Why should investors incorporate ESG into their strategies, and how has the pandemic changed the outlook for ESG? Tony Davis of Inherent Group joins Bhakti Mirchandani of Trinity Church Wall Street to discuss responsible investing.
***
As the Pandemic shifts to its next phase, it’s time to start thinking about what it means for ESG investment. This conversation, hosted by the iConnections Investment Institute on 3 December 2020, brought together two impressive figures from the ESG world.
Tony Davis is CEO & CIO of Inherent Group, a sustainable investment firm that invests across capital structure in both the public and private markets. He was in conversation with Bhakti Mirchandani, Director of Responsible Investing at Trinity Church Wall Street, a thriving Episcopal congregation in lower Manhattan.
***
Tony: It’s been quite a year in terms of what we’ve seen on the ESG front, both in terms of themes, in terms of in-flows and in terms of performance.
There will clearly be trillions of assets that are stranded as a result of climate change; it’s a huge investment opportunity. There’s been a lot of in-flows into ESG this year and a number of these names have really outperformed in a significant way. You have to balance that with the facts about penetration in these spaces. I mean, EVs are less than 1% of the global car fleet. Green energy is still single digits penetration in terms of electricity generation. So, the runway for these businesses to continue growing is extraordinary. We talk sometimes about payments or about cloud penetration and become excited in terms of how much of a runway there is there still, but you know, it’s nowhere close to what there is in renewable energies and EV penetration.
Other things this year have really come to the forefront. The trade in healthcare has been to invest in the company that is earning excess rents and, you know, go long. And I think that’s changing now. One, because Medicare is likely to go cash-flow negative in the next couple of years, and healthcare’s spend approaches 20% of GDP, it’s just not supportable. And two; with the pandemic and the need to figure out different ways of providing healthcare services, we’ve seen some businesses like remote healthcare really accelerate their penetration. I think people understand that it’s cheaper and it can lead to better results.
We’ve seen businesses and innovation around providers taking on risk in managed Medicaid products which I think is moving us towards value-based reimbursements. We’ve seen providers setting up ambulatory surgery centers, which again have one of these rare trifectas in healthcare where the doctors like it better, the patients like it better and the payers like it better. I think the pandemic and what we’ve gone through has really highlighted the social aspect of ESG.
Bhakti: Tony, how have you managed the use of sustainable development growth with thematic investing, and the broad momentum behind some of these themes?
Tony: I like the description of the sustainable development goals as the strategic plan for the Earth. You’re investing with a tailwind. It isn’t enough that they’re just aligned with all those trends, we have to find valuation attractive as well. And then, conversely, we find some companies that really just aren’t investing in those trends, or may just be at odds with those trends. That might be in traditional auto manufacturers or tier one suppliers that haven’t invested in electrification; it could be in carbon-intensive steel production; it could be in healthcare businesses that really still rely on moats and they’re not really offering what we think is value for money to their customers. We look for those on the short side.
On ESG integration it depends heavily on the sector, and on what that company’s particular strengths and weaknesses are. Just to give some examples on the social side of things through the pandemic, we reached out early and signed an investor statement related to coronavirus encouraging our companies to do their best to maintain employment. If they could furlough, maintain benefits, and then if they did have to terminate, really to do so with transparency and communication. But a number of our companies really leaned in on maintaining their workforces and articulated that this would cost them money in the short term, but that they felt it would allow them to emerge stronger from the crisis, and take market share, emerge with their workforce intact and emerge with a productive workforce. So, that was something that we encouraged, and we saw a few of our companies really lean in on that.
Bhakti: Even though the SDGs are a strategic plan for the Earth, and there’s a lot of momentum behind them, it will be difficult to achieve them with purely commercial capital just given the magnitude of the goals. What do you see as the rule for blended finance, and how are you engaging in blended finance?
