This article was originally published in ChicagoBoothReview
Laurence “Larry” Fink, the founder and CEO of BlackRock, the world’s largest asset manager, which has more than $6 trillion in assets under management, issued an open letter to CEOs this past January—and reportedly sent many of them into a tizzy. Fink’s letter said society is demanding that companies, public and private, need to “serve a social purpose,” benefiting not just shareholders but also employees, customers, and neighbors. And, he explained, from that point forward, BlackRock would be “eager to participate in discussions about long-term value creation and work to build a better framework for serving all your stakeholders.” Executives, he wrote, should be able to answer their questions about the company’s actions. For example, what role does the company play in the community? How is it managing its impact on the environment? Is it working to create a diverse workforce? “The time has come for a new model of shareholder engagement,” he wrote.
For nearly 50 years, many have been guided by the idea, laid out most famously by Milton Friedman, that the most appropriate way to create social change is to give profits to investors, and taxes to the government, and use that money to make an impact. For just as long, other investors have argued in favor of divesting from companies to make a political or social point—dumping shares of gun manufacturers or fossil fuel companies, for example.
But with the rise of index funds, divesting from individual company stocks has become more difficult, even though there are some funds that try to do this by designing a basket that tracks an index while excluding “sinful” stocks. It can even be counterproductive.
Investing with a social motivation has moved from divesting from certain companies based on values or preferences to a more regular form of seeking alpha, by investors who hope their stakes will generate returns as well as save the world. Like financial philanthropists trying to affect specific social issues, these investors are often using markets and investing tools to shift behavior and create change. As a result, there are big shifts in thinking about the role of investors, who have had the luxury of worrying primarily about profits. Some prominent managers and investors are advocating for joining other stakeholders to push for change. “I certainly view the letter as symbolic that this is becoming more mainstream,” says Chicago Booth’s Robert H. Gertner, who this spring discussed Fink’s letter on a panel with BlackRock cofounder Sue Wagner. (For a transcript of that conversation, see “Should public companies do more than maximize profits?”)
This, of course, raises questions. Can and should investors force companies to embrace social goals, be they addressing climate change, fighting poverty, or reducing violence? Beyond that, how will this work? What is expected of executives in this new way of doing business? Is this all public relations, or something more? Studies are helping address these as the investment industry readies itself for priorities beyond profits.
Milton Friedman presented his famous argument in a 1970 article in the New York Times Magazine, writing that making shareholders richer made markets more efficient for everyone, and that it was heresy for corporate executives to spend company dollars on anything other than increasing profits. Advocating that corporations should consider alternative goals was, the Nobel Prize–winning Chicago economist thundered, “preaching pure and unadulterated socialism.”
For Friedman, executives who pursue social goals with corporate money are “taxing” the rightful owners of the company. “Here the businessman—self-selected or appointed directly or indirectly by stockholders—is to be simultaneously legislator, executive and jurist,” he wrote. “He is to decide whom to tax by how much and for what purpose, and he is to spend the proceeds—all this guided only by general exhortations from on high to restrain inflation, improve the environment, fight poverty and so on and on.”
Friedman’s notion that a company’s sole job is to maximize shareholder value has greatly influenced US law. In a takeover bid, for example, managers have an obligation to maximize short-term financial value. Friedman felt that anything that got in the way of profits—corporate philanthropy, for example—was suspect, because it took time, focus, and money away from the more important business of the company, and because such activities belonged in the private arena, in an executive’s or shareholder’s personal life. And indeed, many executives, even today, agree that social responsibility on the part of companies, including philanthropy, is not much more than public relations.
But in the meantime, a shift in thinking away from pure profit motive can be seen in the behavior of investors, executives, and entrepreneurs. The Global Impact Investing Network surveyed 229 respondents in 2018 and finds they were managing a total of $228 billion in impact assets intended to generate social and environmental impact as well as financial return. Another survey by the group found assets under management growing 18 percent per year between 2013 and 2015. Legislation and regulation are making it easier for managers to consider a “double bottom line.” Thirty-four states now allow companies to register as benefit corporations, giving them the legal standing to have a social purpose.
