ESG REPORT | Part II: Which ESG Factors Maximize Profitability, Minimize Risk?

ESG is a highly buzzed-about topic within private equity these days, though not all firms thoroughly dissect the concept and identify factors they can target to minimize risk while maximizing profitability. For an optimal investment approach, it’s important to consider environmental, social, and governance dimensions individually to fully understand the results each stratum produces.

Investment managers typically prioritize whichever component of ESG can be most readily enforced. For instance, if a firm has existing criteria for monitoring environmental sustainability, the social and governance pillars will take a backseat in the firm’s ESG framework. This type of behavior reflects how companies typically practice selective integration of ESG initiatives.

In 2015, a study of 126 fund managers sought to determine which ESG dimension was most often prioritized by aggregating self-reported versions of existing criteria. Each company was assigned an ESG score, an indicator meant to objectively measure a firm’s relative ESG performance, commitment, and effectiveness.

Researchers then used the survey findings to derive the long-term financial performance of these private equity firms. They surmised that, on average, 60% of investment management firms had detailed requirements for governance-specific ESG factors, compared to 43% who had specific requisites for either social or environmental factors.

The findings concluded that the most successful firms prioritized corporate governance over social or environmental ESG factors. Past high-profile scandals, which have proven injurious to corporate brands, have inspired higher governance standards throughout the business world, including investment managers.

In November, 2015, for example, auto-giant Volkswagen admitted to illegally circumventing emissions control systems in its diesel engine manufacturing process. This negligence was traced back to Volkswagen executives who knowingly sidestepped government regulations. Stock prices plummeted, and the company paid billions in fines and settlements.

Affairs such as this are likely to inspire fund managers to be more discerning in their assessments of corporate governance in prospective investments. However, firms should not neglect environmental and social factors, as those also positively contribute to a fund’s investments.

Each dimension of ESG has significant benefits for financial performance and provides strong protection against various kinds of loss. Another meta-analysis of 8752 firms’ year-long observations found that factors in the social dimension of ESG had the most significant mitigation on total risk, while environmental factors tended to have the greatest effect at reducing idiosyncratic risk. Social governance factors, such as employee relations, are universal considerations and therefore have significant leverage on financial performance regardless of the industry or firm.

Environmental impacts, meanwhile, can have an all-encompassing effect on financial risk to industries that are environmentally sensitive. Food manufacturing, clothing, as well as oil and mineral extraction businesses may suffer significant losses by neglecting environmental considerations.

The aggregate data show that strong enforcement of corporate governance is the most preferred performance indicator of a given investment. While the benefits of strong corporate governance are substantiated by data, its favorability among businesses is popular perception and should not be prioritized over other dimensions for leveraging profits.

This concludes the second report in a four-part series on the significance of ESG in investment management. To view our work on ESG materials for clients, click here.

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