Impact Investing and The Minority Rule

September, 13th, 2020 marked the fiftieth anniversary of the publication of Milton Friedman’s iconic essay, “The Social Responsibility of Business Is to Increase Its Profits”, which arguably has formed the bedrock of the prevalent idea of ‘shareholder capitalism’. Against this backdrop, it is revealing to consider the fact that ESG/Impact investing is gaining traction among a subset of investors. However, the ability of the rapidly emerging idea of ESG/Impact Investing to make businesses more socially responsible is still viewed widely with an ample amount of skepticism.

The most common skeptical argument raises doubts about the ability of Impact Investing to tip the scale of overall capital allocation away from the pursuit of pure profit maximization to sustainable profit maximization as the proportion of sustainable assets under management still dwarfs in comparison to the amount of traditional impact-agnostic assets under management. This argument holds that overall capital allocation will resemble more or less the capital allocation of the majority of asset allocators who happen to be agnostic about the ‘impact’ aspect of their investments. In short, this argument holds the contention that capital allocation follows the majority rule. However, this contention belies an understanding of complex systems.

Enter the minority rule:

Statistician and essayist, Nassim Nicholas Taleb, introduces the idea of the minority rule as follows: in certain settings, “it suffices for an intransigent minority — a certain type of intransigent minority — to reach a minutely small level, say three or four percent of the total population, for the entire population to have to submit to their preferences”. The primary conditions for this rule to work are that the majority be indifferent between the two preferences and that the switching costs for shifting the preferences be low or absent. Common evidence of this rule is the almost ubiquitous dominance of halal/kosher items over alternatives despite the proportion of consumers with halal/kosher preferences being a minority as “a kosher (or halal) eater will never eat non-kosher (or non-halal) food, but a non-kosher eater isn’t banned from eating kosher”. Applying this logic to the domain of capital allocation, we can rephrase this as ‘an impact manager will never allocate capital to a non-impact business but an impact-agnostic manager has no constraints allocating capital to impact-focused businesses.’

Take the case of the Indian Tobacco Market which has long been an oligopoly dominated by three companies: ITC, Godfrey Phillips, and VST Industries. The institutional investors allocating capital to such businesses would undoubtedly be impact-agnostic who would largely be focused on the consistent above-average returns to capital that these businesses have generated. Yet, the shareholding percentage of foreign institutional investors (who are much more susceptible to this effect) in these companies has seen a near secular decline over the past three years. For an impact-agnostic asset manager, the opportunity cost of not allocating capital to high quality but socially harmful businesses like these dwarfs in comparison to the missed fat cheques from large ESG investors even if they form a minority of the total AUM for the manager.

Enter the constraints:

However, the argument fulfills only the former condition of the majority’s indifference of preferences. For this scenario to succeed, the latter condition of low to negligible switching costs is more important. The criteria for assessing impact should not become so cumbersome that their adherence ends up significantly eroding growth and profitability for businesses, ergo, the investor’s alpha. The criteria to assess impact thus have to be uniform, manageable, and measurable. Globally, organizations like the Impact Development Project are working on this front for the standardization of criteria to measure impact. The second requirement for this scenario to become a reality is the absence of pushback from certain sections of society. A commonly acceptable impact framework should thus steer clear of controversial issues such as individual or collective identity and focus solely on aspects on which a broader societal consensus has already been established.

The age of Impact Premium?

If this scenario fructifies, it may well lead to the idea of an ‘impact premium’ on the valuation of a business becoming a reality. Investors will prefer businesses following sustainable practices as they will have access to a larger pool of growth capital compared to others. Therefore, impact-focused ventures will command a premium on valuation compared to non-impact businesses giving rise to a virtuous cycle. Nowhere more will this effect be more pronounced than the field of venture capital where access to growth capital as a business scales is a key determinant of the success of the venture.