Doing Well & Doing Good: A New Approach to Impact Investing

"A bad system will beat a good person every time.” - W. Edward Deming, American Engineer, Professor, Author (1900 to 1993)

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A big change is happening in the investment world. Family offices, endowments, pension funds, other institutions and certain individuals are demanding that their investments do more than simply generate a financial return. They also want that return to be aligned to their values and, better yet, help to advance those values in some way (e.g., improving the environment). To meet this demand, multiple SRI (socially-responsible), ESG (environment, social, governance) and so-called social impact investment options have become available, in both public and private equity markets. The growth has been notable, with one estimate indicating that nearly $9 trillion dollars were invested in such a manner in 2016, up from under $1 trillion, just 10 years ago.[1]  

In private equity, investments have helped to start innovative companies and projects that might not otherwise have received capital. These investments can provide a strong financial return, be aligned to one’s values, have a material impact on the company itself and, if the innovation is big enough, impact an entire industry (e.g., the Walton Family’s early investment in First Solar). Social impact bonds are another, more creative example. These financings have changed the way that governments, investors and companies work together to drive social outcomes (e.g., less recidivism, homelessness).[2]

However, investing in publicly-traded companies in the stock market is fundamentally different. Here investors are not giving new capital to a company but, rather, simply trading existing capital from one owner to another (with IPOs and public capital raises being rare exceptions). The result is that while there are an increasing number of options aligned to one’s values, there are few public investment firms that have real societal impact. While some will claim this is the nature of public equity investing, it seems like a missed opportunity. After all, public equity markets are massive and hold the potential to be a real driver of change.

To address this gap, M2X is adding a new initiative to its existing values-aligned investment approach (note: the portfolio already has guidelines to ensure investments are made in a way that is aligned to positive societal values such as improving the environment). As opposed to most societal impact initiatives that use capital as the tool for change at individual companies, M2X aims to use its expertise in systems analysis and behavioral economics to promote more socially beneficial market systems. This, in turn, will lead to more capital flowing in ways that benefit both investors and society. Put another way, instead of corporate activism for personal financial gain, M2X’s social impact efforts are akin to systemic activism for societal benefit.

Understanding Where Public Equity Investing Falls Short in Driving Societal Impact

There are multiple options for public equity investors to invest in ways that are aligned to their values, but are not necessarily impactful in advancing those values. For example:

• Negative Screens: The potential investment universe is limited by screening out those companies not aligned to positive societal values. For example, these options will not invest in polluters or tobacco companies.
• Divestment Programs: This is done by retroactively applying a negative screen, selling certain types of investments and indicating they will not be bought in the future. For example, some university endowments have divested of fossil fuel companies.[3]
• ESG Evaluation: Environmental, social, and governance (ESG) data is evaluated to understand hidden risks and actively seek those companies aligned to values which may be an indicator of their potential to outperform.

These strategies are commendable but not very socially impactful. After all, if the financial fundamentals are good, other investors who do not share your values will simply step in and buy the security. Ironically, your avoidance or selling may give more upside to the new buyer who does not share your values.

So-called engagement strategies are the closest public equity investors can get to driving societal impact. For example, shareholders filed a resolution to have AES Corporation, a utility, publish an assessment of portfolio risks under a scenario where global temperatures increase by 2° Celsius.[4] There are several limitations with engagement strategies, however. First, many investors do not have the level of capital needed to exert influence in such a way. Second, such a strategy often means owning shares in a company whose practices may conflict with your values. Third, the impact of these resolutions is not always particularly impressive. In short, for public equity investors seeking positive societal impact, most options tend to fall short as shown in Figure 1.

Question and Answer (Q&A) on M2X’s Approach to Driving Positive Societal Impact

I have spoken to many people on this topic in the past several months. Below are the most common questions posed.

Q: What is M2X’s approach to having societal impact?

