At first glance, this appears to be no environment for any gains. The coronavirus fear grips the entire world threatening to bring everything to a standstill thus cratering risk assets. The only thing moving with rapidity (besides the COVID-19 virus) is central bank action across the globe. Scarred by the financial crisis, still fresh in most minds, central banks seem to be in the driver’s seat pulling all stops-from interest rate cuts, to repo action to funding dollar swap lines- to ensure the financial system remains liquified. Fortunately, post the financial crisis, financial institutions delevered, built capital buffers and overall, remain in good shape today. But not so the corporations, especially lower quality companies in the developed world that binged on cheap credit in an era of everyday low interest rates. Private credit in developed markets is no different with fears surfacing about shaky covenants, excessive leverage (~6x) predicated on adjusted (add backs) EBITDA. And therein lies the Achilles heel of global markets should a recovery from the coronavirus take long. How long, no one knows but the downturn is speculated to last till the pandemic slows down to an incremental pace as in China (if all’s reported accurately) today.
Just as we all survived the global financial crisis, we shall overcome the current crisis, which from all measures is not expected to have after-effects anything like the GFC. Just as financial institutions learnt hard lessons of prudence and conservatism from the GFC, the coronavirus is telling in at least one big way– at least to us. People, societies and social actions create very powerful influences beyond anything that can necessarily be predicted, measured, or controlled. How it all began in Wuhan, how it spread worldwide and how global societies are responding to it today, are all too overwhelming for us to ignore.
As investors, it behooves us to pay close attention to the ramifications of “social effects” on our investments both from a point of risk-management and (as alternative investors) also to explore if social situations can be monetized in any way. The current focus on “S” i.e. social aspects of ESG investing, that is front and center with investors of all stripes, is mostly on understanding and addressing social risks insofar these relate to underlying investments. There is nothing wrong with it in principle but unfortunately, for many skeptics (plan sponsors, fiduciaries, regulators, etc.) research is far from convincing that the emphasis on social aspects along with environment and governance related risks translate into meaningful gains. They allege that there is an implicit trade-off of financial returns for ESG benefits (Source: Franklin Templeton’s 2020 comprehensive study across 21 markets to understand how responsible investing is incorporated into investment decisions). Proponents of ESG can cite research (e.g. JP Morgan Quantitative study, Goldman study, etc.) that show that when ESG criterion is coupled with fundamental analysis of emerging market equities, it retroactively produces alpha vis-à-vis a pure fundamental analysis. Critics, however, argue that ESG disclosures are improving only now in North America (with Europe and Asia corporates leading the pack) with the push toward stakeholder capitalism by asset owners and asset managers (Blackrock etc.) that enable ESG analysis. For some fiduciaries who value shareholder primacy more and opt to maximizing returns for their plan participants, ESG practices are susceptible to “greenwashing” (i.e. portraying ordinary actions as ESG measures) and for others the espoused impact (mostly through private assets) by the outright ESG believers, is far too distant into the future to be measured.
A greater focus on social issues than accorded today, could be the force to bring together ESG believers and skeptics. At the very outset, social aspects have a very intuitive appeal for it is all about people, their everyday lives, experiences and interactions and above all, emotions that often spur irrational, impulsive behavior. It therefore has a more unique appeal than governance -which research shows gets more immediate attention in implementing ESG practices- or environment, where climate change (thanks Greta Thunberg) has become the focal point for virtually everyone (Source: World Economic Forum Global Risks Report 2020), all for good reasons. If social aspects have an equal (if not greater) place, it tends to generally center on labor issues, gender inequality, social inequality, diversity, human rights, health, education, etc., all deserving social causes that need to be fixed as well as risk-managed. But if all these are risk-factors conjoining fundamental risk factors-operational, financial, business, etc., then as (alternative) investors shouldn’t we also expect risk-premiums, or seek ways to risk-arbitrage? As investors, if we looked beyond risk management of social issues to risk-premiums or risk-arbitrage, it becomes an avenue for tapping gains, probably more in the near-term, giving ESG naysayers the staying power to create longer-term impact (e.g. Sustainability themes in line with Sustainable Development Goals like climate change, clean water, etc. and related returns as with blended finance where private investors can invest with Development Finance Institutions who provide the first-loss capital (or risk guarantees) for sustainable projects in EM).