“If a consumer is willing to spend $100 to reduce pollution by $120, why would that consumer not want a company he or she holds shares in to do this too?” Hart and Zingales write.
Some companies have set out to make their commitment to specific social-responsibility values and causes explicit by registering legally as benefit corporations, private for-profit entities recognized in many US states that legally define goals other than profits. Among the ranks of US benefit corporations: Kickstarter, which runs online crowdfunding campaigns; This American Life, the radio show; and Laureate Education, which runs for-profit universities. And some companies seek out a B Corp certification, which the nonprofit organization that awards the certification describes as the equivalent for business of what fair trade is for coffee. It says there are now 2,544 such certified corporations around the world, in more than 50 countries and 130 industries.
On the investing side, Gordon Brown, the former prime minister of the United Kingdom, worked with Sir Ronald Cohen to create what Brown has described as the world’s first social impact bond. In Brown’s case, investors backed a program that provided support to 2,000 newly released prisoners, which ultimately reduced recidivism and paid bondholders a 3 percent annual return. “Just as venture capital, which Sir Ronald also pioneered in Britain, responded to the financing needs of the dot-com revolution a generation ago, social impact investment can help us reach the next stage of innovative social reform,” Brown wrote in the Financial News last year.
Investors, of course, have long had their own preferences about corporate behavior. These preferences have simply not disturbed the clearly defined relationship between a company’s profits and its market value, especially in the world of public companies. What does it mean to have other bottom lines in the mix? In a paper challenging Friedman’s influential theory, Harvard’s Oliver Hart, a Nobel laureate, and Chicago Booth’s Luigi Zingales create an alternate model. Instead of prioritizing shareholder value, companies need to prioritize shareholder welfare, they write. Friedman’s essay bore the headline “The Social Responsibility of Business Is to Increase Its Profits”; Hart and Zingales titled theirs “Companies Should Maximize Shareholder Welfare Not Market Value.”
Shareholder value, in the classic Friedman sense, is measured by the size of the dividends shareholders receive and the amount by which the stock price rises. Welfare can be measured in different ways, including how society benefits from, or avoids harm due to, the company’s actions.
Friedman was too narrow in his focus when he should have considered more widely applicable cases, they argue. “Friedman finds a set of circumstances in which maximizing your monetary return and your utility is the exact same thing,” Zingales says. (In economics, utility is a measure of how useful something is to a consumer.) Consider the example of corporate charity. Friedman saw no efficiency in a corporation spending money on philanthropy when it could instead distribute the dividends and let shareholders donate as they saw fit. But for many questions of corporate operation, it does make more sense for a company to take action rather than leave it to individual shareholders, Zingales says.
Friedman’s idea holds true if a company’s actions toward a social goal and a shareholder’s actions would have the same result. In some cases, however, the corporation can make a difference in a way that individual shareholders cannot. Shareholders concerned about pollution can donate their corporate dividends to the Sierra Club. But if shareholders are investing in a company that pollutes, the researchers argue that it’s ultimately cheaper for shareholders to encourage management to stop polluting rather than allow it and then separately fund a cleanup, which takes money, time, and perhaps medical efforts. (For more, see “When it makes sense to pollute—and how to change the equation.”) Of course, shareholders enjoy net profits but don’t pay net costs, so they could come out ahead financially if others in society help to pick up the bill for cleanup. But the researchers’ model indicates that empowering shareholders to vote could help move companies toward more social goals.
And as Friedman wrote in 1970, some people might have objectives other than profit. Many consumers today choose to pay more for organic produce because they consider maximizing their own utility to be something other than maximizing profits (or savings). They spend more on sustainably sourced food and value the health or environmental benefits over their own wallets. This private ethical behavior can be extended to corporate actions as well, the researchers write.
“If a consumer is willing to spend $100 to reduce pollution by $120, why would that consumer not want a company he or she holds shares in to do this too?” Hart and Zingales write.
