Asset Owners Need To Take Responsibility For System-Level Risks

Much has been written about the negative consequences of public companies focused on short-term returns. Investors focused on quarterly earnings are usually blamed, along with the structure of executive compensation plans and pressure from the board of directors. The concern here is that companies are inhibiting investors’ ability to produce sustainable long-term returns.

This debate is an important one, but it is incomplete. It ignores the overall asset allocation strategies of investors across all asset classes. Investors include both asset owners and asset managers, but little can be done without substantial changes by the asset owners, who sit at the top of the “capital markets value chain.” This issue is addressed in great depth in the Working Paper “ESG 2.0: Measuring & Managing Investor Risks Beyond the Enterprise-level” by Delilah Rothenberg, Raphaele Chappe, and Amanda Feldman of The Predistribution Initiative (PDI). (See also the “Executive Summary.”) This thorough and carefully researched paper contributes to a growing body of work on system-level investing, including the books “21^st Century Investing” by William Burckart and Steve Lydenberg, and “Moving Beyond Modern Portfolio Theory,” by Jon Lukomnik and James P. Hawley.

“Through this research, we identified two key interlocking trends that are contributing to negative feedback loops, and, ultimately, systemic risks to the real economy, society and nature that manifest as systematic risks in the financial system and in investors’ portfolios,” explained Rothenberg, who serves as PDI’s Executive Director.

The first is that in the lower interest rate environment over the past few decades, investors have moved into higher risk asset classes (e.g., private equity (“PE”) leveraged buyouts, venture capital, high yield bonds, private debt, leveraged loans, and collateralized loan obligations) in order to get the overall portfolio returns they need. Other factors contributing to this shift include investor dissatisfaction with public markets, perceptions of growing illiquidity premiums in the private markets, and benchmarking practices, among others. Figure 1 shows the ensuing increase in Assets Under Management (AUM) in the PE industry.

The second is the consolidation of capital flows which I have written about before. For example, in 2019 the 20 largest PE funds had 45 percent of assets under management compared to 29 percent five years ago. Across private asset classes, in 2020 while only 15.7% of the funds raised were in amounts of $1 billion or more, they represented 72.4% of total capital raised. Particularly because asset allocators don’t want to be too concentrated in any asset manager but also need to invest funds in large amounts, the result is increasing capital consolidation with the largest managers. As private market asset managers grow, they need to invest their money in larger deals. Figure 2 shows average deal size has tripled over the last 15 years. Since these are fewer in number and so much capital has flooded private markets, this drives up valuations which lowers returns for a given level of risk. This may incentivize taking on even higher levels of debt, which is easy to do in a low interest rate environment, in order to boost returns.

So far this has worked out pretty well for PE General Partners and Limited Partners. According to Bloomberg, “There are more private equity managers who make at least $100 million annually than investment bankers, top financial executives, and professional athletes combined.” Limited Partners have generally expressed satisfaction with return levels, with many indicating continued interest in allocating even more capital to private asset classes and higher yielding debt strategies.

It is also worth noting that even without PE owners, the “discipline of debt” culture that has been so foundational to the performance of the leveraged buyout industry is increasingly embraced by public companies, as well. Corporations themselves are taking on higher levels of debt. U.S. companies borrowed a record $2.5 trillion in the bond markets in 2020. Non-financial corporate debt level has doubled since the Global Financial Crisis (Figure 3). As a share of GDP, they now well exceed this prior peak (see Figure 3). Given low interest rates and investors’ appetite for higher-yielding products, underwriting standards and credit quality have decreased. The authors reference various sources finding that the number of defaults and bankruptcies ended up much lower than expected thanks to government support. “In September 2020 the Bank of International Settlements reported that based on GDP growth forecasts, bankruptcies should have increased by 20-40% in 2020; instead, the actual number was lower than over the equivalent period in any of the previous five years,” highlights Chappe, PDI’s Chief Economist.

At the same time, it is not clear that workers and other beneficiaries of portfolio companies have received their proportionate share of value created. High debt burdens transfer some risk to a company’s workers and community stakeholders. As companies aim to optimize their capital structures with the highest levels of debt, difficult decisions about financial trade-offs can entail that good jobs deteriorate (e.g., in terms of pay levels, benefits, training, and opportunities for advancement) or even disappear. Investment in innovation and the quality and affordability of goods and services can also suffer. These risks are particularly acute when companies struggle to meet their debt obligations in periods of financial underperformance. This creates knock-on effects in the community when people have less money to spend on consumer staples and services, creating pressure on even more jobs. The systemic impacts for society manifest as growing inequality.

For large “universal owner” investors inequality, just like climate change, is a system-level risk that makes it hard to earn a decent return. Burckart and Lydenberg have written about the risk that inequality poses to investors, along with suggestions of what they can do to mitigate it. These two system-level risks are related. Climate change will have its most serious impacts on those who can least afford it. In turn, when people are struggling to make daily ends meet, it is hard for governments to gather the political will to make the short-term investment so necessary to deal with climate change. We are seeing that dynamic play out through political polarization in many countries and strains in the relationships between developed and developing economies.