A: Use insights from its existing investment research, and expertise in systems analysis and behavioral economics, to identify, analyze and influence market systems to produce better outcomes in the future

Nearly no one deliberately creates nor desires pollution, income disparity, hunger, energy insecurity, inequitable education or poor healthcare. Yet, these problems persist and, in many situations, are getting worse. Why?

These problems are systemic in nature, the result of a complex weave of variables that all influence each other. Often attention is focused on a part of a system or market, such as on a particular company or technology. Yet, these are simply one part of many that exist in most systems or markets (e.g., transportation, energy, agriculture). Other factors can include competitor behavior, domestic policy, foreign policy, commodity prices, technological advances, future expectations, regulation, tax code, compensation structures, macroeconomic variables, public perception, and information flows to name just a few. The way in which these variables influence each other lead systems to exert their own behavior, which is often much more complex than the sum of its parts.

When system behavior is not well understood, well-intentioned efforts can have limited impact – both financially and socially. There are countless examples:

• European climate change policies that ironically led to incentives to burn more coal due to a confluence of events related to shale gas drilling in the U.S., coal-to-gas switching, commodity price linkage mechanisms, and over-supply of carbon emission permits
• Energy-efficiency mandates that have led to more waste as people’s behaviors change (e.g., what is known as the “rebound effect”); the same dynamic has driven people to smoke more with the innovation of low-nicotine cigarettes
• Countless government initiatives, job programs, and agricultural programs waste money with no positive impact – in fact, they often make situations worse; for example, the goal of increasing homeownership was a key factor in the 2008 financial crisis

Many of the biggest issues in society are the result of the dynamics of the system as a whole, even if it is often a single person, company or policy that gets the most attention. Examples include:

• Some systems result in continued worse performance as seen in healthcare and public education; performance declines lead to lower goals, less corrective action and complacency
• Other system dynamics lead to “winner-take-all” outcomes; when advantages beget advantages, inequality results as we have seen in education, wealth and opportunity

Systems analysis (the study of complex systems) and behavioral economics (the study of how people form judgment) are core components of the M2X investment process. These disciplines provide great insights into macroeconomic growth and contraction, industry secular growth and decline, cyclical booms and busts, and individual company performance. This research, which is already done as part of the investment process, often highlights how market systems are leading to poor societal outcomes. M2X aims to take this knowledge and expertise a step further to drive positive societal impact. There are three steps:

1.   IDENTIFY markets (i.e., systems) failing to drive positive societal outcomes

2.   ANALYZE systemic drivers and points of leverage

3.   INFLUENCE systemic drivers to lead to better outcomes

The task might seem daunting. So, the question is: how do we do that? That, of course, will depend on the specific project undertaken. It can take the form of publishing research, helping to close information gaps, working with NGOs (non-governmental organizations), like-minded family offices, or other groups on special projects, and working with policymakers in understanding the impacts of current and proposed policy.

Smart systemic thinking can have more impact with less effort than cynics might think. Take the case of air pollution in China. Several years ago, the U.S. embassy in China installed an air-quality measurement device on its roof and started to tweet out that data. This simple maneuver created an information flow that was missing in the system, which subsequently led the public to pressure the government to take steps to improve air quality. David Roberts from the U.S. State Department, said this:

”When the U.S. Embassy in Beijing started tweeting data from an air-quality monitor, no one could have anticipated its far-reaching consequences: It triggered profound change in China’s environmental policy, advanced air-quality science in some of the world’s most polluted cities, and prompted similar efforts in neighboring countries.” [5]

Creating that information loop impacted policy which then led to an environment where capital flowed to companies focused on improving the environment. Simply putting capital into a company without this change would have been a lot less impactful, both financially and socially.

Another way to think about it is this: If capital is not flowing via existing market mechanisms, is forcing investment the best means to change outcomes? After all, there is a reason that capital did not flow there. Even if some capital may help, there is a risk that too much “socially impactful” capital ends up chasing too few quality opportunities. The result will be disappointing financial and societal outcomes, which could lead to scarcity of much-needed capital in the future.

