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Can investors do well by doing good?

Can investors do well by doing good?. Sébastien POUGET Toulouse School of Economics. Can investors do well by doing good?. Co- director of the research center on Sustainable Finance and Responsible Invesments Chaire « Finance Durable et Investissement Responsable ».

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Can investors do well by doing good?

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  1. Can investors do well by doing good? Sébastien POUGET Toulouse School of Economics

  2. Can investors do well by doing good? Co-director of the research center on Sustainable Finance and ResponsibleInvesments Chaire « Finance Durable et Investissement Responsable » Sébastien POUGET Toulouse School of Economics

  3. Chaire « Finance Durable et Investissement Responsable »

  4. “The Washing Machine”: Investment Strategies and Corporate Behaviorwith Socially Responsible Investors Christian Gollier and Sébastien POUGET

  5. 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)

  6. Source: US SIF, Sustainable and ResponsibleInvesting in the United States 2012

  7. 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

  8. Source: Novethic, Chiffres 2013 de l’investissement responsable en France

  9. 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…

  10. Source: EuroSIF, European SRI Study 2012

  11. 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)

  12. 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

  13. Pourquoi capitalisme devient solidaire? Sébastien Pouget

  14. Pourquoi capitalisme devient solidaire? Sébastien Pouget

  15. 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

  16. Why SRI? Sébastien Pouget

  17. Why SRI? Sébastien Pouget

  18. 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

  19. 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?

  20. 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

  21. 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

  22. 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

  23. 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

  24. Model

  25. Model l

  26. Model

  27. Model

  28. Model

  29. Model

  30. Model

  31. Rational expectations equilibrium

  32. Standard strategy

  33. Responsible strategy

  34. Responsible strategy

  35. Responsible strategy

  36. Responsible strategy

  37. Responsible strategy

  38. 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)

  39. 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)

  40. Intervention of a raider

  41. Intervention of a raider

  42. 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 partα of the shares such that the responsible strategy is adopted

  43. 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)

  44. 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

  45. 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)

  46. Relation with empirical evidence

  47. 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

  48. 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

  49. THANKS FOR YOUR ATTENTION! Researchcenter on SustainableFinance and ResponsibleInvesments www.idei.fr/fdir

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