For example, if human rights abuse (e.g. child labor) in a mining-related company is a potential risk, it could become an idea for a short position. Or further still, its public debt could be priced at a premium affording a debt arbitrage opportunity, between high- and low-priced debt. For an issuer of a social bond to promote women run business enterprises in emerging markets (where women are often considered second class citizens), the cost of the cross-currency swap to hedge currency risk could be linked to attaining the underlying social objective. Options for stocks like Brazilian miner, Vale that suffered the collapse of waste dams killing many and causing an environmental disaster, carries high implied volatility affording short vol. trades. Similarly, Asian supply chain disruptions that have caused great angst in the wake of the coronavirus should be tested for sensitivity to social issues like labor unrest or risk of disruption from labor unions to evaluate activist and/or merger arbitrage plays. Recently, Thyssenkrupp, the German elevator manufacturer preferred the bids of Advent International and Cinven to a higher one from Kone, a Finnish rival as labor union leaders opposed the Kone bid, assuming it would result in larger job losses than a takeover by private-equity groups, as the combined rivals aim for economies of scale. Labor unions are likely to play a bigger role on corporate boards going forward as they ride the rising wave of stakeholder capitalism. Activists can also play a role through engagement and proxy voting to help companies meet their sustainability challenges and lower ESG risk while creating positive societal impacts. Similarly, sensitivity of tourism, travel and entertainment industries to social beliefs, customs, traditions bear watching as mass (anti) movements can roil entire sub-sectors.
If social issues deserve the attention it warrants, there cannot be a better place than emerging markets that is home to over 85% (Source: IMF 2019) of the world’s population. More people mean more interactions, more issues and yes, plenty of emotions. Moreover, bigger social economic disparities, political divides, and illiteracy super-charge emotions precipitating irrational behavior-a recipe for traders on the ground to exploit mispriced social risk. Social unrest has been on the rise globally, led by countries in Asia, MENA and Sub Saharan Africa. In 2019 alone there were protests on every continent and across 114 countries—from Hong Kong to Haiti, to Bolivia (Source: Economist). According to research from the Center of Strategic and International Studies (CSIS), a Washington-based think-tank, such protests are sparked by local events ranging from slow economic growth, climate change, government corruption to anger about inequality and the cost of living (as in Chile) and of course, extradition of suspected criminals to China (the subject of a big discord in HK). Smartphones and social media have revolutionized the way in which demonstrations are organized, advertised and sustained often aiding the spread of fake news and deepening hatred between warring factions, as witnessed in Delhi, India recently.
For example, many investors are questioning the promise of India/Modi feeding on misinformation from the Western media/ “sponsored local media” subscribing to/fueling the narrative of “a wave of Hindu nationalism/divorce of economic agenda”. This could hypothetically induce the misinformed or tourist investors to sell Indian assets prematurely (though Foreign Institutional Flows are +$1.8 billion till Feb 29, 2020-Source: India Manager), thus presenting mispriced assets to the locally informed, who’d benefit from asset repricing when fundamentals around India’s global competitiveness and innovation reassert or rationality returns.
(For those curious, with our ears close to the ground in India, we discern that the recent riots take root in India’s partition over 70 years ago. Back then, many among the religious minority seeking a “land of the pure” could not migrate but happily found their religious freedom and democratic voice in present-day India, a reprieve from the stifling commands of their religion (and commanding religious leaders) in other Islamic countries. While religious freedom and lifestyle of Muslims in India is not under threat as any visitor to the country can tell, their ~60 years of appeasement by the Congress party (using them as a vote bank) is threatened, as the party has been eviscerated in recent polls. Hence the sedition led by a troubled Congress now joined in similar rabblerousing (confirmed by recent arrests of riot masterminds) by AAP, the new party in Delhi replacing Congress, that is aping their appeasing tactics. While similar politics is not unique to India (rampant in Sub Saharan Africa and LATAM too), its malignance spreads (whatsapps) faster in emerging markets where illiteracy among masses runs high, and socio-economic disparities are greater, allowing manipulative politicians to lure gullible masses with freebies of everyday necessities (e.g. free bus rides, water supply, groceries etc.) and even cash to ensnare them into “organized” protests and charge them emotionally to disrupt everyday living and consequently investing sentiments.)
Social divide also engenders corruption in the form of bribes, graft etc. often translating into money laundering (also used for sponsored terrorism as in India’s case above) which then begs tight governance. Systemic corrupt behavior including nepotism in business contract allocation, unfair distribution of regional transfers from the central government and, distorting data can jeopardize investments. A couple years ago news broke out about a rich business family (Guptas) that exploited its friendship with the former Zuma administration in South Africa to win state business contracts and manipulate political appointments. Thus, Muddy Waters kind of detection of negative societal issues like fraud, corruption, etc. can provide a basis for short selling. In a similar vein, infrastructure projects especially in emerging markets have shown cost overruns from bureaucratic delays (poor work ethics, a social anathema) in land acquisition, forest clearance, supply of equipment, funding constraints, legal cases and slack law and order, which could be factored into pricing of private infrastructure debt. Rule of law and bankruptcy provisions are already issues that feature into pricing of private debt extended to counter-parties in emerging markets. Geopolitics as much as local politics is often a result of clashing egos (a game of chicken) as we see currently playing out with Saudi Arabia and Russia feuding over oil prices and production cuts, that macro commodity traders can potentially exploit.