Want to prevent global warming? Conserve water? Reduce wasted electricity? Promote healthier living and eating? Have more secure domestic energy? Effective market systems are critical to achieving these goals and, as such, is the aim of M2X’s societal impact efforts.

Q: Doesn’t this take away from time better spent focused on generating financial returns?

A: To the contrary, it is additive to the ability to generate financial returns

M2X is, first and foremost, focused on generating best-in-class risk-adjusted financial returns for clients. We believe it can be done in a way that is aligned to positive societal values and that the firm’s expertise in systems analysis and behavioral economics can be used to influence markets to produce better societal outcomes. There are two reasons the social impact effort is accretive, not dilutive, to the firm’s investment return objectives.

• Positive feedback to investment research: The work done on the societal-impact projects will positively impact the investment process as the relationship network and knowledge expands beyond those of other investors. Great investment ideas often come from non-traditional sources and thinking, in our view.
• Helps attract talent: A firm with a deeper mission than simply generating a financial return has an ability to attract more unique talent and capital partners.

It should be noted that the impact efforts are limited to 10% of firm time. It is important to keep the time limited in some way but, at the same time, have a dedicated time allocation to the effort to ensure it becomes part of the collective effort and culture of the firm.

Q: Is an investment firm the right group to try to influence this type of change?

A: An investment firm can be a helpful advocate for change for several reasons

Public equity investors can be an effective, incremental voice for several reasons:

• Deep and real-time understanding of how markets work: Good fundamental investors understand companies’ relative strengths and weaknesses, the impact of policies and regulations, looming secular and cyclical changes, and the drivers of capital flows. In short, they understand how industries operate, yielding financial outcomes for companies and non-financial impacts to society.
• Limited conflict with investments: Public equity investing is highly liquid and entire portfolios can be changed in minutes. This is very different than illiquid private equity investing where the motivation to influence a particular market structure could be questioned (e.g., pushing for change to help get out of an illiquid position).
• Not beholden to outside influences: Many other groups are beholden to a certain view. Politicians, lobbying groups and industry executives all advocate in their self-interest based on groups that influence their activities. Public equity investors face less pressure here and therefore can be a more open-minded voice to advocate for the best solutions to the problems faced.

M2X, with its expertise in systems analysis and behavioral economics, is uniquely positioned to advocate for positive systemic change.

Q: How will impact be measured? How much impact can you have?

A: Each case will be unique in its measurement; Systemic impact is hard, but worthwhile

In terms of measuring the societal benefits of the efforts, each project will be unique and, as such, will require project-specific reporting on the benefits achieved.

It is true that systemic issues are hard to influence. Yet, it is also true that the systemic drivers of poor societal outcomes are critical to understand and change to have broad-reaching impact. Even small successes can be very worthwhile and more impactful than numerous investments made into the same sub-optimal market structure.

Q: Do some investors do this already?

A: Few do it with the primary focus on the systemic drivers of poor societal outcomes

Many investors periodically comment on individual positions, their industry view or agitate in some way to help their investments gain in value. Yet, that is not done with the intention of societal impact. For those that do occasionally comment on such issues, few have a dedicated portion of firm time set aside to affect such change.

Final Thoughts

Market-based economic systems have lifted untold millions to a better quality of life. Yet markets in many industries and geographies can – and do – evolve in ways that yield needlessly poor societal outcomes. Sometimes it is a poor policy, an information gap, or an entrenched player thwarting change. Other times, it is a confluence of several factors. But, no matter the reason, good intentions will make no difference to the outcome if a particular market system is not functioning well.

So-called impact investing exists, in a sense, because some of these systems (e.g., transportation, energy, education) are not working well. Ultimately, the goal is to make impact investing obsolete as well-functioning markets produce an optimal set of financial and societal outcomes. While this is unattainable as the thousands of market systems in the world economy are constantly evolving as their constituent parts change, it is a helpful reminder of the core objective. After all, if “a bad system beats a good person every time,” why not strive to improve systems to create better outcomes more of the time?

