Overlap 101: A Semi-Subjective Primer On Sustainable Investing

Welcome everybody to the latest installment of our monthly newsletter!?

It’s been a very productive month at Overlap, especially on the hiring front. We’ve tripled the size of our team! Granted, that means we’ve gone from 1 person to 3, but it’s a big first step.

I was thrilled to welcome Rob Morelli to the team as our Director of Ops in mid-December, and Gauri Jaswal at the beginning of this week as our Chief of Staff. Both Rob and Gauri bring a level of sophistication, intelligence, experience, and talent that are rare for any business, let alone a startup, and are already adding value in a wide variety of ways as we build out our organization. In addition, both new team members share a strong enthusiasm for Overlap’s mission, an essential attribute for anyone we bring on to the team. Please join me in welcoming them both.

Now that we have a larger org in place, I'll be sharing more operational updates in future months. Today, though, we continue the process of educating our readers on topics that are essential to Overlap's strategy and mission. With that in mind, below please find a (semi-subjective) primer on Sustainable Investing.

********

ESG. SRI. Impact. World-Positive.

There's a lot of terminology thrown about in the world of "Sustainable Investing", and people are largely confused about what it all means. Making matters worse, there are plenty of charlatans looking to capitalize on this confusion by cloaking themselves in false virtue by using these words. Further worsening matters, there are politicians of all stripes looking to stir up fights and generate fury from what's essentially a wonky, apolitical topic.

At its highest level, Sustainable Investing refers to taking the societal and environmental effects of a company into account when evaluating an investment. It takes the view that the "traditional investing" mindset of not taking these effects into account has sometimes led to certain unsustainable business practices which, while not illegal, put society/humanity at risk. Sustainable Investing is a trend which has come into its own over the past decade-plus and is one of the highest growth areas of the overall investing landscape.?

Under the umbrella of Sustainable Investing, we get into a confusing array of methodologies, each of which demonstrates a different strategic philosophy and tactical roadmap to fulfill the overall goal referenced above. My hope in today's newsletter is to explain how we got here, demystify these terms, and offer a blueprint for the future. At the very least, I want to remove the specific type of investing that Overlap does (“World-Positive Investing”) from the fray, as I think we're doing something that everyone, regardless of party affiliation or economic philosophy, should be able to rally behind.

In order to get there, though, we first need to talk about how we got here. With that in mind, Let's start with a History Lesson:

A Brief History of Capitalism: Versions 1.0 - 3.0

Let’s consider Sustainable Investing in the context of history as a paradigm shift in market behavior which can be thought of as Capitalism 3.0. This stands at the end of a time continuum which began with Capitalism 1.0

Capitalism 1.0

This was the no-holds-barred free market that existed from the birth of industry to the early 20th Century. The underlying mindset of Capitalism 1.0 was, basically, "Do Whatever You Want (except maybe murder or enslave people [unless whatever government you exist under is okay with that, in which case, whatever…])". As all but the most strident libertarians will admit now, this was a brutal system for the great majority of people.? While economic output flourished, the societal effects that came with it (forced labor, factory fires, child amputation, stock swindles, neo-colonialism, monopolization, etc.) were highly unsustainable.

As a result, people demanded (through the vote in democratic countries, and through violence in non-democratic ones) an evolution of the system. Many countries, including the US and the UK, took a path wherein the excesses of capitalism would be restrained by the government in a manner intended to benefit the greater good.?

(Some other countries made the disastrous choice of embracing Communism, a model which posits it’s a good idea to hand over all of the governmental and economic power of a society to a small cabal of people, who are magically supposed to not act greedy, corrupt, or callous while wielding this power. But, that's probably another topic for another post…)

Capitalism 2.0

In America, an era of reform was primarily ushered in through the presidencies of the Roosevelts (Teddy from the Republicans, FDR from the Democrats), and led to what I refer to as Capitalism 2.0. The essential concept was that companies would agree to follow laws that provided for a more competitive market and better treatment of workers (and, eventually, certain environmental and consumer safety considerations). As long as a company followed these laws, they could essentially act however they wanted. If a specific negative wasn't legislated externally, companies were free to ignore it without any risk of blowback from customers or other stakeholders.

Capitalism 2.0 was a significant improvement over the original, but that didn't mean it wasn't controversial in its infancy. There was intense pushback from both sides of the political spectrum; many conservatives felt it would upset the free market efficiency and resourceful spirit that had led to the industrial success of the day, while many liberals felt it was a superficial dressing of a broken system which wouldn't lead to any actual improvement in people's lives. Fortunately, both sets of extremists were primarily wrong, and the 2.0 version of Capitalism led to a combination of increased productivity and livelihood for most people through the next century or so.

