Morningstar - Q3 2021 - 10

Dispatches
The Smithy of the
Soul of Capitalism
Are ESG and private
equity competing
ideologies?
PHILLIPS CURVE
Don Phillips
Vanguard recently made separate announcements:
that it was hiring environmental, social, and
governance professionals for an ESG product push
and that it would soon offer clients access to
private equity investments. Vanguard's
endorsement lends further credence to the merit
of both of these trendy investment themes-
and stands in contrast to the firm's hesitancy to
date to embrace cryptocurrencies.
Vanguard's unique cost advantages and
Jack Bogle's legacy of investor-first behavior put
Vanguard in an uncommon position among
asset managers and brokerage firms. The
firm has much more to risk from embracing
a gimmicky concept than from being late
to participate in an enduring one. As such, its
decision to jump on the ESG and private
market trains simultaneously bodes well for
the future of both, but it also raises an interesting
question: These areas are rising in
popularity at the same time, but are they
really compatible?
Sustainable investing and private markets
spring from very different roots and appear
to gravitate in opposite directions. Sustainability
leans left. Its proponents argue that the
investment world places too much focus on
maximizing shareholder value and that
more concern must be given to a broader set of
stakeholders-a company's employees,
its partners, its clients, the communities it serves,
and the environment from which it takes
resources and into which it dumps its trash.
10
Morningstar Q3 2021
Private equity, on the other hand, has long
pulled to the right. Its modus operandi
concentrates shareholder power in an oligarchy
driven to (re)focus management on increasing
shareholder returns, often at the expense of other
stakeholders, such as employees who have
suffered layoffs and gutted pension plans or
consumers whose healthcare costs have risen in
the wake of private equity investments in
hospitals or pharmaceutical patents. By its inherent
nature of privacy, private equity purposely
shuns the sunlight of disclosure, transparency,
and accountability upon which ESG assessments
depend. Thus, while ESG seeks to diffuse
shareholder power through the inclusion of more
voices, private equity by definition concentrates
shareholder power through the exclusion
of potentially dissenting ones, starting with public
shareholders.
Clearly, the ESG and private equity trains run
on different tracks. Not surprisingly, the
fields also have markedly different advocates.
One is beloved by the Marxist economist
railing about unpaid labor and the unpaid cost of
environmental exploitation. The other is the
darling of the right-wing business school professor
who gushes over the superior returns private
equity generates by making tough decisions,
cutting fat, and making companies lean, mean
profit machines.
Just as these opposed economic views coexist
(at times contentiously) inside academia,
so too may they soon cohabitate in an individual
investor's Vanguard account, which may
hold an ESG-themed mutual fund, some green
energy stocks, and a private equity fund.
Large endowments and pension funds already
show such potentially incongruous behavior.
Endowments that have long promoted social
justice and advocated a broader stakeholder
perspective are now among the biggest funders of
private equity and venture capital firms that
are judged primarily for their ability to maximize
shareholder value.
How long can the private equity and ESG fields
operate on different wavelengths if they
increasingly have the same owners? One way or
another, the playing field will have to grow
more level as public and private markets come
together. Surely, endowments that prize
stakeholder capitalism and want to use their
power to advance social and environmental
causes can't carve out a separate set of standards
for their private market investments. They
cannot ignore the collateral damage done by the
shareholder-first practices of the leveraged
buyout and private market practices of yore. More
likely, rather than ESG concerns yielding
to traditional private equity standards, it will be
the private equity world that must adapt
to today's calls for greater ESG accountability.
But if private equity becomes less private-
if it is forced to adopt higher standards of
accountability and transparency-can it still
generate the superior returns it has in the
past? Or will private equity go the way
of big mutual fund managers whose investment
returns regressed to the averages once
Regulation Fair Disclosure blocked their privileged
access to corporate management or follow
the downward trajectory of the Yale investment
model whose relative returns regressed
during the past decade as more players adopted
the same playbook? Level playing fields
tend to level results.
Private markets and sustainable investing
remain two of the hottest areas in finance. So far,
they have been on independent paths, but
as each grows, their Venn diagram will
increasingly overlap. This potentially contentious
intersection will likely be the focus of some
of the most heated investment debates of
the next decade-the smithy where the very soul
of capitalism or its potential collapse may
be decided. Will either shareholder or stakeholder
concerns emerge victorious, or will some
sort of Hegelian synthesis emerge? Vanguard has
prudently hedged its bet, leaving the decision
where it belongs: in the hands of investors.
It's up to us whether we forge a new consensus
or, as with politics, we bifurcate into
hostile camps. K
Don Phillips is a managing director at Morningstar. He is a
member of the editorial board of Morningstar magazine.
https://www.morningstar.com/authors/286/don-phillips https://www.morningstar.com/authors/286/don-phillips http://Entire footnote http://Entire footnote

Morningstar - Q3 2021

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