A new paper by the multi-stakeholder Predistribution Initiative finds that:
- Factors such as the consolidation of capital amongst institutional investors and the resulting capital flows; increasing corporate debt burdens; the mix of investment products in a portfolio; and the pressures that weak capital structures linked to these investment products put on companies
- In turn create barriers for diverse fund managers and entrepreneurs, jeopardize quality jobs, erode the quality and affordability of goods and services, increase asset class correlations, reduce diversification opportunities, and ultimately fuel economic inequality and market instability
- This eventually translates into lower financial returns for investors, and greater precarity and inequality for workers and communities.
The paper highlights eleven solutions for institutional investors to reassess their investment strategies and rebalance their portfolios. If this is not done, institutional investors are left playing a game of whack-a-mole: trying to address negative impacts of weak capital structures without addressing the investment structures themselves.
The Predistribution Initiative (PDI)—a multistakeholder project designed to influence and co-create more equitable and sustainable investment structures—published a working paper exploring “how the growth of institutional investors (asset owners and allocators) and certain asset allocation strategies can be in conflict with ESG objectives.”
ESG 2.0: Measuring & Managing Investor Risks Beyond the Enterprise-level is the first paper in a forthcoming series “that explores the consolidation of capital amongst institutional investors and the resulting capital flows; increasing corporate debt burdens; the mix of investment products in a portfolio; and the pressures that weak capital structures linked to these investment products put on companies when it comes to matters that impact stakeholders.”
We highlight below some of the key findings of the paper.
“Institutional investors have migrated up the risk-return spectrum” in search of higher yields:
- Institutional investors have “significantly shifted their overall asset allocation strategy” over the past two decades, investing increasingly in private markets and investment vehicles like private equity, private debt, venture capital, infrastructure, real estate, high yield bonds, leveraged loans, and collateralized loan obligations. Specifically, “[p]rivate capital assets under management (AUM) in 2019 was approximately US$6.5 trillion, an increase of over US$4 trillion over the past ten years.”
- According to the paper, this shift is spurred by a variety of factors such as declining interest rates by central banks, interest in the illiquidity premium of private markets (i.e. higher returns received for the additional risk of investing in less liquid assets), growing investor dissatisfaction with investments in public markets, and other factors.
Higher risk asset classes pose higher risks not only to investors but also to other external stakeholders:
- While “shifts in asset allocation [toward higher-yield private investments] may suit near-term goals, such as meeting actuarial targets, this institutional allocation to higher risk asset classes has also meant increased global debt burdens, corporate and fund manager consolidation, and risk across capital structures, resulting in fragility for companies, the real economy, and the stability of financial markets. The resulting risks are therefore shared not only by investors, but also governments, workers, and communities alike.”
- “Although creditors, employees, and [the] public sector are external stakeholders bearing the costs of the externalities, their absorption of such risk arguably contributes to market risk, which boomerangs back to institutional investors’ portfolios. Wide defaults across credit markets can lead to liquidity or solvency crises, causing markets across asset classes to seize up. In such situations, public sector spending aimed at putting a floor on losses can contribute to persistent low interest rates, currency devaluation, and inflation. Massive unemployment stemming from corporate restructurings exacerbates the problem, reduces consumer spending power, and stifles economic growth. None of these are good for markets and therefore the portfolios of large, long-term, diversified investors, or Universal Owners.”
- “Ultimately – in the long-run – the dependence of institutional investors on higher risk strategies and fewer managers may not serve their interests. High valuations in equity asset classes can lead to bubbles and lower returns, while high leverage can lead to deteriorating socioeconomic conditions, waves of defaults and bankruptcies, debt traps, and market instability in the form of credit and liquidity crises. The consolidation of capital among fewer large asset managers appears to also contribute to corporate consolidation and — among both asset managers and companies — reduced competition, innovation, and bargaining power of other stakeholders (including, in the long-run, ironically, asset owners and allocators in addition to workers and consumers). The need to maintain low interest rates and easy monetary policy contributes to asset class correlation, potentially contributes to currency fluctuations and inflation, and challenges institutional investors to meet their required rates of return. The opportunities for diversification and sustainable economic growth weaken. Yet, these strategies persist.”
The adverse impacts on stakeholders are varied
They include:
- “cutting costs, which could be related to quality jobs, the quality of goods and services (e.g. elderly care), community engagement (e.g. in a project with significant land take), or even environmental issues (e.g. biodiversity preservation);
- increasing pricing, which could be for rental homes, essential healthcare services, or infrastructure (e.g. water);
- restructuring in extreme cases of bankruptcy or to avoid defaults, with significant job losses; and
- asset manager and corporate consolidation, leading to monopsony dynamics which reduce labor’s bargaining power, a stifling of SMEs and smaller fund managers, reduced innovation and productivity, increased economic inequality, and political capture.”
The challenges are complex, interconnected and require ecosystem solutions:
- “The conflict materializes in various interconnected ways, particularly from institutional investors’ role in increasing global debt levels and fund manager and corporate consolidation, which in turn can create barriers for diverse fund managers and entrepreneurs, jeopardize quality jobs, erode the quality and affordability of goods and services, increase asset class correlations, reduce diversification opportunities, and ultimately fuel economic inequality and market instability.”
- “In practice, the negative impacts of weak capital structures are typically being addressed piecemeal through company-by-company interventions that focus on corporate operations, like a game of whack-a-mole; but key roots of the problem — the investment structures themselves — are left unaddressed. For instance, asset owners and allocators may engage with a PE firm to ensure workers are compensated fairly in a portfolio company (including in the instance of a bankruptcy), or that the quality and affordability of rental homes are improved. While these efforts are noble in intention and impactful for each situation, they are not addressing a more systemic issue related to the ongoing practice of high-leverage in investments.”
- “ESG and corporate governance teams may be engaging their counterparts at companies and asset managers about treating workers and communities fairly, but at the same time, investment analysts and consultants urge their counterparts — executives and investment teams of asset managers — to increase returns, often through leverage. Thus, the ESG and investment teams of an institutional investor may have competing objectives.”
The paper proposes several solutions to these challenges for institutional investors:
- “Reconsider asset allocation”
- “Align investment team incentives, performance reviews, valuation methodologies, and benchmarking with ESG goals and systematic risk management”
- “Evolve financial analysis to include a focus on systematic risk and return”
- “Develop responsible debt practices”
- “Evaluate fund manager compensation with an ESG lens”
- “Measure and manage fund manager political spend & corporate capture”
- “Measure and manage fund manager tax practices”
- “Invest in industries that contribute to sustainable economic growth”
- “Engage beneficiaries and stakeholders of companies and institutions within the portfolio”
- “Evaluate whether your own corporate governance and investment practices can improve”
- “Engage on policy and field-building”
“Building Back Better will not be successful if it is built on a house of cards of fragile debt burdens. It is critical that corporates, sovereigns, and investors take into account how capital structure and various investment products themselves have ESG implications – with potential to negatively impact workers, society, and the stability of our economy, and therefore markets and financial returns.”
Delilah Rothenberg, Raphaele Chappe and Amanda Feldman, The Predistribution Initiative, ESG 2.0: Measuring & Managing Investor Risks Beyond the Enterprise-level (April 2020)
“In practice, the negative impacts of weak capital structures are typically being addressed piecemeal through company-by-company interventions that focus on corporate operations, like a game of whack- a-mole; but key roots of the problem — the investment structures themselves — are left unaddressed.”
Delilah Rothenberg, Raphaele Chappe and Amanda Feldman, The Predistribution Initiative, ESG 2.0: Measuring & Managing Investor Risks Beyond the Enterprise-level (April 2020)
