The promise and pitfalls of investing for change

TPG got a head start, adopting an ESG performance policy in 2012 and signing on to the United Nations–backed Principles for Responsible Investment the following year. It launched an impact investing platform, The Rise Fund, in 2016. Coulter and Steve Ellis, MBA ’90, serve as two of the fund’s three co-managing partners. (The fund’s founders board includes Laurene Powell Jobs, MBA ’91; Jeff Skoll, MBA ’95; and Bono.)

“Any type of company has the ability to participate in ESG,” Coulter says. But for investors who want to go beyond putting their money into corporations that are trying to do better, there’s investing for impact — “the extra credit of ESG.” When The Rise Fund launched, Coulter recalls, “Impact investing was something we had to sell rather than something people were looking to buy.” Today, Rise is the world’s largest private equity impact fund, with $13 billion in assets and investments in 50 companies across six continents. At the end of 2020, it reported having delivered an estimated $3.3 billion worth of impact in areas including education, health, and decarbonization.

There is a growing consensus that the stakes are too high not to try to harness the power of profit to tackle urgent environmental and social issues. Yet as players such as TPG and Engine No. 1 articulate a vision for long-term investing in change, the landscape is still dotted with heated debates and potential pitfalls.

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Like O’Leary, Coulter notes that doing well by doing good is not easy to get right. “This is hard,” he says. “It’s an attractive type of investing, but it’s a difficult type of investing because we’re adding a whole other level of complexity by holding ourselves to the highest standards for measuring and delivering impact. But being early means you have to build the tools and refine your approach as you go.”

Measuring Up

David Larcker, a professor emeritus of accounting at Stanford GSB and director of the Corporate Governance Research Initiative, believes it is imperative to achieve ESG goals. But he has some questions about how that will happen. He has found that many investors and companies are unclear about what, precisely, they are trying to achieve by pursuing ESG goals, and as a result can’t honestly say whether they are succeeding. And that uncertainty is compounded by numerous flaws in how policies and impacts are measured and analyzed. “There’s a lot of bad assumptions, bad measures, and unsupported claims,” he says.

In a recent paper, Larcker exploded several “myths” surrounding ESG investing — starting with the idea that it has a widely accepted definition. What exactly constitutes an ESG activity isn’t cut-and-dried. If a U.S. bank invests billions in initiatives to advance racial equality and economic opportunity, for example, is it really pursuing ESG objectives — or is it simply taking credit for complying with federal regulations that require it to serve low-income communities? After Russia invaded Ukraine in February, a German defense industry group said that weapons makers should be recognized for their “positive contribution to ‘social sustainability’ under the ESG taxonomy.” Larcker questions why governance is part of the formula: Shouldn’t shareholders value good governance at all companies, regardless of their environmental and social priorities?

Measuring the effects of even the most well-meaning ESG effort is tricky. “You start peeling back the onion, and it becomes very complicated,” Larcker says.

While calculating the environmental impact of a company’s carbon-reduction program might seem relatively straightforward, it becomes considerably less so if one considers all the emissions generated along the enterprise’s supply chain. Putting a figure on the “S” is even more challenging: How, for example, do you quantify the impact of a socially responsible policy on the lives of workers in the developing world?

“Good luck measuring the impact of an investment on social or economic inequality,” says Amit Seru, a professor of finance at Stanford GSB and a senior fellow at the Hoover Institution. “The data are messy, crude, and measured with a lag.”

Most publicly traded ESG funds construct their holdings by considering the universe of all stocks, excluding the most obviously “dirty” companies, and weighting whatever remains according to a rating system. This strategy descends from a tradition of socially responsible investing focused on avoiding “sin stocks” and morally questionable enterprises (think of the movement to divest from apartheid-era South Africa).

But ESG screening is more complicated than simply excluding firms from a particular industry: a company that promotes good governance or racial equity, for instance, may still have a huge carbon footprint. And without mandatory disclosure or commonly accepted metrics, it’s difficult to make apple-to-apple comparisons of firms’ track records. Corporations may cherry-pick the numbers they disclose, increasing the possibility of greenwashing or greenwishing — mistaking good intentions for meaningful impact.

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There is little overlap among the various proprietary methodologies for rating public companies’ ESG performance. A company might get high marks on one scale but failing ones on another. O’Leary cites the example of a medical-device maker in Engine No. 1’s portfolio that, according to one rating provider, has lower E and S scores than the Altria Group, one of the world’s largest producers of tobacco products.

“There are a gazillion ESG measures, but who knows whether any of them are really relevant?” Larcker says. “Are they measuring what they claim to be measuring? And if you don’t have good measures, how the hell do you build your investment portfolio?”

Known Unknowns

Fuzzy numbers can complicate decisions about whether to invest in a company or encourage it to undertake a particular ESG initiative. “It’s hard to push them until we really have that data,” says Madeline Hawesopen in new window, MBA ’17, a director at Engine No. 1. Her firm tries to make up for the lack of high-quality information through “the magical work of our data science team,” which employs imputation methods to fill in gaps in the data.

Coulter says “information availability” is more of a problem in the public market than the private market. Nonetheless, “we would like clear standards,” he says. “We remind people that it took 70 years for GAAP to develop and 50 years for Moody’s to come up with A/B ratings for bonds. But we can’t wait. We’ve got to get action.”

To that end, TPG launched its own research arm, Y Analytics. It’s designed to “take the guesswork out of our impact assessments by deliberately avoiding intuition-based definitions of impact in favor of peer-reviewed, research-based definitions,” Coulter explains. “And we assess the potential impact of our investments on a net basis, so we are taking into account the potential for both positive and negative outcomes.”

