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E-MailRonald J. Gilson is Stern Professor of Law and Business at Columbia Law School and Meyers Professor of Law and Business Emeritus at Stanford Law School; Paul Brest is Professor Emeritus at Stanford Law School; and Mark A. Wolfson is Adjunct Professor in Accounting and Finance at Stanford Graduate School of Business. This post is based on their recent paper. Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst.; and Social Responsibility Resolutions by Scott Hirst (discussed on the Forum here).
Most investors have a single goal: to earn the highest financial return. These socially-neutral investors maximize their risk-adjusted returns and would not accept a lower financial return from an investment that also produced social benefits. An increasing number of socially-motivated investors have goals beyond maximizing profits. Some seek to align their investments with their social values (value alignment), for example by only owning stock in companies whose activities are consistent with the investor’s values. Others may also want their investment to make portfolio companies create more social value (social value creation).
In an essay available here, we show that while achieving value alignment is relatively easy, creating social value is far more difficult.
The literature published by asset managers, foundations, and trade associations expresses optimism that socially-motivated investors can create social value, particularly through non-concessionary investments. We are skeptical about these assertions; they are often too loose to support a disciplined assessment of the claim, and the absence of fees keyed to social, rather than financial, value creation fuels that skepticism. To address this problem, we first offer a taxonomy of socially-motivated investments so that investors can clearly articulate their goals, and asset managers can clearly articulate how their performance should be measured.
We then address three big questions. First, can investments in public companies create social value whether or not with concessions on return? Second, can investments in private companies create social value, again whether or not with return concessions? Third, can investors, working with socially motivated stakeholders, cause public corporations to create social value.
The thrust of our essay is as follows:
- Value-alignment. Socially-motivated investors who only wish to align their portfolios with their values must determine whether a potential investee company’s outputs and practices are so aligned; and whether concentrated holdings in or divestment from a particular sector will increase portfolio risk by reducing diversification. If portfolio risk is increased, then the investor must decide whether to pay the price of value-alignment. Value alignment is important, but we think it is extremely important not to confuse it with social value creation.
- Social value creation. As the term “impact” suggests, impact investors wish to go beyond value alignment to create social value by using their investment decisions to influence a portfolio company’s performance. This requires that:
- The investee company’s outputs or practices have social value beyond the private value created between firms and those with whom they contract directly.
- The investment either must 1) lower the cost of capital compared to commercial markets, thereby allowing it to produce more socially valuable outputs; or 2) provide the portfolio company with expertise it does not have, with the same effect.
- Public markets. It is virtually impossible for a socially-motivated investor to affect the outputs or behavior of companies whose securities trade in public markets through buying and selling shares in the secondary market. Socially-motivated investors who seek to affect public companies’ ESG practices must join forces with consumers, employees, corporative activists, and regulators. As we have seen, ESG-based proposals are gaining institutional investor support when proposals explicitly tie to company financial performance.
- Concessionary investments in private markets. It is possible for concessionary impact investors to affect the outputs of portfolio firms through private market transactions by providing subsidies through accepting financial returns below the level that socially-neutral investors would require. Foundations’ program-related investments are examples. The difficulties of concessionary impact investments lie in targeting the subsidy so as to benefit one’s intended beneficiaries by, for example, assuring accountability for whether and how much social value was created.
- Non-concessionary investments in private markets. It is also possible for non-concessionary impact investors to affect the outputs of firms while still earning a risk-adjusted market return through private market transactions by taking advantage of private knowledge or special expertise that they or their fund managers possess. However, such claims to value-relevant private information should be viewed with healthy skepticism. These investors play in a highly competitive game with the universe of private equity investors whose success depends on developing such private information. The ultimate test of a non-concessionary impact investment is whether 1) the risk adjusted financial returns match the market, a familiar assessment for which there are accepted measurement techniques, and 2) how much social value is created, for which there is still little consensus on how to measure it. The differential measurability of financial and social value has resulted in asset managers running impact funds being paid based (almost) exclusively on financial value. If the managers’ success in creating social value cannot be measured, neither can that of the investors.
We disagree with those who define impact investing to include only concessionary, or only non-concessionary, investments. Under appropriate circumstances, both can create social value. But the field can only grow responsibly if impact investing trade associations, foundation officers and asset managers are candid about the conditions necessary for social value creation and rigorous with respect to how it should be measured.
This leads us to offer some advice for the large majority of individual impact investors who place their confidence in the general partners of impact funds.
- First, it is difficult, though not impossible, for a fund to create social value—as opposed to achieve value alignment—while also promising to deliver market-rate financial returns or better. Funds that promise both deserve special scrutiny and clarity of how both elements of performance will be measured.
- Second, a serious impact fund should report on the amount of social value created, including how it was calculated. A strong signal of commitment to creating social impact as well as financial returns would be that asset manager’s compensation is based on the social value created as well as on financial returns. We note that doing so is difficult because vague measurement standards impose risk on the general partner that effects incentives.
- Third, make sure that the fund manager is using appropriate benchmarks for the fund’s performance. The appropriate benchmark against which to evaluate private investments is other private investments, including the illiquidity premium associated with such investments.
- Fourth, be especially skeptical of a private impact fund that includes pubic equities.
- Finally, the socially-screened ESG mutual fund industry should be regarded as offering investors a value alignment strategy, not an impact investment strategy. Prospective investors should understand the premium expense ratios charged by such funds, the sacrifice in diversification these funds may incur and the financial engineering employed to offset diminished diversification. Investors should also be skeptical of claims of impact that may appear fund marketing materials.
The complete paper is available for download here.
