Practical and enhanced implementation of ESG Oversight
By Robert Swift
Environmental, Social and Governance (ESG) themes are becoming more visible and popular in money management. Leatherback managers use ESG considerations explicitly in the way they research companies and build portfolios. It is very likely that a company or investment will be considered less attractive by us based upon ESG shortcomings.
This is not an attempt to explain why ESG is more popular but is a brief consideration of how Leatherback views ESG and why and how we incorporate it across the range of capital we manage for our clients.
Leatherback is a collection of active management groups. As active managers we all believe that we benefit our clients by taking a view of what is not discounted or understood by other market practitioners, and own less, or more, or none of a particular company or industry. Some of the reasons for liking or disliking a particular investment can be ESG related.
Indeed, part of the mosaic of active management research has always been interaction with company management and to better understand its approach to governance of the business in the broadest sense; to verify with them what you believe to be the current state of the business; the risks in the business, and to explore management's future plans. Typically, judgements have always been made by active managers on a company's management; its ethics, its diversity and skills, and its approach to shareholders, the law, and regulators. Bad governance and risky businesses deserve lower ratings or higher risk premiums, and always have.
This use of an ESG perspective in active management then is not new, but the clarity provided by the ESG research lens and the positive benefits of beneficial change as a result of investor pressure, are now more of a focus and we embrace that.
Failures of governance can and do result in bankruptcy, unfair and overly aggressive management of employees, and anti-social effects such as bribery and corruption. It is increasingly evident that while government, and government agency, regulation provides sufficient firepower to deal with transgressions, it is often not deployed or subject to, and diluted by, powerful corporate lobbying. Shareholders and providers of capital to governments can, and should, step in to lend additional weight for necessary change. The consequences of bad capital stewardship for the company, employees, shareholders and wider society are increasingly the responsibility of the providers and owners of the capital and not government or regulators alone.
In our work we have found typical ESG attributes to be random in their impact on stock performance and some of them highly correlated with standard analyses of valuation such as capital structure or leverage. For example, good governance typically results in sensible leverage and prudent accounting policies as well as long term planning perspectives.
On the other hand, a universally agreed set of ESG principles or a common values system is probably not possible. It would be a form of cultural imperialism to demand that all companies adopt Western business practices and policies if cultural values are different?
For example, Japanese companies tend to 'hoard labour' rather than aggressively shrinking the workforce during downturns. Who are we to say that this is wrong when there is no simple binary decision to be made between maximising the bottom line or ensuring a fair share of pain is taken between capital and labour during recessions? Consequently, we do not embrace the principle of a 'universal truth' in ESG.
Additionally, excluding companies from consideration for investment solely on ESG principles ignores the potential for positive change which can drive a reduction in risk premiums. Simply put a company may be worth investing in as it gets better in ESG rather than after it has gotten better. Exclusion of companies also removes the right to participate in shareholder resolutions and AGMs. Not engaging is not managing but abdicating responsibility.
This ESG responsibility extends to all parts of the capital structure and even to funding government debt issuance. Governments can and do raise money for the wrong reasons and implement bad policy by spending this capital. It is not enough then to solely focus on equities with an ESG perspective.
How we implement ESG based research at Leatherback is based on the integration of ESG with the other aspects of the research process.
Simple scoring or box ticking ignores the nuances present in all situations and the absence of any binary 'good vs evil' values system. The many ESG providers of boxes to tick are also inconsistent in the boxes they choose. We believe it is our judgement that matters on what is relevant and do not favour one data provider or another.
We do not tick boxes at Leatherback, however any investment in which we have ESG concerns will be the subject of our conversations with management and communications with clients. We may invest in a company with less than average ESG assessment where we believe we can effect change either alone or in conjunction with other investors.
Our belief is that G is the most important dimension of the three. G covers all companies in so far as all companies are managed by executives who choose policies, external service providers and build a culture. It is possible, and useful, as a portfolio manager to make valid comparisons of management skill, attitudes to shareholders, and company risk based on G, across the full universe of opportunities. This is less true of S and E where some companies may have minimal impact on E whereas others are engaged in activities which are directly impacting E and S. G is relevant everywhere, at all times and is an unchanging important constant.
Consequently we apply explicit consideration of G in all company analysis and portfolio construction and employ forensic research services to help us evaluate.
We apply an ESG lens to all parts of a company's capital structure and to government policies funded by their debt issuance to public markets. Not owning equity in a poorly governed business is scarcely responsible investing if the debt securities are not similarly shunned?
All Leatherback strategies, whether equity or debt based use ESG.
Finally, we are pleased to state that we are fully open to discussing our ESG considerations with clients and prospective clients. This is the start of a journey for more responsible and open capital stewardship.