ESG Investing Interview - Part One

According to a 2018 report by the U.S. Forum for Sustainable and Responsible Investment (SIF), more than one out of every four dollars under professional management in the U.S. was invested incorporating some ESG criteria.¹

The ESG movement has its roots in SRI, or socially responsible investing, a process through which investors screen out certain types of securities from their investment portfolios in order to better align their portfolio with their organizations’ missions or their personal beliefs.

In recent years, impact investing, which aims to generate specific positive social or environmental effects in addition to financial returns, has also started to gain popularity among investors.

In December 2019, Wendy Pan, a Director from Segal Marco Advisors’ private markets team, participated in AssetTV’s ESG Masterclass as a panelist. Here are Wendy’s answers to questions on ESG, innovation and how ESG factors are considered in private markets.

This is part one of a two-part series. Look for Wendy’s continued interview with AssetTV next week.

Interviewer: “We know that ESG is another way to invest with a conscience, yet it is different from SRI investing. Could you tell us about the differences and your assessment of the landscape?”

Wendy: “SRI, or Socially Responsible Investing, has tended to focus more on negative screening. Essentially taking out the things you do not want from an investment portfolio, while ESG is more focused on looking at factors that could impact your return from a materiality perspective.

I definitely see a paradigm shift with all the managers I met from doing SRI to implementing ESG. And what's driving that is really data. In the past, you could just purchase data from ESG data providers and then implement screening to exclude the companies you don't want from the investment portfolio.

However, right now, some of the most sophisticated asset owners are able to do that in-house themselves. As investment managers and investment consultants, we have to provide services that can help our clients move to the next level and to do that we have to do more fundamental analysis and more due diligence on which ESG factors or processes can improve investment results.

Going forward, the industry needs to do more work in that direction and asset managers need to invest in fundamental analysts and data structure to make sure their ESG processes work.”

Interviewer: “When you're assessing asset managers, how have their approaches to ESG implementations evolved?”

Wendy: “Definitely. I think asset managers have been moving from product to process to philosophy. To further explain this, in the past, we have seen many asset managers offer ESG funds as products, meaning, according to the managers, “I have this ESG product for a specific set of investors, and I have all the other products that are non-ESG for another set of investors.”

The teams offering these products don't necessarily talk to each other. Now we see more and more asset managers treating ESG as an integral part of their investment process. No matter if you're on the investment team offering an ESG product or if you're offering any type of investment product, you have to do ESG analysis.

I will give an example in private markets. One of our real estate managers, no matter what product, what property, what projects they're doing due diligence on, they always assess the environmental footprint of their properties.

They will look at the energy, waste, and water consumption of all of their properties. They also install smart meters in homes to track energy and for water. Not only does this help them save on costs, it also helps them detect where potential leakages are going to be. Through these initiatives, the investment manager actually sees the cost saving and improvement in their profits and return on investment.

The last stage is philosophy. That's probably the hardest one to get to. There are fewer investment managers who really from the top of the organization to the people on the ground buy into the idea of ESG. These managers will do macro research, they will train all their investment teams on integrating ESG factors into the investment process, and they have people in their legal and compliance departments to verify if the investment teams do the work. We think that is the final stage.”

Interviewer: “When it comes to risk and reward, how is ESG as well as sustainable investing applicable in private equity as well as in real assets investing?”

Wendy: “Private equity and real assets are a bit different than public markets when it comes to applying ESG factors. For one, private assets are long-term holdings.

You have to do more due diligence upfront, and once an investor gets into these funds, the investor has to hold them for 10, sometimes 15 years. As a result, during the initial due diligence, why wouldn't a long-term investor want all the information about these companies?

I think that naturally fits with the long-term benefits that ESG and sustainable investing bring. Secondly, private equity has this unique opportunity to do a lot of value creation. Private investors could start changing the assets very early on without too many owners involved. As a result, they could execute certain plans more effectively than public companies. Integrating ESG into these value creation plans could generate value for shareholders.

Last, but not least is in private markets, investors have to prepare these companies ultimately for public listing. If these companies go IPO, many corporate governance specialists will ask questions about the governance structure, or ask them questions about environmental social metrics.

Private equity firms and investors have to prepare their portfolio companies for eventually being a public company and private transparency for a broader shareholder base. As such, I think ESG is applicable to private markets.”

Interviewer: “When it comes to innovation, what do you see on the horizon?”

Wendy: “There are two things worth looking out for. The first one is data innovation. How can we use more data in investment process? It's already hard on the public market and even more difficult on the private market side, as a lot of companies are not yet sharing the data with investors. Firms that could solve that problem for investors will thrive.

The second key issue is that ESG investing has to be tied to innovation in private markets to generate outsize return. Ultimately, in venture capital, private equity, and in some forms of private debt, investors provide funding to entrepreneurs. These entrepreneurs we fund will be representing what the 21st Century will bring to us. These entrepreneurs are the names that everyday people now recognize.

In the last century, we have a group of entrepreneurs their businesses are now matured. Some of them are doing very well and thriving, while some of them of gradually leaving the playing field. It's investors’ jobs to pick out which are the companies of the future and which are the companies of the past.”

^{1 Source: US SIF}