Most private equity firms, principal investors and corporate leaders understand that businesses have a key role to play in tackling urgent challenges such as climate change and contributing to positive changes in the society. Zinqular believes that investing in companies that pursues a sustainability agenda do not runs counter to the wishes of their shareholders.
With so many perspectives on ESG and sustainable investing – flooding the business media, it’s uncommon to find one that truly original. So, when the Co-CEO of private equity firm Zinqular Group shared his simple view on sustainable investment, it stood up.
During the recent United Nations Climate Summit in Madrid; our Co-CEO – Michael Yaw Appiah sat down for an interview with Emma Nilsson – Director Media & Communications, to discuss Zinqular’s approach to sustainability and how they engage their portfolio companies on environmental, social, and governance (ESG) issues. Next, Michael describes Zinqular’s way of translating their ESG principles into action i.e. meaningful steps Zinqular is taking to integrate sustainability issues into their investing criteria.
Emma: How has ESG themes of investments changed over the past decade? Does your business treat ESG issues as “nice to do” or something for the future but not a priority today? How do you view it?
Michael: Strong Environmental, Social & Governance (ESG) performance has the power to unlock significant positive impact for investors, companies and wider society. ESG issues have become much more important to us as long-term investors. In Zinqular, we seek to analyze tangible issues such as climate risk, board quality, or cybersecurity in terms of how they impact financial value in a positive or a negative way. That’s the integrative approach we are increasingly taking for all of our investments.
The numbers validate the view that the investors and/or capital markets are in the midst of a sea change. In early 2006, when the UN-backed Principles for Responsible Investment (PRI) was launched, 63 investment companies (asset owners, asset managers, and service providers) with approximately 6.9T USD in assets under management (AUM) signed a commitment to incorporate ESG issues into their investment decisions. By Spring 2019, the number of signatories had grown to over 1700 and represented close to 82T USD in AUM. We also know that more than half of global asset owners are currently implementing or evaluating ESG considerations in their investment strategy.
Emma: How do you approach sustainable investment strategy? What is your way to sustainable investing?
Michael: Zinqular’s model of sustainable investing encompasses a menu of strategies that can be used in combination. Here are some few examples:
- We use Negative/exclusionary screening to eliminate companies in industries or countries or projects deemed questionable or objectionable.
- In the area of Norms-based screening we eliminate companies or assets that violate some international set of norms, such as for instance the UN Sustainable Development Goals for 2030 or 10 Principles of the United Nations Global Compact.
- For Positive/best-in-class screening we select companies with strong ESG performance.
- In Sustainability-themed investing we target society impacting funds or firms such as those in the area of access to clean water or renewable energy or recyclable materials, etc.
- We also use ESG integration including ESG factors in fundamental analysis to eliminate or select companies.
- We consistently engage deeply with our portfolio companies using the Active ownership model
- Impact investing – we find companies that make a positive impact on ESG issues while still earning good market return.
In Zinqular, our sustainable investing strategy is based on building a portfolio of companies (in family of asset classes) that for example will be carbon neutral in 2035 or have a carbon footprint 75% lower than benchmarks and have 80% less exposure to “stranded assets” such as fossil fuel assets that have become uncompetitive or non-performing or obsolete as a result of legislation, decreased demand, or other factors.
Emma: Does it mean the timing of ESG thematic investment is a coincidence? What’s driving the change or growing demand?
Michael: Over the past few years, Zinqular crafted investment guidelines around ESG issues. Generally, we believe three factors are acting as tailwinds for this heightened focus.
First, has to do with the size of investment firms. I believe private equity firms and principal investors put together holds more capital than comparable players in the investment industry. Large investment firms are now so big that modern portfolio theory—which holds that investors can limit volatility and maximize returns in a portfolio by combining investments from asset classes with varying levels of risk—cannot be used to mitigate system-level risks. For instance, a small investment firm might be able to hedge against climate change and other system-level risks by investing in “safe haven” assets, such as gold, or in shares of companies that build survival shelters. But Private equity firms and other principal investors with massive capital base under management have no hedge against the global economy; in short, they have become too big to let the planet break down. What’s more, our investors such as pension funds are forced to take a long-term view because they have long-term liabilities—they must plan to pay out retirements for over 100 years. This means we are a classic universal owner with intergenerational responsibilities and thus have an inherently long-term view.
