Last year, European ESG assets shrank by $2 trillion due to an improved review of labelling practices and processes. This year we’ve witnessed a massive ESG legal showdown, with a number of financial institutions feeling the heat from authorities and regulators. Key stakeholders are becoming increasingly sophisticated and making clear who is being left behind, found out (ESG-washing) and failing to drive observable ESG integration and improvements.
At Blume, we welcome this scrutiny. As a women-led team, we are made up of (hopeful!) sceptics, requiring a data-driven approach to guide both our investing approach and global view. We examine what makes a good business, good exits, and compounding, future leaders. We believe this scrutiny will lead to improved ESG standardization, benchmarking, and aligned incentives: welcome developments for the current sustainability-related alphabet soup.
In addition to traditional financial analysis, it is our job to think deeply about practical and actionable ESG efforts that help improve risk management, cultivate impactful businesses for future generations and create value-accretive initiatives to position companies for future exit potential. Many articles have been written on ESG as a means to identify blind spots related to risk management and retain and attract top performers and new customers. Less has been written on exiting a company that has built ESG within its DNA.
So, what have we learned to help prepare sustainable businesses for exit?
Firstly, we have learned that disclosing more ESG information in the pre-IPO documents helps to reduce information asymmetry between the firm and investors, “positively benefiting the companies’ financial performance”. In one of the few statistical papers on ESG and the pricing of IPOs, Fenili and Raimono parsed through the S-1 documents and relevant ESG disclosures on a sample of ~750 US, IPOs occurring from the beginning of 2012 to mid-2019. The econometric analysis performed on these observations revealed some intuitive findings, like the median number of “ESG” words increasing significantly during the sample period.
Some findings, however, beg for additional consideration. For example, “IPOs in the first environmental quartile have average first-day returns of 29.82 percent compared to 14.87 percent for the fourth Environmental quartile, a difference of 14.95 percent, between the extreme quartiles”.
- Takeaway: Quantity of positive ESG words matters. Build businesses that can tell this story.
Secondly, once we have gone public with the market-recognized quantity of ESG disclosures, what next? In his 2018 research paper, Public Sentiment and the Price of Corporate Sustainability, household expert, George Serafeim, draws a link between a company’s market value and public appreciation of the firm’s sustainability practices. With over 250,000+ unique (English language) articles written on ESG annually, tides have shifted, and with 25 percent of the market made up of retail investors, who are more likely to invest with their value, the general publics’ sentiment matters.
Drawing on both ESG metrics from industry providers (MSCI) and “public sentiment” data aggregated from industry releases, news, NGOs and think tanks, Serafeim’s research reveals a welcome value play in the ESG world, as growth stock get clobbered. Serafeim argues that positive public sentiment and awareness of ESG initiatives can support an increase in market value and that “firms with strong sustainability performance and negative sentiment have been undervalued”.
For example, Serafeim explains, Dominos and the Cheesecake Factory scored identical ESG scores (5.2/10) on MSCI’s scale but diverged by a wide margin (15 vs 87 out of 100) on TruValue’s public sentiment scale due to public concerns with Domino’s customer welfare and perceived quality and safety standards of the pizza making company. Dominos outperformed.
- Takeaway: Public sentiment around ESG activities and programmes increasingly play a part in market valuation.
Arguably, many other factors are at play that drive commercial and ESG performance, but Serafeim is not the only one to point out that “the valuation premium paid for companies with strong sustainability performance has increased over time and that the premium is increasing as a function of positive public sentiment momentum”. As our most recent portfolio company, Normative, analysed, “investors will pay a 10 percent premium for a company with a positive ESG record”. We can dig further with UBS-compiled research. Leveraging Sustainalytics “ESG Risk Ratings” for 13 sub-sectors (as classified by Sustainalytics) across aerospace and defense, to technology hardware and transportation, the UBS research team assigned each company a discrete Sustainalytics ESG risk rating score. Using the middle-rated companies as the benchmark, the UBS team calculated valuation multiple premiums or (EV/NTM EBITDA multiple) and discounts for the highest and lowest ESG rated companies from February 2019 to 2022. UBS observed that in Europe there is a “clear and growing gap between the premium awarded” to first-quartile companies in each sub-sector relative to second- and third-quartile companies in the respective sub-sector. There is also “a discount applied, on average across these 13 sub-sectors, to 4th quartile companies”. From three years ago, this gap has grown from 1.7x EBITDA multiple to 3.0x (as of February 11, 2022).
- Takeaway: Recent studies are pointing to a valuation premium for strong sustainable businesses, with above-average ESG scores.
While ESG has been a piñata for 2022, we welcome this shakeup and increased scrutiny, knowing that proof will play out in data and that ESG is here to stay. We also know that competitive advantage and sustainable businesses come from a combination of good strategy, culture, vision and execution. We’re not here to play the market or figure out creatively how to cultivate public sentiment for future payoffs, but we do believe these insights help incentivize robust ESG practices, activate the above drivers and capitalize on the growing interest in ESG.
When we partner with entrepreneurs, they know that our investment is intertwined with a mission to transform the health of planet and people for a more sustainable world. If historical data is our reference, Normative and other tools will be our forward-looking guide. These partnerships help keep our goals ambitious and push us to lead in an increasingly scrutinized space.
Clare Murray is a co-founding partner at growth investor Blume Equity. Drake Hicks is an ESG specialist.