Capitalism 2.0 was, and remains, far from perfect. Instead of compelling companies to further consider the external ramifications of their processes and behaviors, some businesses that exist under Capitalism 2.0 treat the regulatory environment as a morality car wash; ie, if they're following the law, then they're acting appropriately, and there's no need for them to further consider their businesses impact on the environment or society at large.?

Such a mindset has led to persistent neglect of certain societal problems over the course of decades. The most obvious examples being climate change, racial equity, and infrastructure/supply chain fragility. The legislative gridlock preventing change on these issues has led to a push for a refinement to the system, wherein companies recognize their obligations to society at large and the ramifications of unsustainable business practices without being forced to by the government. This has set the stage for the current discussion around Sustainable Investing, and is ushering in the era of Capitalism 3.0.

Capitalism 3.0

At a high level, Sustainable Investing is focused on making sure that capitalism remains, well, sustainable. It recognizes that the incentives of profit and enterprise, while incredibly powerful in getting things done, can create blind spots. The goal is not to throw out the current system, but rather create structures of process, measurement, and accountability which encourage companies to develop business models which are beneficial to shareholders, but not at the expense of the planet or society overall.

If this sounds like a lot of pie-in-the-sky thinking, that’s because at some level, it is. While it has all come a long way in the past decade-plus, the Sustainable Investment ecosystem is still figuring out the specifics of what it wants to be. There are a lot of competing ideas and methodologies that focus on how to best get at this long-term solution, which creates a fair amount of the confusion that people feel with all the various acronyms floating about. I’ll do my best in the next section to demystify what’s going on in the trenches.?

Alphabet Soup

Let’s dive into some of the various methodologies/terminologies that are utilized by the Sustainable Investing community.

SRI?

Initially, there was SRI, or “Socially Responsible Investing”. SRI is the practice of explicitly excluding certain investments or industries from one's portfolio. It’s pretty straightforward - if you don’t like the environmental harm caused by fossil fuels, you don’t invest in them.?

SRI became popular a decade or so ago, as it was the first commonly-accepted investment methodology for articulating a position against a specific societal problem. Many investors or funds still follow some sort of industry exclusion protocol, and many of us do this within our own stock portfolio, even if we don’t realize it, by shying away from investments in industries that don’t sit well with their conscience.

Unfortunately, while SRI is easy to understand, and has its use cases, it’s also a pretty crude tool for actually affecting change for two main reasons:

• It doesn’t encourage positive industries, it just discourages ones perceived as negative?
• Simply rejecting an entire industry doesn’t leave the option of investing in companies which may be working to reform or migrate a negatively-impacting market?

For instance, let’s say you were looking at investing in an energy company that, a decade ago, used to only own fossil fuel-burning power plants, but has since migrated its way to a variety of renewable energy sources, such as solar, wind, and biofuels. If this company now generates 70% of its revenue from renewables and growing, but still has 30% of its revenue coming from fossil fuels (the profits of which it is reinvesting into more renewables capacity), is it really in the best interest of the planet for investors to reject that company? Most people would say not; in fact, the argument is likely that more outside capital should support this business, and hasten their transition towards renewables.

These shortcomings of SRI led to the desire for more nuanced sustainability strategies, including the emergence of the strategy which has become the biggest topic of discussion and controversy in sustainability today: ESG.

ESG

ESG, which stands for "Environmental, Social, and Governance", has become the dominant form of Sustainable Investing, with nearly every large financial institution adopting some form of ESG framework for their investing process.

In an ESG investing framework, a detailed analysis is performed on potential investments to determine the overall negative or positive contributions which that company is responsible for with respect to a set of three guidelines:

1. Environmental
2. Social; and
3. Governance

This includes items such as a company's carbon emissions footprint, the diversity of their employee base, and the independence of its Board of Directors. These ESG factors will oftentimes be used to generate an "ESG score" or rating based on a proprietary formula, and asset managers will then create guidelines for the required level of ESG score/rating for an investment to be considered viable for that institution or fund.

The thesis behind ESG protocols is that, by measuring and reporting these metrics, potential investors can get a better picture of the overall sustainability (or lack thereof) of a company's operations. This judgment will thereby affect the perception of the company's long term investment viability. If the company scores too poorly against an ESG rubric, it loses its luster as a potential candidate for investment. This McKinsey study gives a helpful overview of how a prudent ESG strategy drives value for a company.