Tony: So we also manage a foundation. We manage the endowment of the foundation, and our goal, which we’ve achieved, was to align all of our investments in the foundation with either the mission of the foundation or at least have the impact of ESG-underwritten investments. In the foundation, we use blended finance. This is often for-profit businesses where we’ll provide capital to them at below-market rates of return.
In the US, that qualifies as a PRI, a program-related investment, that counts towards your 5% statutory disbursement requirement. And there’s been a lot of them. One of the most exciting job training programs that I’ve seen is a coding bootcamp focused on the population that doesn’t traditionally have access to coding bootcamp. So it’s for those who didn’t graduate from college: the average median income of the last cohort that I have data for was $18,000, and their median wage upon graduation — with 85% placement rate — is $85,000. It’s also skewed heavily towards a minority population, and is about 50% female.
We were really excited when we saw that, and we went in and said, look, you’ve got to scale this because the impact is so large. So we came up with a model where we lent them money at below-market rates to expand the size of the program. We also created a mechanism where the attendees, once they graduated and were placed in a high-paying job, would pay back some portion of their income to service the loans, so that we could continue to grow.
We did a pilot program with them, and they’re in the process of rolling out a much larger one. There are opportunities for wonderful social entrepreneurs where the right business model for them is a for-profit business model. In this case it was a not-for-profit that used this financing, but in other cases they’re for-profit business models where we’re investing in social entrepreneurs, often below market rates to help them scale.
It’s hard to scale blended finance solutions. I don’t know why exactly; there seems to be a lot of capital available as grant capital, and then there’s a lot of capital here in the market rate world. It’s just a lot harder to find that ‘in-between blended finance’ piece. We think it can be a really effective tool because it allows us to recycle the capital and re-deploy it out of the foundation.
The IPCC says we need two trillion at least invested annually in our clean energy systems to have a chance of staying below 1.5°C of warming, and for those sums of capital you really need the capital markets to work. That’s what we’re so excited about, in terms of what we’re doing on the capital market side and our involvement and engagement at Inherent. We think there’s this flywheel effect, and we can help be part of the conversation. There is a dialogue that gets the capital markets really thinking about how to price these externalities in, and how to encourage companies and capital flow to go towards solutions and mitigation.
Bhakti: How does an allocator know that a manager is serious about ESG?
Tony: What I typically tell folks is: ask what they’re doing as an investment manager. It’s a really good way to know if they are walking the walk. The second thing I say is: pull some investment committee memos at random, and see how ESG is really talked about in an investment committee memo and integrated into the process. It’s not just a separate function, a cost area — you really want it to be integrated into the investment process, owned by the analyst and really part of the underwriting.
I’d say as an investment manager, we measure our own carbon footprint and offset it. As an asset manager, at the top of the list is just being a good fiduciary and really putting our investors first in every decision we make.
Another thing is promoting diversity within our own firm. Firms that are more diverse in our space perform better. So it’s not just the right thing to do, it’s the right business thing to do, and I think that’s an area where we as an industry have a lot of work to do. Coming out of Black Lives Matter, we sat down as a firm and said: what can we do as a firm, and one specific thing, rather than just making a statement? Is there something specific we can do?
One thing that we have done coming out of that is to really re-think our internship program so it’s focused on internships for students that wouldn’t have the opportunity of being part of a hedge fund or a Wall Street firm. This tends to be students from households of color, and often low income neighborhoods and under-represented colleges.
We’ve taken it from being just a summer internship program to having shorter modules, so it can be evergreen throughout the year. They spend time in each of the functional areas within the firm over a three or four-week period. So we’re trying really to walk the walk and contribute to the community in the same way that we’re asking the businesses that we invest in to do.
Bhakti: You just hit on two of our three pillars. Since our first Chief Investment Officer, Meredith Jenkins, joined Trinity Church Wall Street in March 2016, and even prior to that, manager character has been a key driver of manager selection, and the investment team has used the lens of alignment with Trinity’s mission and values.
