Listed Equity: The five tests of impact
Andrew Parry argues that five key tests should be applied to public market investments before they can be termed impact investments
The World Economic Forum estimates US$1trn of assets will be committed to impact investing by 2020. Such a dramatic flood of capital suggests a profound opportunity to improve the long-term sustainability of society and the planet. However, with capacity in private markets constrained, the less proven public markets are the obvious destination for much of these new commitments.
With a potential massive flow of capital at stake, the real question is whether public markets can rise to the challenge of being truly impactful investments. This will mean moving beyond mere asset gathering to providing a real catalyst for change.
Public markets have the potential to deliver positive impacts on a vast scale, but must first learn from the approach of private impact investing. For public markets to replicate private markets’ success, a fundamental re-think is required to transform the way in which they invest. I believe there are three crucial concepts to consider before conferring ‘impact’ status on public markets: additionality, measurement and intentionality.
Additionality, developed by impact investors, brings a useful focus on unmet needs as a source of untapped growth. For example, we should see the surge of interest in the UN Sustainable Development Goals, not as a cynical data tagging exercise of existing themes, but a framework for understanding areas of structural future growth through tapping into unmet needs.
However, the weakness of traditional investing is the limited scope for allocation of new, early-stage capital into emerging impact enterprises. For many, this is a stumbling block for considering public equities as true impact candidates. Direct additionality of quoted companies is limited, as capital is already deployed and corporate purpose set. Through corporate engagement we can influence established companies to recognise the benefits of additionality from opening up new areas of sustainable growth and leading to more resilient long-term business models.
The measurement of impact is integral to a holistic, fundamental valuation of a company. Moreover, impact measurement provides accountability and transparency, demonstrating capital is having its intended effect, thus shedding light on investment strategy efficacy. It is also crucial in improving credibility around impact investing.
If measurement is challenging in private markets, it is even more difficult in public markets and cannot rest solely on data collection: A qualitative assessment of impact is equally as important. Currently, the quality of publicly available impact data is limited. Already, listed companies are complaining of survey-overload, and a new-found zeal for reporting is seeing an explosion in bespoke requests from investors.
The concept of intentionality ensures investors focus on wider corporate purpose beyond the short-term maximisation of shareholder value. It is vital to safeguard the integrity of the term ‘impact investment’ as it becomes more mainstream. Post-rationalisation of investments as ‘impact investments’ contributes to ‘impact washing’ and undermines credibility.
Clear corporate purpose and true intentionally can be difficult to define as long-established companies tend to be diversified. However, it is possible for a major, complex multinational to establish a clear sustainable purpose, deliver a net improvement to the system and generate attractive financial returns.
While much has been achieved by private markets impact investment, we can accelerate the transition to the next phase of growth through public markets. As Archimedes said: “Give me a lever and I can move the world”. Public markets provide enormous leverage to improve the overall system and deliver a more sustainable world. But this purpose must be driven by belief, not marketing cynicism, and implemented through the shared aspirations of investors and asset owners.
An imperative for public impact investing is, therefore, to help encourage a reduction in the negative impacts and a reinforcement of the positives. This is the power of public markets: the size and breadth of coverage provides a powerful opportunity to leverage change on a scale that can endure over time.
Undoubtedly, there is a need for public market impact strategies to match investors’ specific risk/return objectives. However, we need to be aware of dangers associated with a sector in search of a definition. The classic definition of impact investing is too readily applied, by some, to existing strategies. These approaches may have merit and meet specific client needs, but it is wrong to automatically label them ‘impactful’.
Intentionality is, therefore, a key element in bringing demonstrable change in our ecosystem. Merely investing in a listed company because it is ‘green’ is not sufficient, if there is no demonstrable evidence of improvement. Equally, excluding fossil fuels might make a fund feel virtuous, but where is the demonstrable reduction in carbon emissions?
An important aspect often omitted from impact strategies is active company engagement. It helps address the issue of diluted ownership in public equities and encourages a company to scale-up its impact. It also provides a feedback loop between investors and management, encouraging long-term strategic thinking and robust measurement of the impacts delivered. Relying on stale or backward looking data is not a sufficient condition to render an investment impactful; there needs to be a clear set of goals.
By advocating and changing the way we invest, we can bring transformative change. Even passive asset managers have the opportunity to affect change through active and collaborative engagement, and using their voting power to influence corporate behaviour.
A new way of thinking about investing is necessary if public equities can be classed as truly impactful. In my opinion, there are five key tests:
• Long-term thinking in looking at companies and managing client portfolios. This means three things: changing the way we examine companies’ fundamentals to better understand sustainability of the value-creation process; clarity on the purpose and degree of intentionality at the stock specific and portfolio level; a time horizon aligned with the capital allocation cycle of the business.
• High conviction positions in concentrated portfolios. Portfolios managed with an obsession for tracking error against a benchmark reflect the old economy or this year’s momentum flavour. There are a limited number of truly impactful businesses and false labelling will not improve the system or our credibility.
• Active ownership focusing on constructive dialogue with companies to facilitate improvements. Private markets investors have a level of control that public equity holders cannot have. Through active and constructive engagement, investors can have a voice well above their shareholding size. Engagement helps us understand companies better: reinforcing improvements and increasing net-positive impacts, while boosting shareholder wealth.
• Aclear measurement framework identifying, in advance, clear goals at the company and portfolio level – and where progress on achieving positive change is reported consistently over time. Measurement should go beyond numbers: there should be a qualitative assessment of company progress, alongside quantification of specific metrics.
• A recognition this is meant to be hard work, not superficial, and should be integrated throughout the investment process, and ideally across all products.
Public markets represent an opportunity to profoundly improve the ecosystem in which capital markets are imbedded, by helping to eliminate negative impacts and reinforcing the positive ones. However, this can only be achieved by taking a truly long-term perspective, by being good stewards of client assets and using active company engagement to encourage a more sustainable and resilient system. Anything less will lay the industry open to the accusation of viewing impact investing as no more than a cynical new business growth opportunity.
Andrew Parry is head of equities at Hermes Investment Management. This article is based on a speech he made at the Impact Investing World Forum in London in March 2017