Second, regards Financial returns. Zinqular only invests in companies that have a functioning structural process to measure, manage, and communicate performance on ESG issues. Actionable Intelligence we have analyzed from our portfolio companies and funds of funds for the past few years – have led us to the conclusion that – firms with the highest ESG ratings outperformed the lowest-rated rated counterparts by as much as 48% to 59%. In addition, firms with a better ESG record than their peers produced higher three-year returns, were more likely to become high-quality stocks, were less likely to have large price declines, and were less likely to go bankrupt. We view the key to the new generation of sustainable investing is that which focuses only on “tangible” ESG issues that impacts firm’s valuation—for example, greenhouse gas emissions are tangible for an oil & gas company and electric utility company but not for a financial services firm; supply chain management is tangible for an apparel-retail company using low-cost workers in developing countries but not for a pharmaceutical company.
Third, Tangibility matters. We believe sustainable investing also involves “tangibility”. A company that allocates large capital and invest huge sums of money trying to address every conceivable environmental, social, and governance (ESG) issue will likely see its financial performance suffer; however, companies that focus on tangible issues tend to outperform those that don’t. In our experience, tangibility varies by industry. The Sustainability Accounting Standards Board (SASB) has identified the tangible ESG issues for over 70 industries in its classification system. For example, tangible issues for companies in food retail and distribution include greenhouse gas emissions, energy management, access and affordability, fair labor practices, and fair marketing and advertising. For internet and media services the list includes energy management, water and wastewater management, data security and customer privacy, diversity and inclusion, and competitive behavior.
Emma: So you are saying there is seismic shift that driving adoption to Sustainability Investments. Can you highlight other factors on this “shift”?
Michael: We can think of three additional parameters that come into mind:
Firstly, due to Growing demand. The co-head of Zinqular ESG investment program has confirmed that Zinqular has seen a marked increase in the number of new inquiries on thematic investments on ESG issues. What’s driving this growing demand? Not only are sophisticated asset owners aware that sustainable investing improves returns, but many of them, including high-net-worth individuals, are also focused on the nonfinancial outcomes. Our wealthiest clients want to know their investments are making a difference to make the world a better place. The demand for ESG investment options is so high that Zinqular is rushing to put together new offerings. We have seen very strong asset growth in our Sustainable and Impact offering; client demand has simply accelerated over the past 18 to 26 months.
Secondly, an evolving view of fiduciary duty. The culmination to the mistaken belief that sustainable investing means sacrificing some financial return is the belief that fiduciary duty means focusing only on returns—thereby ignoring ESG factors that can affect them, particularly over time. However, more recent legal opinions and regulatory guidelines make it clear that it is a violation of fiduciary duty not to consider such factors. Although adoption of this new understanding has been slow in some countries, some are taking steps to redefine the fiduciary duty concept.
Finally, impact within investment firms. It is one thing for the CEO or chief investment officer of a major investment firm to embrace sustainable investing and quite another for it to be practiced by the analysts and portfolio managers who make the day-to-day investment decisions. Historically, the ESG group at investment firms was separate from portfolio managers and sector analysts (on both the buy side and the sell side) in much the same way that corporate social responsibility groups were historically separate from business units. For some time now, senior leaders in Zinqular Group have systematically integrated ESG analysis into the fundamental financial activities carried out by our analysts and portfolio managers across all asset classes.
At Zinqular responsible investment is central to our investment philosophy, portfolio managers are accountable for assessing every investment in the context of risk, return, costs, and ESG. This has been a native cultural evolution.