Many financial researchers agree that divesting is not the most effective mechanism for bringing about change, as the number of shares affected is unlikely to be enough to meaningfully affect the market price of a large, public company. Columbia University’s Harrison Hong and Imperial College London’s Marcin Kacperczyk find that there’s a cost to abstaining from “sin” stocks, and other investors are happy to step in. Alcohol, tobacco, and gaming stocks tend to be 15–20 percent cheaper than comparable nonvice stocks, plus they outperform the others by around 2.5 percent per year. And Zingales cautions that investors lose what leverage they have to enact change and hand decision-making to people with whom they disagree. “If all the socially conscious investors sell oil stocks, the only ones buying oil stocks are the Koch brothers, and the companies end up being run in the most environmentally unfriendly way,” he says.
Instead, he and Hart argue that investors should exercise their rights by voting for directors and proxy measures that speak to their own views, and companies should put many more questions of corporate strategy to a shareholder vote. This would require individuals to vote their shares. Although individuals held 30 percent of voting shares, they cast votes for only 29 percent of those shares in 2017, according to ProxyPulse, a publication that tracks shareholder voting trends.
Companies could initially resist this directly democratic idea of greater shareholder control out of fear that they will have to confront difficult issues, the argument goes. But, led by Europe, which has a stronger cultural emphasis on corporate social responsibility, US companies may also become more open to putting more questions to a shareholder vote. The market would serve as a check on extremist impulses, especially if company bylaws were changed to require that some percentage of shares, say 5 percent, support a proposal before it’s circulated to all shareholders, the researchers write.
While academics debate the theoretical mechanics of corporate responsibility, some companies and shareholders have been working out a new set of market rules and expectations. For the markets to consider social responsibility a regular part of investing—as ordinary as putting money in growth funds or value funds—there has to be a framework for how these investments are organized, says Chicago Booth’s Jessica S. Jeffers. For example, if executives or asset managers make corporate or investment decisions with social impact in mind, they need more specific profit and impact goals.
The arguments of Friedman, Hart, and Zingales focus on the public markets, but trails are being blazed in private markets—especially in private equity and venture capital, where funds have been set up to invest the money of limited partners who want to put it toward creating positive social or environmental impact.
This activity is possible in part because many investors in these types of funds are already wealthy, says Jeffers, who says the boom in impact investing can be traced in part to “high-net-worth individuals who say, ‘We have a large pool of capital and we want to invest in social enterprise rather than investing purely for profit and then donating to charity.’” They are increasingly joined in impact investing by institutional and retail investors.
Limited partners, too, benefit from having their profit and impact goals more specifically defined. Investment contracts, which establish the rights and responsibilities of the parties in a fund, establish if the fund is a traditional profit-only enterprise or if it has contractual obligations to pursue impact alongside profit.
The contracts for impact-investment funds establish impact expectations, obligations, and enforcement rights through terms that, for example, specify intended geographic impact or prohibit certain types of harm-producing investments such as nonrenewable energy. These same contracts define the priorities and responsibilities of the limited and general partners—and consequently reflect the balance these funds seek to strike between profit and impact goals.
The contracts establish direct and indirect means for investors to monitor and enforce the dual pursuits. Putting impact incentives and expectations in writing both encourages investment and ensures that agents—the fund manager at the fund level and the portfolio company executives—use their discretion consistent with those expectations and without fear of litigation or reputational harm.
“One immediate lesson from these contracts is that impact investing is not greenwashing,” writes Jeffers, along with University of Pennsylvania’s Christopher Geczy and David K. Musto and Georgia State University College of Law’s Anne M. Tucker. The researchers—having examined 202 documents belonging to 54 private-equity and VC funds and 92 of their portfolio companies—find that contract language highlights how impact-investment transactions differ from traditional investments in subtle but important ways. Terms in the contracts, at the fund level and the portfolio-company level, differ when the fund is specifically focused on making impact investments.
The study points to several differences between the contracts of traditional, profit-only funds and impact funds, including ones seeking market rates of return and those seeking below-market rates. For example, impact funds appear to place more emphasis on participation, via advisory committees at the fund level and board seats at the portfolio-company level. This could reflect an added desire for advice—or monitoring—in a space where opportunities to achieve both profit and impact goals overlap and require manager discretion to navigate and prioritize.
