How Could ESG Investing Work?

Matt Levine has a characteristically terrific set of posts on socially responsible investing here and here you should read.  

He contrasts two theories for how ESG (environmental, social and governance) investing in the public markets could work in the way intended by advocates.  What is interesting is that the mechanism for creating a positive social, environmental or governance outcome in each theory is in direct conflict with the other theory.  

My takeaway from the posts is that there are significant intellectual hurdles to believing public market ESG funds will impact the world in the way they are being marketed to investors.  Matt is too kind to use the word fraud here, but the argument is succinct and damning.  Pretty remarkable for an industry that already has over $1T in assets under management.

What happens when the same rigor is applied to private markets?

My theory for early stage private markets in general is that there is a large number of potentially viable companies that are competing for capital, employees, customers and attention all at the same time.   At each stage of corporate development, from an idea to formation, to initial product, etc, there is a winnowing of this potential pool of viable companies.  

The winnowing process is noisy.   No one knows in advance which companies will survive each stage. There is no 'market return'  for investors. Performance varies dramatically more in private markets than public markets.  

Let's say that 5% of all potentially viable companies make it through each stage up to some point when the company moves from default unviable to default viable.   The job of the founding team (and early investors, employees) is to move the company forward far enough that the organization can survive without them.

This is a critical threshold in my theory of startups. That is, the creation of a new entity that has not existed before requires some subset of founders, investors and early employees to will into existence the company that has, at present, no real viability in the world.  

If some meaningful portion of those founders, investors, and early employees woke up one morning and said 'no more', well, that company would then not exist.  That isn't true for Ford, Apple or General Electric. Public companies, and large private companies, are going concerns that are viable independent of any specific subset of individual actions.

From here, the theory of impact for purpose driven investing (my preferred term to ESG) follows.  If there is more capital willing to invest in companies that signal they are purpose driven, then there is an incremental increase in the potential viability of those organizations.

Note: this theory applies equally to any attribute of startups, up to a point. If a critical mass of investors said they wanted to invest in companies based in Kansas, then in my theory of startups, there should be an increase in the subsequent number of viable companies emerging out of Kansas. (Arguably, this is the mechanism for Bay Area success over the past few decades).  

This isn't true if the attribute preferenced by the investors is somehow limited in the subsequent market. For example, if investors all thought there should be more tea startups, all things equal, I don't hold that more tea startups will eventually make it to viability.  There is a limited market size for tea and, unless that changes through consumer preferences for tea, more capital at the early stage won't result in more mature tea companies.  But there isn't a similar natural limit on customers buying products from Kansas.

What is true for investors, is also true for customers.  If potential customers of an early stage company are more willing to try a product offering if they know the company produces it sustainably, for example, then it the company has an advantage, all things equal, to all the other hundreds of potential companies vying for that initial trial with the customer.   The same logic applies to employees and distribution.

In the terms of the market, purpose driven companies have found a credible signal to customers, employees and investors that enables them to distinguish themselves in a dimension that matters to some critical subset of those customers, employees and investors.   The signal provides a coordination mechanism for resources. The incremental additional resources tip the scales in favor of those companies during the critical winnowing process from non-viable to viable.  

Consider an initial primary task of a startup founder - getting the word out that the business exists.  Would you rather pitch the media, a talented Google engineer you are trying to recruit, or a new investor as the hundredth AI driven photo sharing app, or as a company formed to solve climate change through breakthrough technology?

An important caveat to this argument is that it focuses on survivability, not scale of outcome. Returns for investors in the early stage are driven by outliers that have disproportionate impact on fund returns.  

While purpose driven companies may be more likely to survive, one could argue the magnitude of the outcomes will be smaller.  A flip side of the signaling effect that attracts early customers, the credible commitment of purpose to something other than serving customers at the lowest cost with the most shareholder returns, may also limit the company's upside potential.