Note that ESG is more focused on the processes which a company follows rather than what its ultimate product or service is. A company's products don’t have to necessarily correlate with an altruistic mission in order to score well on an ESG ranking, as long as the company is prudent with respect to its emissions responsibility, the way it treats its employees, and so on. For this reason, companies that are sometimes perceived to be in “bad” industries can nevertheless achieve high ESG scores, which leaves this system somewhat vulnerable to potential claims of hypocrisy, or “greenwashing” (ie, pretending to care about sustainability but not) as it’s known in the investment industry. In a further attempt to stifle greenwashing, certain foundations that have helped define the ESG movement have recently changed the yardstick by which they determine what funds should be considered ESG integrated/compliant and which should not, which has led to some confusion on the overall ecosystem’s growth trends.?

Furthermore, the detailed system for ESG scoring that some institutions use can sometimes become too convoluted, leading to head-scratching results, the most notable example being the S&P ESG index's move a while back to include ExxonMobil but exclude Tesla from its ranks. These types of outcomes are usually the result of a clunky ESG rating system that doesn’t appropriately weigh all its factors in a manner that holistically holds true.

Quirks like this provide ammunition to claims that the entire ESG system is flawed, and that investors which abide by these systems are not making rational investment decisions, and that they should therefore be thrown out wholesale. On the other hand, there are parties which are fine with such inconsistencies, as long as they encourage societal/environmental goals they hold dear, regardless of the economic ramifications.?

As usual, both extremes likely miss the point. ESG is, for the most part, a well-intentioned framework which is still being developed, vetted, and proven, and will be for the foreseeable future. Instead of coming out solidly “for” or “against” the system, it’s probably in everyone’s best interest to work towards determining common-sense contours and developing measurement tools which can be applied and understood easily without a lot of additional cost.

In general, a well-mapped ESG scoring framework will reflect the fact that running an ESG-compliant business is a helpful mechanism for generating long-term shareholder value. By focusing on being a responsible steward of one's employees, stakeholders, and the environment, a company allows itself to benefit from societal tailwinds, positive public opinion, and avoid the types of systemic shocks which come with a short-sighted investment approach. It is for this reason that some people consider ESG as a proxy for corporate integrity.

Impact Investing

Up next is Impact Investing, which is often conflated with ESG, but is distinct. Whereas ESG is primarily focused on a company’s processes, Impact is more focused on the specific product or service that a company provides. More specifically, Impact Investing is the act of investing in companies whose business model is directly aligned with some sort of clear societal or environmental good.?

Impact Investing was brought to the forefront by a number of philanthropic organizations (including the Rockefeller Foundation) over the course of the past decade or so as a reaction to some of the concerns and difficulties associated with other sustainability models discussed above. The core concept is that, by investing in companies who “do something good” as their basic business model, encouraging their success contains a direct collinear relationship to making the world better.?

For instance: If you run a business that replaces fossil fuel energy generation with solar power, your business is directly contributing to the reduction in carbon emissions; therefore, the more you grow your business and execute on a logical business plan, the better off we all are. Similarly, if you have a business that offers affordable, responsible healthcare in underserved communities, your business model is directly aligned with doing something great that many other companies aren’t doing. You don't need to donate a portion of your sales to charity, or develop a set of non-core activities to position your company as being good for society - if your company is an Impact business, you can just show up to work and do what you do and you'll be benefiting us all.

There’s an elegant simplicity in the concept of Impact Investing which is missing from its wonkier cousin, ESG. Having said that, Impact can get very nuanced as well, when it comes to deciding what companies qualify for a specific investor’s definition of “Impact”, and which companies do not. With everyone trying to claim the mantle of “doing good”, it is just as important in Impact as it was in ESG to develop a thoughtful, defensible methodology which can be consistently applied across companies and industries to determine what makes the cut and what does not. As I discuss more in the next section, this is an imperfect practice, but a necessary one to at least keep out companies which are not directly mission-oriented.

A lot of times, instead of someone considering themselves a broad impact investor, they’ll instead dedicate themselves to a specific mission or area within the overall Impact umbrella and invest solely in that theme. For instance, the proliferation of climate-focused investment funds, which invest solely in alternative energy (with similar examples focused on education, life sciences, etc), is a perfect example of an Impact investment strategy that has achieved significant mainstream success.?

