Can investors do well by doing good?
Sébastien POUGET
Toulouse School of Economics
Can investors do well by doing good?
Sébastien POUGET
Toulouse School of Economics
Co-director of the research center on Sustainable Finance and Responsible Invesments
Chaire « Finance Durable et Investissement Responsable »
Chaire « Finance Durable et Investissement Responsable »
“The Washing Machine”:
Investment Strategies and Corporate Behavior
with Socially Responsible Investors
Christian Gollier
and
Sébastien POUGET
What is SRI?
Sébastien Pouget
Socially Responsible Investments
Complements financial analysis by taking into account
Environmental, Social, and Governance (ESG) factors
ESG factors (externalities): pollution, working conditions, employee
relations, product safety, transparency of decisions…
SRI represents today between 5% and 15% of assets under
management in Europe and the USA
Several trillions of euros (3.7 trillion$ in the US according to US SIF
and 0.4 trillion€ in France according to Novethic)
5
Source: US SIF, Sustainable and Responsible Investing in the United States 2012
6
Players in SRI
Sébastien Pouget
Pension funds (CALPERS, TIAA-CREF, APG, FRR…)
Sovereign funds (Norway GPF, CDC…)
Institutional investors are major promoters of SRI (see e.g.,
the UN-backed Principles for Responsible Investment)
Numerous asset management companies are also proposing
SRI funds (for example, Calvert in the US, and all the
sponsors of the Chaire FDIR in France)
More than 250 funds in France
7
Source: Novethic, Chiffres 2013 de l’investissement responsable en France
8
SRI strategies
Sébastien Pouget
There are 3 main types of strategies
Exclusion
Boycott sectors that are jugged as irresponsible
Best in Class
Invest more in companies with best ESG performance
Engagement
Change corporate behavior by exerting voice
Other strategies: microcredit, thematic funds…
9
Source: EuroSIF, European SRI Study 2012
10
Why SRI?
Sébastien Pouget
Why could it be important to foster Corporate Social
Responsibility?
Milton Friedman (1970): corporate social responsibility is to
maximize firm value
According to Benabou and Tirole (2010):
Quid if there are missing markets and thus externalities? Delegated
Philanthropy
Quid if firm value does not reflect long term items? Bonus culture
(Benabou and Tirole, 2014) may be dampened by using ESG
performance to evaluate firms (extra-financial rating agencies)
11
Why SRI?
Sébastien Pouget
Necessary conditions : market failures (due to externalities)
and government failures (due to territorial limits in juridical
influence or to transaction costs)
SRI motivations:
Creating economic value in the long run
Being ethical
Institutional investors and asset managers often cite both due
to:
Fiduciary responsibility that imposes financial objectives
Reputational risks that call for acceptable behaviors
12
Pourquoi capitalisme devient solidaire?
Sébastien Pouget
13
Pourquoi capitalisme devient solidaire?
Sébastien Pouget
14
Pourquoi capitalisme devient solidaire?
Sébastien Pouget
Norwegian GPF has more than 800 billion $ of AUM
The Fund launches enquiries regarding the behavior of companies
on the field
The list of excluded companies is made publicly available online
Its choices are followed by a lot of asset owners and managers
15
Why SRI?
Sébastien Pouget
16
Why SRI?
Sébastien Pouget
17
Why SRI?
Sébastien Pouget
63 companies are currently excluded by the Norwegian Fund
Excluded sectors: non-conventional weapons, tobacco, severe
violations to human rights, severe degradation of environment
In France, Safran and Airbus Group are excluded due to their
implication in nuclear weapon production
18
Can investors do well by doing good?
Provide some theoretical underpinnings for SRI industry
Financial performance?
Change within companies?
Analyze the practical implications for SRI industry
What type of funds?
With which strategy?
Our approach
Set up an asset pricing model for socially responsible assets
Study the link between financial markets and corporate
decisions via shareholders’ voting decisions
Propose a business model for SRI funds that associates
financial performance and changes in corporate behavior
Within the SRI industry, engagement strategies and private equity
funds can display abnormal returns at equilibrium
The “washing machine” investment strategy
Profitable SRI?
