ESG integration can also lead to the reassessment of an investment thesis. For example, as part of our sovereign monitoring process, a South American issuer was flagged for further research and review. The primary drivers of the flag were related to deteriorating underlying third-party governance and social metrics, as measured by the World Bank’s Worldwide Governance Indicators and the United Nations Human Development Index, respectively. The flags indicated a decline in the country’s control of corruption and a decline in life expectancy at birth.
Prompted by the flag, one of our fixed income investment analysts conducted a deeper analysis into these issues. Anti-corruption efforts for this issuer had been deteriorating for many years and our analyst determined that the weaker anti-corruption controls could further increase geopolitical risk. The analyst also believes it could hinder the sovereign’s future ability to secure funding from the International Monetary Fund (IMF) or multilateral institutions (which are often the lenders of last resort). Meanwhile, the analyst concluded that an observed fall in life expectancy was mostly due to the COVID-19 pandemic and that inadequately funded public services would not support a meaningful rebound.
Consequently, the analyst had a more cautious outlook — viewing limited exposure to the country as prudent. In their view, bond pricing did not fully compensate investors for an overall deterioration in the country’s credit risk, partly due to heightened concerns around the country’s control of corruption. Translating third-party ESG data into actionable insights is another way in which ESG integration can add value.
3. Support deeper engagement with issuers
Engaging with companies and issuers is a crucial aspect of understanding management teams and their strategies, as well as assessing investment risks. Engagement topics on material ESG-related risks and opportunities can run the gamut — from employee morale (as noted earlier) to the nuances of environmental regulatory risk. Better understanding of these issues helps our investment professionals make informed decisions and can help encourage improved disclosure on these topics in the future.
In some industries, engagements on certain topics can arise more frequently than in others, such as executive compensation in information technology and other high-growth areas of the economy.
Recently, one of our investment analysts had grown concerned by compensation structures at a U.S. human resources software and services company. Over an extended period, the analyst discussed compensation policies at the firm and how they could align better with shareholder interests.
So-called evergreen provisions, which allow for the automatic increase of shares available for issuance in an equity plan each year without the need for shareholder approval, had become a particular concern. The firm’s evergreen provision allowed it to increase its share reserve by up to 3% of shares outstanding per year over the 10-year life of the equity plan — a clear dilution risk that could diminish value for long-term equity investors.
Following further research and analysis, our investment analyst met with the company to share their views on prevailing industry standards relating to the structure of incentive plans and to discuss the dilution risk that the evergreen provision creates for long-term investors.
The board approved a revision to the equity incentive plan that removed the evergreen provision. Furthermore, the firm now recognizes that prevailing industry practice is to present an annual general meeting ballot item requesting a specific allotment of shares to use in their equity plan every few years. This approach allows shareholders an ongoing opportunity to assess the potential for dilution. Initial research and analysis on this “G” issue, therefore, informed our investment analyst’s engagement with the company and set the stage for productive discussions on improving alignment with shareholder interests.
The bottom line: ESG integration can complement traditional financial analysis
As evidenced by these examples, ESG integration, in our view, helps surface issues alongside traditional financial analysis that inform a long-term investment outlook.
Similar to other considerations when investing, ESG integration is about incorporating relevant data and insights that help assess, price and decide. Considered alone, each individual input into an investment process may have limited value. In combination, however, ESG integration can complement traditional financial analysis and help complete the “puzzle” of investing.