The ESG Gap

In recent years, demand for companies to promote environmental, social, and governance (“ESG”) values has increased dramatically. Investment in ESG-oriented mutual funds (green funds), rose globally by 53 percent in 2021 to $2.7 trillion (Kishan, 2022). Bloomberg forecasts that by 2025 ESG assets may hit $53 trillion – a third of global assets under management. Not only are people investing more in ESG, but they are willing to pay higher fees for such investments. A recent study found that investors are willing, on average, to pay 20 basis points more for an investment in a fund with an ESG mandate as compared with equivalent funds without one (Baker et al. 2022).

Yet, these preferences do not necessarily translate into successful corporate action. Many corporations do not effectively promote ESG goals, as scholars such as Bebchuk, Kastiel & Tallarita (2022) and Bebchuk & Tallarita (2022)have noted. Professor Aswath Damodaran at the Stern School of Business at NYU (2022)  wrote, “I believe that ESG is, at its core, a feel-good scam that is enriching consultants, measurement services and fund managers, while doing close to nothing for the businesses and investors it claims to help, and even less for society.”

In a new article, we underscore the structural problems that prevent companies from achieving ESG goals. Competence is necessary because promoting ESG goals is generally more complex than maximizing profit and requires long-term vision. Furthermore, ESG goals are multi-dimensional and uncertain, and weaving them effectively into the culture and operation of firms is daunting. Competence is not enough, however, because no change will happen without strong motivation to achieve ESG goals.

We analyze the central corporate actors that can potentially bring such change – managers, institutional investors, and activist hedge funds – and  demonstrate that none of them have the two central elements required for promoting ESG goals: motivation and competence. We refer to this problem as the ESG gap. Managers have close familiarity with the ins and outs of their firm and, at least in principle, possess the requisite competence necessary for accommodating ESG goals. Yet, managers largely lack the motivation to engage with ESG goals due to their short horizons and compensation structure, and ESG goals often require very long horizons.

In contrast, institutional investors possess the motivation for incorporating ESG into corporate activity. As ProfessorJeffery Gordon (2022) has recently observed, because institutional investors hold almost the entire market in their portfolio, they are sensitive to systematic risks, and as “universal owners” have a strong interest in reducing inter-firm externalities. At the same time, institutional investors lack the competence for leading such change. The proper integration of ESG goals into a given firm depends on the business model and environment of that firm, and institutional investors are not involved in the firm’s operations.

Activist hedge funds have the competence to form new business plans for companies, especially under-performing ones. Unfortunately, activist hedge funds do not possess the motivation to incorporate ESG goals into the objectives of firms because their business model is predicated on relatively quick “fixes,” such as spin-offs, dividend distribution, and R&D cuts, and implementing ESG policies requires substantial time.  Hedge funds are partnerships in which capital investment is locked – there is no secondary market on which it can be bought and sold. Hence, they must cater to the wishes of impatient investors who cannot freely exit and therefore opt for relatively short-term engagements.

We propose bridging the ESG gap by forming a new entity: the activist ESG fund (“AEF”). The AEF would be an exchangetraded, closed-end mutual fund, uniquely designed for targeted activist investment. The closed-end traded fund structure would enable the fund management to have long horizons by attracting patient money while impatient investors could always sell their shares on the highly liquid stock exchange. In addition, the remuneration structure of the AEF’s management would be based on carried interest, like the hedge fund model: Managers would receive a significant share of fund profits, perhaps 20 percent, as hedge funds do. Unlike hedge furnds, though, the AEF would have an unlimited life span, without a no partnership dissolution date, and even more important, a secondary liquid market for its securities. Hence, the AEF would possess both the competence and the motivation to advance ESG goals.

Our proposal faces a critical obstacle under current law, however. The 1940 Investment Company Act imposes heavy regulation on investment companies (including closed-end funds) that in our case would be prohibitive. Specifically, to discourage excessive risk taking by fund managers, the Investment Company Act highly disfavors success fees. This, in turn, sharply contradicts our vision of providing incentives to AEF managers through generous success fees that are typical of unregulated hedge funds. The establishment of the AEF would thus require either an exemption from the Investment Company Act or an amendment of the act’s provision concerning success fees.

This post comes to us from Sharon Hannes at Tel Aviv University, Adi Libson at Bar-Ilan University — Faculty of Law, and Gideon Parchomovsky at the University of Pennsylvania’s Carey Law School and the Hebrew University of Jerusalem — Faculty of Law. It is based on their recent article, “The ESG Gap,” available here.

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