The diagram above summarizes the implications of these trends on market structure, drawing a direct link to risks to investors’ portfolios. As credit levels rise, macroeconomic risks increase, and markets become more sensitive to even the slightest downturns or increases in interest rates. The authors reference the work of Princeton professor, Atif Mian and his colleagues, noting these dynamics result in a “debt trap.” The economy is increasingly dependent on persistently low interest rates that make it more difficult for asset owners and allocators to generate sustainable returns, in turn incentivizing continued reliance on higher risk and leverage (the implication for portfolios’ risk-return relationship is depicted in the graph below). This creates a vicious cycle in which high debt burdens ultimately make a rise in interest rates and the withdrawal of government support of the economy even more difficult, ultimately perpetuating the drive toward more risk and debt in the system. Overall, the paper questions how long these dynamics can last, highlighting collateral damage in the form of inequality and secular stagnation as the problem grows.

Through a series of workshops, the PDI team is refining a non-mutually exclusive set of 11 recommendations that are discussed in great detail in the second half of their paper (pp. 44-65). The key to these recommendations is actions by asset owners. They are currently giving mixed messages to the asset managers to whom they give mandates, as well as other portfolio companies. “On the one hand, they are telling them to invest responsibly and for the long term. On the other hand, they are fine with their investees using high-risk financial structures which maximize short-term returns. This leaves the asset managers and portfolio companies caught between a rock and a hard place,” Rothenberg explains. Given concentration levels in the asset management industry, she stresses that it is especially important that asset owners address the mandates they are giving to these largest managers and that they consider how to allocate more capital to smaller and diverse managers.

The 11 recommendations can be summarized in four themes.

Theme 1: Improve internal governance practices. This should start with investment belief and policy statements that articulate the asset allocator’s commitment to long-term, responsible investing from a system-level perspective. These statements need to be backed up with how the asset owner will measure system-level risk and return, not just at the portfolio company level. From here asset owners need to give mandates that are consistent in terms of time frames and incentive structures. PDI, together with The Investment Integration Project, Jon Lukomnik, and Keith Johnson are launching programming for asset owners and allocators on this topic.

Theme 2: Account for externalities. There are a number of emerging approaches to account for externalities. Investors should be engaging with these groups to build consensus around the right methodology, how historical financial benchmarks might be adjusted to account for the true cost of human and natural capital, and how to assess the value of future investments. PDI, together with the Responsible Asset Allocator Initiative (RAAI), and Paul O’Brien (Trustee and Member of the Investment Committee, Wyoming Retirement System; former Deputy CIO, ADIA), recently convened a roundtable on this topic, and PDI expects to develop further programming to facilitate this process with asset owners and allocators.

Theme 3: Consider regenerative investment structures. There are a number of investment opportunities in the middle of the risk/return spectrum that could offer a more stable path toward meeting investors’ required rates of return, rather than relying on a barbell approach across asset classes with heavy allocations to very high and very low risk-return investments. PDI is producing research and programming for institutional investors on revenue-based financing, redeemable equity, and worker and community ownership models, for instance. In addition to their potential to generate attractive risk-adjusted returns, these models can reach a greater number of small and growing businesses across the economy which may not typically be appropriate for PE and venture capital investments. These emerging investment structures and asset classes therefore offer asset owners increased diversification. PDI is also encouraging asset owners to adjust asset allocation practices to enable more exposure to smaller, emerging, and a more diverse group of asset managers, thereby deconsolidating capital flows throughout the economy and markets. Overall, such practices can reduce heavy procyclical behavior and asset class correlations, while also de-risking the economy and markets for society at large, as well as investors.

Theme 4: Engage in policy making and field building. A key focus here is the ever-contentious issue of fiduciary duty. Fundamentally, there is universal agreement that asset owners owe a duty of ensuring returns for their beneficiaries. The debate is whether taking account of sustainability issues contributes to or detracts from returns (the empirical evidence is now clear that the relationship is a positive one), whether the unit of analysis should be at the portfolio company or system level (the focus of the PDI paper), and whether future beneficiaries should be taken into account (it follows from the system-level approach that they should be). Asset owners need to ensure that regulations that govern fiduciary duty support a system-level perspective. They should also work to develop disclosures and guardrails in order to better understand how their own activities support or detract from a system-level perspective. Good work is being done here by The Shareholder Commons and the Task Force on Inequality-Related Financial Disclosures.

Reflecting on the work of the PDI and others Rothenberg noted that “We’re thrilled to see emerging interest in system-level investing. To move the industry forward, we now need to focus on practical solutions for institutional investors, and we hope that our programming can offer some support.”