Proposing a model in which SRI investors outperform traditional ones
is challenging
Consider that CSR pays at the company level, i.e., virtuous firms
display higher (long term) earnings than vicious firms
If one considers that financial markets are informationally efficient
Both SRI and traditional investors overweight virtuous firms
These investors display identical performances
If one considers that financial markets are inefficient
Both SRI and traditional investors try and collect information to spot the
firms that are mispriced
Again, these investors display identical performances
Profitable SRI
There are at least three reasons why SRI might outperform
traditional investment funds
SRI may be better at spotting the most promising companies
because of expertise in extra-financial analysis
SRI may be better at anticipating new trends in corporate social
responsibility and benefit from the subsequent enthusiasm
SRI may implement the “washing machine” strategy we
characterize in this paper
Related literature
Other pricing models for socially responsible assets include
Heinkel, Kraus, and Zechner (2001), Barnea, Heinkel, and
Kraus (2005), and Barnea, Heinkel, and Kraus (2009)
These models feature investors with private benefits from firms’
responsible policies but there is no voting issues
Existing models of voting in firms include Gromb (1993),
Burkart, Gromb, and Panunzi (1997, 2000), At, Burkart, and
Lee (2011)
Gromb and ABL study the optimal design of security-voting structure
and optimal allocation of control rights
Closest paper is BGP (2000) that features conflict of interest among
shareholders but no voting on strategic decisions
Financial
market
Date 3
Date 2
Date 1
Model
Shareholders’
meeting
Firm’s results
Date 3
Model
Firm’s results
• Standard strategy:
– financial return r =l N(Er,σ2)
– no externalities
• Responsible strategy:
– financial return r - c
– positive externality e > c
Date 2
Model
Shareholders’ meeting
• Strategy choice: standard vs. responsible
• Vote: simple majority
• One share = One vote
Date 1
Model
Financial market
• An initial owner sells his shares
Date 1
Model
Financial market
• An initial owner sells his shares
• Socially responsible investors:
– value r, c and e
– proportion π
Date 1
Model
Financial market
• An initial owner sells his shares
• Socially responsible investors:
– value r, c and e
– proportion π
• Traditional investors:
– value r, and c only
Date 1
Model
Financial market
• An initial owner sells his shares
• Socially responsible investors:
– value r, c and e
– proportion π
• Traditional investors:
– value r, and c only
• Trading at price P
Rational expectations equilibrium
Corporate
strategy?
Shareholders’
vote?
Investors’
holdings?
Investors’
demand?
Share price?
Standard strategy
Corporate
strategy
Standard
Standard
Strategy
chosen if
Shareholders’
vote
Investors’
demand
Er - P
As 2
p < 1/2
Identical
Investors’
holdings
Share price
P = Er - As 2
Responsible strategy
Corporate
strategy
Shareholders’
vote
Investors’
holdings
Responsible
Investors’
demand
Share price
Responsible strategy
Corporate
strategy
Shareholders’
vote
Responsible
Traditional
Investors’
demand
Er - c - P
As 2
Responsible
Er + e - c - P
As 2
Investors’
holdings
Share price
Responsible strategy
Corporate
strategy
Shareholders’
vote
Responsible
Traditional
Investors’
demand
Er - c - P
As 2
Responsible
Er + e - c - P
As 2
Investors’
holdings
Share price
P = Er + pe - c - As 2
Responsible strategy
Responsible
Traditional
Er - c - P
As 2
Responsible
Er + e - c - P
As 2
Responsible
hold
more than
traditional
P = Er + pe - c - As 2
Responsible strategy
Responsible
strategy
chosen if
1/2
p>
1+ x
1- p )e
(
with x =
As 2
Responsible
Traditional
Er - c - P
As 2
Responsible
Er + e - c - P
As 2
Responsible
hold
more than
traditional
P = Er + pe - c - As 2
Results so far
The responsible strategy is adopted when π > (1/2)/(1+x)
Responsible company offers a lower risk-adjusted return than
the standard company
In line with Hong and Kacperczyk (2009)