Seru worries that the scarcity of consistent, quality information could place a ceiling on how much the overall ESG market can expand. “There’s a big conundrum here,” he says. “Standardization is hard. And because standardization is hard, it’s going to create pockets of people who more or less agree on things. But they’re going to be very specialized pockets, and as a result, the market will not grow as much as people might think.”

There is also the question of how many truly attractive opportunities the market contains — and whether there are enough to make this type of investing work at scale. Larcker says there’s not enough evidence behind claims that focusing on ESG criteria inevitably leads to better returns. A 2021 meta-analysis of 1,400 studies performed by researchers at the Wharton School, NYU, and Johns Hopkins indicates that the financial performance of ESG investing has on average been indistinguishable from conventional investing.

A 2019 study of the municipal bond market that Larcker conducted with Edward Watts, PhD ’20, now at the Yale School of Management, found that investors were unwilling to pay a “greenium,” or sacrifice returns to invest in eco-friendly securities. On the flip side, Stanford GSB finance professor Jonathan B. Berk recently showed that divestment from companies that fail to meet ESG criteria has little impact on their financial performance or their cost of capital.

While Larcker and Seru acknowledge that there are situations where investors can make money while making the world a better place, they question just how many of them are sprinkled throughout the broader economy. “The whole idea of win-win only works at scale if you have a bunch of mismanaged firms,” Seru says. Well-governed firms, he explains, will already have undertaken all the projects that could potentially maximize shareholder value — including those with obvious environmental and social benefits.

By that logic, ExxonMobil would be the exception rather than the rule, at least in developed markets. Seru argues that Engine No. 1 was able to rally larger shareholders to its cause because the oil company was already seen as being so poorly managed that it was failing to maximize returns. A well-run company, however, would not have needed any outside nudging to pursue an ESG-friendly course that clearly served its bottom line.

Or, as Larcker puts it, “If there were returns to be had, the greedy capitalists would already have been doing it.”

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Confusion and Opportunity

The issues raised by researchers like Larcker and Seru are not news to the proponents of sustainable investing. Coulter has stressed that ESG depends on accountability, not promises. “We have 1,500 companies that have made net-zero pledges — and yet none of them can say how that’s going to happen,” he told Bloomberg last year. In 2020, O’Leary published a book, Accountable: The Rise of Citizen Capitalism, which echoes much of Larcker and Seru’s critique. He and his coauthor wrote an article last year for Harvard Business Review with the ominous title “An ESG Reckoning Is Coming.” “A movement meant to benefit the public good risks becoming a buzzword coopted to keep maximizing short-term profits,” they warned.

But O’Leary and Coulter are determined to overcome and even capitalize on the uncertainty in the current boom. “It’s like a three-sided coin: We have need, chaos, and opportunity,” Coulter says. “Any time you flip the coin, you’ve got to ask which side you’re on. The way you deal with the chaos is through knowledge. I think this really speaks to the need for specialized capital and dedicated impact investing efforts.”

“Good investing of any type requires that you can take a contrarian stance and place a bet on a company or a trend that is different from what the rest of the market thinks,” O’Leary says. “And that’s possible right now because there’s so much confusion over what ESG investing even means.”

Coulter is adamant that investing for impact can — must — be a win-win. From the outset, The Rise Fund was intended to be “absolutely, unapologetically, non-concessionary.” “An impact deal doesn’t know it’s an impact deal from a financial point of view,” he says. If competitive performance is viewed as a tradeoff for positive impact, he argues, impact investing can’t scale. That defeats its purpose, which is to generate the capital necessary to spur large-scale change. “If you are building real companies that are solving real problems, there’s no reason that you can’t get real returns. And you create a more sustainable company,” Coulter says. “If you ask people to take below-market returns, there isn’t enough below-market capital out there to solve the problems we have to address.”

Coulter thinks there’s much more untapped demand, not just from ESG-curious investors but a new generation of entrepreneurs seeking “impact capital.” “I think there’s an opportunity for this market to grow — substantially,” he says. He has said that he believes the “climate revolution” will mimic the explosion of the digital economy: Many people 30 years ago knew tech would be big, but they still underestimated just how big it would get.

So far, institutional investors have driven much of the growth in ESG investing. Engine No. 1 hopes to bring its approach to active ownership to the masses with a recently launched exchange-traded fund called Engine No. 1 Transform 500 ETF (ticker symbol VOTE). Composed of the 500 largest companies in the U.S. public equity markets, it is by exposure virtually identical to any S&P 500 fund. The difference lies in how it plans to wield its shares.

The asset managers who run many ESG funds often vote their shares in ways that run counter to the values of impact investors. “There are climate-focused funds that have voted against 90 percent of climate-related proposals,” says O’Leary, who came up with the idea for VOTE while sitting on the second floor of Bass Library at Stanford GSB. “Every additional dollar in the [VOTE] fund makes us one dollar stronger in our voting and our advocacy work.”

It remains to be seen how many investors can muster the level of ambition and expertise required by Engine No. 1 and TPG’s respective strategies. Whatever happens next should provide an excellent test of Larcker’s and Seru’s questions about the potential size of the sustainable investment market.

Larcker looks forward to seeing how it all pans out. And he is willing to concede that when it comes to investing for change, the perfect should not be the enemy of the good. “At some point,” he says, “there’s a leap of faith where it’s like, ‘Let’s go for it and see.’”