Sustainable investing has been one of the fastest-growing areas in finance. The sustainable asset management industry (mainly the five sustainable asset managers representing 25% of all sustainable assets in the US), anticipate a “tsunami of (passive) assets poised to invest in sustainability over the next two decades” (Source-Bank of America Sept 2019). The wave is likely to be brought about by sustainable ETFs (accounting for 40% of flows into overall sustainable funds, registering nearly fourfold annual increase in 2019 to $8.5 billion-Source Morningstar), which would likely prove a major market force/technical that savvy traders can use to their advantage. In a similar vein, sales of green, social and sustainable bonds rose 43% to US$222 billion in 2019, (Source: Refinitiv) thus expanding the opportunity set of tradeable bonds. Sure enough, investment bankers are translating this budding interest into ESG derivatives sales. European banks are already selling billions of euros-worth of equity structured notes based on ESG indices, and ESG futures volumes are also rising steeply. Before long, this trend should extend to emerging markets, where private banks (especially in Asia) are known for offering structured products to their high net-worth clients. Development of ESG-friendly credit derivatives is also in the works allowing for additional hedging tools against interest and currency moves. Also, to implement relative value “social trades”, transparency and disclosures in EM are quite encouraging given initiatives like the Sustainable Stock Exchange Initiative, promoted by the Shenzhen and Shanghai stock exchanges, India’s BSE, Bursa Malaysia, and Brazil’s B3.
On the positive side of things, EM societies have been harnessed for the all-powerful mass/mid-market consumer by asset managers of every description, simply because the opportunity set is of giant proportions and the underlying story is very intuitive (note our comment about people/societies above). However, new social issues like the coronavirus extends itself to the many start-ups (caveat the hiding black swans) that have sprung up in its wake to invent the coronavirus vaccine much like initiatives of Regeneron, or Gilead’s remdisivir. By the same token, telemedicine (health specialist consultations and drug sales) from the likes of China’s Ali Health, Ping An Good Doctor, JD Health are promising areas for growth in venture capital addressing public health safety as much as managed care facilities for private equity/private debt investors investing into countries with stressed health care systems. Also, many rural folks in emerging markets remain unbanked and are attractive targets for financial inclusion, where fintech has proliferated immensely benefitting from a smartphone revolution. Similarly, consumer brands (e.g. FabIndia) in EM that carry a social message often tend to resonate well with local masses, offering an attractive opportunity. In this new digital era, it is imperative to recognize “data” as an element equally important as wind, water, and solar. Thus, managing data (cybersecurity and data privacy) for our protection and avoiding both its disruption or its pollution (corruption) is equally compelling as recognized by GDPR and increasingly likely to be adopted by other regulators around the world. Regulation in of itself creates long and short trading opportunities. With access to consumer data in emerging markets (e.g. China) easier, it poses greater risks of misuse, enlarging the opportunity set or TAM-total addressable market in venture-speak, for innovative preventive technologies from a multitude of start-ups funded by venture capital. Where localization of data (e.g. India) is a planned safety measure, local data centers become an attractive infrastructure play.
To sum up, social issues have so far been viewed from a singular lens as a set of risks that have either warranted avoidance by the more serious asset owners and asset managers or fetched a mere check-the-box mentality for those simply looking to satisfy ESG enthusiasts. Thus, many ESG skeptics wonder if investment returns get potentially compromised to address social (and broader ESG) principles. Without undermining the social principles of LPs and GPs, social issues especially in the emerging markets (where such issues abound more than anywhere else), could be monetized by arbitraging mispriced social risks and by extracting risk premiums for measured social risks. Our preliminary thesis warrants further thinking and proper implementation by EM managers on the ground, who can extract social gains from such social opportunities without compromising (on the contrary delivering) LPs’ social objectives. What works and what does not work on the bigger playground for social issues, can also be extended to monetizing environmental and governance issues. LPs can also go a step further in negotiating deferral of GP carried interest to attainment of realizable sustainable goals/results and introducing GP controls and incentives to promote alignment of interests. When monetizable tangible gains from social issues (extendable to environmental and governance issues) bring ESG considerations into investment i.e. risk and return discussions, from where it stands currently as a separate or additional consideration, it’s more likely to unite LPs around the table than divide them on their personal beliefs and perceptions around such matters.
ÊMA continues to remain responsive to investors’ ongoing search for elusive gains and welcomes conversations with LPs and local EM alternative specialists to discuss how they are positioned to monetize gains from social issues/sustainable investing, one of the fastest growing areas of asset management. Stay tuned.
Kamal Suppal, CFA
Chief Investment Auditor
March 11, 2020
The above content is intended for sophisticated audiences as in institutional investors or family offices. Readers are advised that any theme or idea discussed above is not an offer to buy or sell any investment.