Responsible companies market cap is higher than the one of
standard companies when πe > c
Helps explaining why event studies on CSR are unclear – see, for
example, Krüger (2014)
Value creation thanks to engagement
When π < (1/2)/(1+x) and πe > c, …
… responsible investors do not hold a majority of shares (the
standard strategy is adopted)…
… and the firm is undervalued (with respect to the situation in
which the responsible strategy would be chosen)
Potential for value creation (both financial and social)
Shareholders’
meeting
Date 3
Financial
market
Date 2
Takeover
Date 1
Date 0
Intervention of a raider
Firm’s
results
Date 0
Takeover
Date 1
Intervention of a raider
Financial market
• Raider makes a take-it or leave-it offer
to the initial owner
• Raider sells back its shares to investors
Raider’s strategy
At date 0, raider offers a low price Er-Aσ2 at which the initial
owner accepts to sell his shares
At date 1, raider could be tempted to sell back all its shares at
high a price of Er+πe-c-Aσ2 (greater than Er-Aσ2)
This strategy is not feasible because, if it sells back all its
shares, responsible investors do not have a majority
The raider has to keep a part α of the shares such that the
responsible strategy is adopted
Raider’s behavior
We assume that the raider is risk-neutral and internalizes a part
θ of the externality
Its expected utility is: (1-α)P1*+α(μ+θe-c)-P0*
Raider sells back 1-α shares if c/e<θ<π
Its expected utility is: Aσ2+θe-c+(π-θ) 2e2/(4Aσ2)
Last term: the raider reaps the responsibility premium
Pure financial returns can be higher than for a traditional raider
Raider prefers to keep all the shares
If θ<c/e: votes against responsible strategy and it is less risk averse
than other investors (expected utility is Aσ2)
If θ>π: votes for the responsible strategy and it finds that the price is
not high enough despite the responsibility premium (Aσ2+θe-c)
Raider’s commitment for CSR
This strategy is not credible unless the raider votes, at the
shareholders’ meeting, in favor of the responsible strategy
If it focuses on financial returns only, it will always favor the
standard strategy
Hence, a traditional raider cannot intervene and restructure the
firm
Only a socially responsible raider can at the same time change
the strategy of the firm and benefit financially from this change
Relation with empirical evidence
There is a responsibility premium:
Hong and Kacperczyk (2009) on sin stocks
Bauer and Hann (2010) on green companies and credit spreads
Bauer, Derwall, Hann (2009) on employee relationships and spreads
Chava (2011) on green companies and bank loans
Dimson, Karakas and Li (2012) show that investment strategies
based on engagement on environmental and social issues can
generate positive abnormal return
Activism profitable on governance issues: Brav et al. (2006),
Becht et al. (2009)
Relation with empirical evidence
An emerging strategy
The “Washing Machine” strategy has not yet been
implemented
However, a fund, Tau Investment Management, is currently
being set up in New York that follows the same principles
Objective (“NY firm sees investment opportunity in garment
factories”, Reuters, 9/27/2013):
Invest in garment factories in emerging countries (i.e., Bengladesh,
Vietnam…)
Be a very active minority shareholder
Transform companies mainly by improving labor conditions
(compensation, security, training…) and supply chain organization
Resell shares on stock markets
Conclusion
To benefit from the “washing machine” strategy, SRI should:
Invest in non responsible firms and turn them into responsible
Have a long-term orientation
Have a credible orientation towards social responsibility
Strategy can be implemented
Alone by SRI private equity or hedge funds
In group by SRI mutual funds or pension funds
Two remarks:
Investing in non responsible firms raises a reputation issue for SRI
Traditional raiders can profit from targeting some CSR-oriented firms
THANKS FOR YOUR ATTENTION!
Research center on
Sustainable Finance and Responsible Invesments
www.idei.fr/fdir