The lynchpin of our investment stewardship and integration strategy is a three- pillar framework that we use to monitor current managers and underwrite prospective ones. This framework allows us to systematically gauge the sustainability and inclusion status and momentum of each manager. The three pillars are: portfolio sustainability; manager sustainability; and diversity and inclusion. Each pillar consists of numerous factors. For example, for pillar 1, portfolio sustainability, the factors include things like the range of sustainable investing tools used, the breadth and progressiveness of the approach to sustainable investing as shown by the underlying holdings, sustainability momentum, alignment with our values and mission. These factors, roll up to manager scores.
For our current portfolio, this three-pillar framework helps us highlight manager strengths and address development areas as a thought partner and resource. For prospective managers, it helps us screen and underwrite. We’re all on a journey, and the more we can contribute to the sustainability and inclusion of our managers, the smoother the journey will be.
Some of the managers in our portfolio, like Inherent, take a cutting-edge approach to sustainable investing, and are not in particular need of capacity building. We try to be helpful by gleaning and highlighting broadly applicable nuggets from their work to share in the marketplace, as we are doing in this conversation today.
Tony, your approach to responsible investing is pretty robust. You use multiple types of tools, you have robust processes, you even publish academic research about cutting-edge sustainable investing work with a lean team. There are only so many issues you can take to a portfolio company when asking them to make changes, so how do you prioritize?
Tony: We try to understand what we think the financial material issues are, where there are gaps, and distill that into two or three things that we focus on with the management team. We’ve found that to really get their attention and their engagement, we have to come with a strong case of why we think this is good for their business over the long term, and we have to be focused. It has to be specific to their business. Whether carbon mitigation is your issue, or water conservation, or gender diversity, or the living wage, you really have to tailor the issue to the situation and the company. You must understand where that management team is on its journey, and their willingness to engage.
On the company side, we focus on those issues that we think are most critical and most financially material to them. As we find an area that we’re excited about, like wind or EVs, we tend to get deeper and learn more over time. But it’s difficult: there are a lot of investor statements, and a lot of things that we support and believe in, but we can’t send too many blanket requests to our companies or they start to get drowned out.
I think our strength has been in going really deep on a specific company, understanding their business, understanding their economics, how they make money, and showing up with an informed view of why improving these ESG issues are good for their business over the long term.
That’s where get the most traction, rather than trying to find shared resolutions or just signing on to blanket statements and sending letters out to our companies.
We did get a really good response on a ‘make time to vote’ letter that we sent to all of our portfolio companies. That was one issue we felt strongly about, that not having time off work was one of the reasons people don’t vote. We thought it was really important, and we got really good feedback from many of our portfolio companies on that one.
Bhakti: There have been so many changes this year, and you’ve talked quite a bit about how materiality has changed this year for some issues. It might be helpful for allocators and managers to hear more about your approach to distressed.
Tony: So, distress is interesting because the house is on fire, typically. Everyone is busy trying to put the fire out, but it’s a golden opportunity in restructuring. You often have a blank slate with respect to governance and how you want to move forward with the company. You can really hit the reset button.
You can think about what you want governance to be going forward, and everything stems from good governance. You can think about whether you want a separate risk committee, or even a separate sustainability committee, certainly in terms of executive compensation design and alignment. We prefer things like economic return on investment capital relative to TSR, and if it is TSR, we like it over longer timeframes We really think that in the annual incentive plans at least one of the items should be one of the top issues in that business.
We’re talking about distress, but also thinking about the capital structure more generally, like credit investing. If you think about the value of ESG as a risk assessment tool, it’s especially valuable in credit, where you have limited upside and all the downside. Really, as a credit investor, you’ve written this out of the money, but on the enterprise value of a company, you’re trying to figure out what can go wrong.
When you just spread the numbers it’s not always clear what’s going to cause the blow up. But it is things like governance, time and time again. We really pay attention to the culture of the company, to see if anything could lead to a selling crisis such as Wells Fargo, or a risk management crisis such as BP, or an entrenched CEO and a board with weak governance that becomes their personal fiefdom.
