Investment. December 2015. 
[2] Morgan Stanley: Institute for Sustainable investing. Sustainable Reality: Understanding the Performance of Sustainable Investment Strategies. March 2015. 
[3] University of Oxford. From the Stockholder to the Stakeholder: How Sustainability can drive financial outperformance. March 2015.
[4] Eccles, R., Ioannou, I. and Serafeim, G. The Impact of Corporate Sustainability of Organizational Processes and Performance. November 2011. 
[5] Ocean Tomo. 2015 Annual Study of Intangible Asset Market Value. 2015. 
[6] EY. Tomorrow’s Investment Rules 2.0. Emerging Risk and Stranded Assets Have Investors Looking for More from Nonfinancial Reporting. (EY Climate Change and Sustainability Services). 2015. 
[7] CFA Institute. Environmental, Social and Governance (ESG) Survey. 2015.

 

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Impact investments are investments made into companies, organizations, and funds with the intention to generate measurable social and environmental impact alongside a financial return. Impact investments can be made in both emerging and developed markets, and target a range of returns from below market to market rate, depending upon the circumstances. Impact investors actively seek to place capital in businesses and funds that can harness the positive power of enterprise. Impact investing occurs across asset classes, for example private equity / venture capital, debt, and fixed income.

Impact investors are primarily distinguished by their intention to address social and environmental challenges through their deployment of capital. For example, criteria to evaluate the positive social and/or environmental outcomes of investments are an integrated component of the investment process. In contrast, practitioners of socially responsible investing also include negative (avoidance) criteria as part of their investment decisions. Threshold Group makes no representations or guarantees that any specific investment opportunities will meet such goals of impact investors or impact investments.