The universe Geczy, Jeffers, Musto, and Tucker study is a relatively small part of overall investing, but impact investing is growing. Some large private-equity groups have launched impact funds. The Rise Fund, which touts a commitment to a double bottom line, is put out by TPG Growth, Elevar Equity, and the Bridgespan Group—and reportedly raised $2 billion in short order. Irish pop star Bono is a director, as is Virgin’s Richard Branson and eBay founder Pierre Omidyar, among others. Bain Capital also has an impact fund. Partners Group, one of the largest private equity groups by market capitalization, launched a $1 billion impact fund in line with the UN’s sustainable development goals.
There are still issues to work through for pension funds and others with fiduciary responsibilities, but there seems to be plenty of demand from investors, including those without billions of dollars or family offices. MSCI, which creates investing tools for institutional investors, touts environmental, social, and governance (ESG) factors including climate change, gender diversity, and privacy and security. According to its website, “many investors look to incorporate ESG factors into the investment process alongside traditional financial analysis”—and the United Nations–supported Principles for Responsible Investment network has more than 1,800 signatories representing more than $68 trillion in assets under management, as of April 2017.
Fund-research company Morningstar launched a sustainability rating system in March 2016 in which it assigned one to five globes to each of the 20,000 funds in its database. Before the Morningstar ratings came out, it was difficult for investors to choose funds on the basis of how sustainable their investments were.
Chicago Booth’s Samuel Hartzmark and Abigail Sussman find that fund flows changed after Morningstar began rating the funds in this manner. The data from an 11-month period following the launch of the ratings suggest that high sustainability ratings led to an inflow of investor funds. There was no evidence that these funds performed better, patterns that are consistent with investors either inaccurately believing that these funds would outperform the market or placing a greater value on the social-impact aspect than on their returns.
To disentangle these two possibilities, the researchers conducted an experiment that asked people to report their beliefs about different mutual funds that varied primarily in their sustainability ratings. They find that the respondents expected funds with higher sustainability ratings to have both higher returns and lower risk. The experiment also asked study participants to allocate money to these mutual funds, but the researchers find that the expectations of performance did not fully explain hypothetical allocation decisions. After the researchers controlled for those factors, study participants continued to prefer the socially responsible funds, suggesting an additional motive of altruism or concern for the environment.
These findings suggest that there is demand for sustainable investment opportunities, Sussman says. Since investors cannot always easily identify which companies are more or less sustainable, disseminating more information about this could lead more investors to socially responsible investments.
Sustainability, corporate social responsibility, and impact investing are all related to something else: the growing pushback against short-termism, or the quarterly pressures driving public companies. Fink’s argument points companies toward long-term value creation, which is BlackRock’s interest, rather than the relentless quarterly profits.
“Without a sense of purpose, no company, either public or private, can achieve its full potential,” Fink wrote in his letter to CEOs. “It will ultimately lose the license to operate from key stakeholders. It will succumb to short-term pressures to distribute earnings, and, in the process, sacrifice investments in employee development, innovation, and capital expenditures that are necessary for long-term growth.” JPMorgan Chase’s Jamie Dimon and Berkshire Hathaway’s Warren Buffett chimed in with a Wall Street Journal op-ed in June titled “Short-Termism Is Harming the Economy,” in which they urged companies to end quarterly earnings forecasts.
When Friedman wrote in 1970, short-termism was not the issue it is now. In his essay, he described a corporate executive as responsible to business owners, who wanted their company to make money and follow the rules, “both those embodied in law and those embodied in ethical custom.”
What could be at issue is that the basic role of the company itself has changed and is again evolving. “Profits are, and remain, not only not passé but really the lifeblood of the economy,” says Booth’s Christina Hachikian, who sees the corporate sector not just as a provider of jobs and therefore livelihoods but also as a potential part of solving the problems the world is barreling toward in the short run, including climate change, the impact of widening wealth gaps, and other social issues. “Society is increasingly turning to the private sector and asking that companies respond to broader societal challenges. Indeed, the public expectations of your company have never been greater,” wrote Fink. In that case, investors’ and executives’ job descriptions are being rewritten—and some are rewriting those themselves—with an evolving end in mind. Not everyone may be on board with this idea—in the short run, at least.