Investment Managers Are Adjusting to ESG as a Requirement, Not a Request

Investment Managers Are Adjusting to ESG as a Requirement, Not a Request

Alternative assets managed under an ESG framework continue to accumulate, and are now estimated at 40% of the $14tn industry. As ESG momentum gathers pace, demand is growing for investment managers to prove their efforts.

What can managers expect from clients and regulators in the future, and how can ESG investing be improved? Industry experts Bobby Turner, Principle and CEO of Turner Capital, and Dazzle Bhujwala, Director, Investor Network at Ceres, shared their thoughts in Preqin’s Motivating ESG in Alternatives webinar on 28 January.

Here are some highlights from our conversation:

Geographically, Preqin is seeing varying degrees of ESG commitment in the asset management environment. Asset owners were the earliest adopters, with slower response rates seen among the investment management industry. What are the incentives for managers to commit to an ESG framework?

Bobby Turner opened:

“Firstly, with regards to asset owners and business operators, the incentives have been clear for some time now. They see a clear correlation between an ESG framework, or between doing good socially and environmentally, and profits. Over the past decade they’ve witnessed a paradigm shift in consumer values and corresponding habits of spending, with the majority of consumers choosing brands they believe represent their values and rejecting brands that don’t. These organizations recognize that a failure to employ ESG practices such as equal pay, diversity, and environmentally responsible supply chains puts the revenues and enterprise value at risk, regardless of their underlying business.

It's a little more complicated on the investment management side. Where most investors and some allocators see a clear correlation between the profits and purpose, most managers believe the opposite. They see that if you're going to superimpose a social metric on a financial return, it will come at the cost of yield.

The elephant in the room here is that yields, or profits, are typically the sole metric on how investment managers are measured and compensated. If managers believed that employee ESG practices at work or investing in companies with a social or environmental mission were good for returns, I don't think we'd be having this conversation.

And therein lies the quagmire and, of course, I wouldn't be on this panel if I believed that, because I am in a unique position to refute this. Turners’ focus on investing in minority communities has continuously proven that investing in social change does not come to sacrificing yield if done correctly.”

Dazzle Bhujwala agreed, adding:

“LPs just don't rely on numbers and ratings; they want to engage with their managers to understand to what extent ESG or climate issues are linked with GPs’ strategic risk management and strategy diversification decisions.

We all understand that, yes, it is important to have a more defined and prescriptive approach to ESG, but we can't wait for that golden day to arrive. The best approach for any GP is to start somewhere and try to get ahead of the curve. They should report on environmental and social factors that are relevant to their investment decisions and, where they can, collect data that is meaningful, auditable, and cost effective.

If meeting LP demand is a key incentive, then GPs need to share their approach with them. It doesn’t need to be the perfect answer, but they need to show how they are adopting ESG and how they are moving toward engaging portfolio companies.”

In Preqin’s most recent study of managers’ ESG transparency, we noticed that they became less transparent from the firm level to the asset level. For larger managers, impact investing may require a certain amount of flexible morality, where only some investments focus on making a positive impact, while other areas of the firm do not. Does transparency take away that flexibility when it’s reduced to a binary response?

Turner answered:

“It depends if we're talking about practices or investments. It's very easy to show transparency in practice; Washington-based non-profit Business Roundtable said that businesses should be held accountable for more than just the purpose of shareholder benefits and that business should be a force for good. I'd be hard pressed to say that when those titans of industry went back to their day jobs, they truly implemented those strategies at their own firms.

When it comes down to specific assets or investments, it becomes a little more difficult because it’s an art, not a science. A manager can check the box and say that it’s impactful, but is it a good impact or a bad impact? I don't think many people have the skillset to recognize a positive impact and, more importantly, how to measure it. Analytically, can you superimpose the impact of investments to demonstrate that they correlate positively with risk-adjusted returns?

Social initiatives correlate with socially enriching infrastructure, and are much more defensive during times of global and political crisis, so it is defensive alpha for a portfolio.”

Bhujwala added:

“There are two points here I see that are driving the market in the direction it’s going. To Bobby’s point, I completely understand that transparency is required – gone are the days when you can tick the box without proving or justifying the intent behind doing so.

There are two market dynamics which are really forcing transparency. The first is the regulatory framework. Regulatory requirements are coming fast across countries. Investors and managers are going to be required to disclose specific environmental and social standards to meet regulations. The EU's Sustainable Finance Disclosures Regulation (SFDR) is likely to come into force in early 2022 and will require mandatory disclosures on environmental and social standards from both asset owners and managers.

Much more strongly going forward, and beyond regulations, I think it’s important to note that as more and more asset owners come into ESG, they are going to demand transparency from their managers. So as more LPs raise the climate and ESG ambitions for their portfolios, they will go beyond asking the standard questions.

LPs will demand that GPs articulate and refine their investment processes, redefine value creation playbooks, and enhance these disclosures in alignment with TCFD framework, or even in terms of SASB on the operational and accounting legal disclosures. So, I think the market is moving in a positive direction; there is demand from LPs and regulation is supporting that.”

Read more from Charlie McGrath and the Preqin writers: https://www.preqin.com/insights/research/blogs/investment-managers-are-adjusting-to-esg-as-a-requirement-not-a-request