Why ESG needs to focus more on the social aspect

There is not sufficient reward for investments that benefit society, argues Ignacio Diez Torca of Trea Direct Lending, who says it’s time for government tax breaks.

Ignacio Diez Torca

Over the last two decades the US and Europe have undergone a process of de-industrialisation with one clear loser: the middle class, which has effectively become the lower middle class. Excessive offshoring of production to Asia-Pacific has reduced production costs and increased profits for those companies that have carried out that offshoring. Globalisation, offshoring and excessive ‘financialisation’ of the economy – along with other factors such as increased robotisation and digitisation, and zero interest rates – have led to an all-time high with regard to wealth inequality.

As we move into probably one of the most severe economic downturns in the last 50 years, financial risk will increase, but so will social risk – especially among the most vulnerable in our society – and political risk, thereby opening the doors to extremism. The strength of the European Union will surely be tested.

When we recover from the health effects of the covid-19 virus and we assess the economic consequences it has had, it will be time to take action and correct the intrinsic misalignment of interests in the financial world that continues to produce undesirable consequences.

Are incentives really aligned?

In capitalism, the best economic system – or the ‘least bad’, for those who may wish to discuss semantics – is one in which the economy is driven by shareholders who risk their money to pursue an economic activity. In financial terms, shareholders have options on the value of the company. New and better products would increase sales and margins, thus increasing the value of the company and therefore boosting equity value. To increase the value of their equity, shareholders rely on top management, who in turn are often incentivised with equity option plans: if the equity price increases, they stand to make a lot of money.

It was recently announced that Boeing will have to be rescued by US taxpayers as it is a strategic company for the US. How could a cash cow like Boeing, whose shares went up over 200 percent in three years, be in such a situation? There are potentially several reasons for this. The collapse of the air traffic industry has had a highly negative effect on demand, but certainly the $40 billion in shares bought back (a large contributor to the 200 percent share price increase) does not help. Had Boeing not bought back those shares, the rescue would not be needed or certainly would be much smaller.

In a zero-interest environment it is easy to see what the easiest and fastest way to increase the value of your equity is: not by innovating, improving products or expanding production; that takes too long. It is by taking on a lot of cheap debt to cancel equity. Call it share buybacks for publicly listed companies, or leveraged buyouts for private companies.

ESG and what’s going wrong

Now is the time for environmental, social and governance criteria to be used to measure the impact capital has on society rather than using the term ESG as a marketing catchphrase.

Typically, ESG has focused mostly on the ‘E’ and on banning certain sectors such as weapons, tobacco, gambling, alcoholic beverages and other morally controversial sectors. However, it has ignored a very relevant meaning of the ‘S’.

To understand social impact, it is important to realise that a company is not just made up of shareholders and creditors. It has other stakeholders: employees, whose main source of income is their salaries; governments, which collect taxes from the company and its workers to finance public spending; clients, which might depend on the company’s product or service; suppliers; and society as a whole, which will suffer or enjoy the negative or positive externalities the company creates.

An externality is the effect, positive or negative, on a third party of an activity that said person did not choose.

To see the effect of the externalities that an investment decision could produce, let’s look at two investment cases as examples:

Case A A fund acquires a healthy company through an LBO, leveraging the company by 7x EBITDA to increase the equity IRR. Demand drops and, as a result of such high leverage, the company goes bankrupt. Leveraging the company so much produces a negative externality to its stakeholders.

Case B A fund invests in a company to expand capacity, hiring new employees and increasing production in the country. This is a case of a positive externality.

Investors that invest in Case A currently do not pay for – or were not obliged to price in – the negative externalities that such high leverage would potentially pass on to stakeholders. These externalities include the risk of unemployment, potential loss of taxes, and reduced production that will be substituted with imports.

Investors that invest in Case B currently do not benefit from the positive externalities they are creating – including hiring employees, increasing activity and overall salaries – and which result in higher tax revenues.

Investors prefer Case A as the return is higher due to the fact that no one is paying for the externalities. Case B is less attractive as no one is paying for the positive externalities it creates.

Time to refocus our financial system to save Europe

Governments should start incentivising or subsidising – probably through tax breaks – productive investments and activities that generate positive externalities. Publicly listed companies, private equity managers and credit managers are too focused on financial engineering (promoting leveraged buyouts or share buybacks) rather than on spending time and effort in making productive investments.

The time has come to price in externalities since the private sector has not yet done so. That is the real evolution of ESG.

Let’s use this crisis to redirect our focus and create an economy that works for the people and for their countries. Earnings and financial returns are the drivers of a well-functioning system. However, they should be obtained when a company creates value for society instead of when someone uses financial engineering and thus puts stakeholders and society as a whole at risk.

Let’s shift priorities and incentives to save the European Union.

Ignacio Diez Torca is managing partner at Trea Direct Lending, a fund manager with offices in Madrid and Barcelona