This shift changes the way Zinqular engage with companies and their corporate executives especially on their views and efforts on sustainability. The two key conversations— our investment team talking to a company’s CEO and CFO, and Zinqular ESG team members discussing with their portfolio companies’ corporate counterparts— are combined into all-in-one conversation about tangible ESG issues. Business leaders are forced to factor ESG into their calculations when its clear investors internalized ESG issues in their decisions.
Emma: What’s holding back ESG thematic investing? Can you share with us practical metrics that contributes to this attitude?
Michael: I think despite the forces propelling ESG investing forward, there are still barriers to overcome. The biggest obstacle to investment is that most sustainability reporting by companies is aimed not at investors but at other stakeholders, such as NGOs, and is thus of little use to investors. To be sure, there are data vendors that scour through an assortment of source materials, including whatever reports or data they can get from companies, to provide some assessment of ESG performance. But this is a poor substitute for comprehensive ESG information reported directly by the company and compatible with ESG ratings agencies.
Several organizations—such as the Climate Disclosure Standards Board, Global Reporting Initiative (GRI), and the Sustainability Accounting Standards Board – are trying to fill this gap. However, no governments are thus far mandating the use of the standards. And even when companies choose to adopt them, the reported numbers are rarely subject to a rigorous audit by a third party.
While the world of ESG data is still uncoordinated, substantial progress in improving the quality and availability of information is being made through market forces, the efforts of NGOs, and, in some territories, regulation—such as an EU directive requiring all companies of a certain size to report nonfinancial information once a year. The quality of ESG data is not perfect, but it’s rapidly improving.
Emma: With ESG what’s your advice to companies that will access investors or capital markets. How should they position themselves to ESG minded investors? How do they prepare for this new era?
Michael: There are some few ideas I believe will be useful to these companies:
First, Articulate your mission. In our annual letter to CEOs of Zinqular portfolio companies in 2019, “Mission & Profit,” stating that “mission and purpose is not the solely to pursue profits but the foundational force for achieving them.” We further highlighted that “profits are in no way inconsistent with mission—in fact, profits and mission are inextricably linked.” The mission and purpose of a company is in addition to produce profits; produce practical solutions to problems of people, community and planet and in the process to produce profits. The easiest way for board members to communicate their company’s place in society is to publish a “Statement of Mission/Purpose.” In it, the board articulates the company’s reason for being, identifies the stakeholders most important to its continued prosperity, and lays out the time frames over which senior management’s decisions are evaluated and rewarded. It is essential that this statement come from the board since its role is to represent the intergenerational obligations of the corporation. It’s a pillar of constructive engagement with investors and other stakeholders.
Second, Improve engagement with shareholders and stakeholders. Companies must seek deeper levels of engagement with stakeholders. The “Statement of Mission/Purpose” companies provides a good foundation, but it should be part of a larger, integrated report for shareholders. An integrated report from our portfolio companies is a concise communication about how the firm’s strategy, governance, performance, and prospects, in the context of its external environment, lead to the creation of value. In practice, this means that company reports should include a tangibility analysis that identifies the ESG issues that affect financial performance. Such a report is an effective way to demonstrate to shareholders and other stakeholders that the company is practicing “integrated thinking” regarding its role in society. It is a way of changing the orientation from short-term financial results to long-term value creation.
Third, Increase involvement by middle management. Firms must increase their own middle management’s involvement in identifying and managing the tangible ESG issues. After all, middle managers are the ones who commit resources for achieving strategic objectives. Investors and the CEO create the space, but it is middle management that will create the products and services that serve both shareholders and society.
Lastly, Improve measurement and reporting. I believe ESG reporting ecosystem is the fundamental enabler to management of ESG performance. Some ESG issues don’t affect a company’s bottom line but still impact society at large. A growing segment of the investment community is interested in those impacts—and willing to allocate capital to firms that actively work to benefit society. The challenge for companies wishing to attract these investors is that there is currently no agreed-upon way of measuring a firm’s “externalities”—the positive and negative effects of its products and services on society. As just one example of the challenge, consider geographical location. A wind turbine farm replacing coal plant(s) in China has a material or tangible positive impact than adding a similar wind farm in Norway, where nearly all of the energy comes from hydropower.