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[1] Report on U.S. Sustainable, Responsible and Impact Investing Trends 2016, U.S. SIF Foundation

[2] See “Sir Ronald Cohen: Impact Investing is the Future,” for a good discussion on social impact bonds https://www.youtube.com/watch?v=VgWJZiRL7BQ. Or, see, “Biggest 'Social Impact Bond' In The U.S. Targets Recidivism,” Forbes, February 2014.

[3] See “Stanford to Divest from Coal Companies,” Stanford Report, May 2014. Also, “Why Divestment Fails,” The New York Times, May 9, 2014.

[4] Ceres, an advocate for sustainability leadership formed after the 1989 Exxon Valdez oil spill, maintains a list of such resolutions. See https://www.ceres.org/investor-network/resolutions.

[5] Wired Magazine, “Opinion: How the US Embassy Tweeted to Clear Beijing’s Air,” March 2015

Michael Molnar Biography

Michael Molnar is the Portfolio Manager and Managing Member at M2X Capital LLC, an asset management firm focused on investing in public equities. He has been involved in the energy, industrials, materials, agriculture and consumer sectors as a hedge fund investor, investment banker and sell-side equity analyst for over the past 15 years. In 2016, he published the book, Decoding the Energy Enigma: Improved Decision-Making on This Generation’s Most Pressing Issue, which applies systems thinking and behavioral economics to important topics in energy.

Previously, Michael was a Founding Partner and Co-Managing Member of Lorem Ipsum Partners LLC, a long/short equity hedge fund focused on the energy, industrial and agriculture sectors which grew to approximately $200 million in assets under management during his tenure.

He was also a Founding Partner of Greentech Capital Advisors where he advised clients on M&A transactions, strategic joint ventures and private capital raises. He served on the Board of Directors and the Commitments Committee, helping the firm to grow nearly 10 times, raise two rounds of capital and expand to three offices around the world.

Prior to Greentech Capital Advisors, Michael was the lead equity analyst for the U.S. alternative energy and coal sectors at Goldman Sachs. At Goldman, he also helped to start the Small and Mid-Cap Research Team and was a member of the Special Situations Research Team.

Prior to Goldman Sachs, Michael was a Visiting Research Fellow at Accenture’s Institute for High Performance Business, a company-sponsored think tank. His research focused on management techniques to most effectively maximize shareholder value and was published in both internal and external business journals. He was also a manager in Accenture’s strategy consulting practice.

He started his career as an auditor with Arthur Andersen LLP. While in university, he interned at the Federal Bureau of Investigation where he assisted in white-collar crime investigations.

Michael received an MSc in Decision Sciences with Merit from the London School of Economics, an MBA in Finance from the University of Chicago, and a B.S. in Accounting with Honors from Rutgers University. He is a CFA (Chartered Financial Analyst) charterholder and is a former CPA (Certified Public Accountant - inactive), CMA (Certified Management Accountant – inactive) and CFM (Certified in Financial Management - inactive).

Outside of work, he enjoys yoga (completed yoga teacher training), stand-up comedy (both watching and performing) and training in mixed martial arts.

He can be reached at [email protected].

Disclaimer

This report is confidential and intended only for the person to whom it has been delivered and may not be published, distributed or reproduced for any purpose without prior written consent from M2X Capital LLC. 

References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as a recommendation to purchase or sell such securities. The contents hereof should not be construed as investment, legal or other advice. Where information provided in this document contains forward-looking information including estimates, projections and subjective judgment and analysis, no representation is made as to the accuracy of such estimates or projections or that such projections will be realized.

The views and information expressed herein are solely those of M2X Capital LLC as of the date of this letter and are subject to change without notice. This is not an offer or solicitation for the purchase of interests in any investment. Past performance may not be indicative of future results.

Copyright 2016 by M2X Capital LLC. All rights reserved.

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