World-Positive Investing

Last, but certainly not least, we come to World-Positive Investing, which is the Sustainable Investing model that Overlap has embraced. World-Positive investing is very similar to Impact Investing - we are focused on investing in companies whose business models have a direct positive impact on society. The biggest divergence from Impact Investing is that World-Positive Investing typically adds, within its definition, companies that look to invent new products or systems which have the potential to drastically improve productivity, even if we don't yet know the specific tangible societal benefit that will accrue from their widespread adoption.

As mentioned above, the world of Impact investing has developed a set of very specific rubrics which define what Impact is and what is not. This is useful for establishing clear parameters in later-stage investing, but in the world of frontier tech, it has the potential to leave some highly-beneficial companies behind. To wit, one of the requirements in most Impact Investing definitions is that a company provide a tangible, trackable, Day 1 benefit to the environment or underserved/lower income people, which can be measured over a company or investment’s life cycle.?

The purpose of this requirement is well-intentioned - it makes it harder for companies without a clear Impact thesis to invent a convoluted one that isn't measurable. However, there are some startup companies in frontier tech working on new technologies that do not have a specific, trackable societal benefit at their inception, but have the power to dramatically improve productivity, or reinvent an industry in a manner that generates an exponential step-change in efficiency. While these companies could be excluded from some definitions of Impact Investing, they are nevertheless important companies to support and invest in, as it is very likely that such benefits will translate to society overall from their development.?

When I take a look historically at some of the innovations that have created the biggest benefits for humanity, many of them would fit in this gap when they were just getting started. Significant examples include the printing press and electricity. I doubt very much that Johannes Gutenberg would have been able to raise money from Impact investors in 1436, as printing presses were very expensive and literacy was primarily the domain of the church. However, the ability to drastically lower the cost of publishing created a soaring increase in literacy and the proliferation of dissenting points of view. This, in turn, led to cascades of reforms that improved peoples’ everyday lives. Similarly, electricity was originally a product used by rich people and industrial titans. Very few people at the time could have foreseen the outsized improvements in quality of life it would yield for the entire world.?

As an investor, it is important to me that Overlap must have the freedom to invest in early-stage companies in sectors like these. Quantum computing, robotics, and space exploration are all areas that I feel have a similar ability to improve society in ways we can’t even dream of now, and I don’t want to be constrained from supporting them.?

Closing Argument

While I believe I’ve made my personal views clear above, I am not here today to convince you that all of Sustainable Investing is important, your institution needs to use ESG rubrics, or that one side is more right than the other in their current views on any of this.?

Instead, my goal is for you to take away the idea that World-Positive Frontier Tech Investing is a great thing, regardless of what political party you’re a part of. Investing in great companies creating new things that will make our world better is something that everyone can get behind.

If that’s not enough for you, below are specific reasons for liberals and conservatives to get on board:

Conservatives

• World-positive investing isn’t really that novel. It’s following the ethos that inventors and titans of industry have followed for ages: creating great products that the world needs in a way nobody else is doing
• Even if you don’t believe in climate change, relying on countries like Russia for our energy security is risky; developing renewable energy solutions here in the US is important for national security
• The same can be said for computing/AI solutions that we can develop here as opposed to in dictatorial regimes around the world
• Robotics and space breakthroughs developed in the US have the ability to transform domestic manufacturing
• You may not like woke liberals, but they’re out there, and better to have them focused on free enterprise solutions to these “problems” than chaining themselves to oil refineries
• This is what Elon Musk does when he’s not saving democracy at Twitter

Liberals

• World-positive investing is a very useful mechanism for encouraging entrepreneurs to keep the benefits to society top-of-mind when starting new businesses; more people will form world-positive businesses than world-neutral or negative businesses if there’s more capital flowing there
• Furthermore, knowing that investors are focused on this will work to “keep founders honest” when they’re growing. Time and time again we’ve seen early-stage founders claim to care about the world but then lose that ideal as the companies get bigger and more powerful or bureaucratic. Having your investors focused on World-Positivity makes that portion of a company’s effort top of mind as it grows
• There are direct benefits to the environment and both direct and indirect benefits to the underserved through the efforts of world-positive companies
• It’s difficult to “greenwash” a company’s business model to spin it as World-Positive in a way that’s convincing if it’s really not. The “sniff test” for the definition is pretty simple and straightforward
• You may not like red meat conservatives, but they’re out there, and if you can channel their efforts into businesses that are solving a problem instead of creating one, all the better
• This is what Elon Musk did before he destroyed democracy by buying Twitter

I hope you’ve found this post informative and encouraging towards Overlap’s mission. Now that I’ve described World-Positivity and Frontier Tech, next month’s post is going to be a deeper dive into early-stage Venture investing, and what that means compared to “traditional”, later-stage investing.