Monday, September 02, 2013

Adapting Portfolio Theory To Social Capital

Today I attended an awesome seminar on the research behind the Bay Area Impact Investing Initiative.  A diverse bunch of finance types gathered at the East Bay Community Foundation to hear the principals behind BAIII discuss work that is very relevant to the social capital movement.  I don't have time this week to attend SOCAP13 at Fort Mason so this seminar will have to tide me over until next time.

R. Paul Herman from HIP Investor elaborated on the five "HIP" factors that he uses to describe previously unquantified drivers of corporate valuation.  Human capital has heretofore been an off-balance sheet intangible asset that financial models have ignored.  Endogenizing this asset into a financial model adds depth to a balanced scorecard managerial approach.  Incorporating environmental, social, and corporate governance (ESG) factors into corporate management is a new approach to mitigating risk.  Asset management firms are now publishing ESG reports and corporate managers are plotting projects and business units on a 2x2 human capital matrix.  We've all seen BCG's growth-share matrix, so just picture one with profit on the y-axis and a human capital scale on the x-axis.  I learned from Mr. Herman that Infosys tracks its human capital according to a formula from a 40-year old Harvard Business Review article.  I'll bet that reference is the Lev and Schwartz model for the present value of future earnings referenced under human resource accounting.

The HIP theory has some surprising implications.  I've noticed that lots of investing styles - growth, GARP, sector rotation - all claim to outperform benchmarks at some point.  Mr. Herman's research reveals that even "vice" portfolios of investments in cigarettes and gambling can outperform market benchmarks, but sustainable ESG portfolios can also outperform with reduced risk.  His findings indicate that more diverse corporate boards of directors are associated with higher ROE and lower volatility, and that unsustainable companies have more volatile share prices.

Lauryn Agnew from Seal Cove Financial discussed her work on attracting institutional assets to social capital investments.  Modern portfolio theory is limited by its emphasis on historical measures of risk, like tracking error and volatility.  She wants to educate investment managers on how ESG criteria mitigate future risk.  Institutions are starting to come around.  The Federal Reserve Bank of San Francisco held its Impact Investing in the Bay Area conference this past May.  Get the conference report and read the working paper.

Ms. Agnew's focus stems from her work with the governance of local non-profit institutions.  These investors want to align their fiduciary duties with the social benefit mission of their endowments.  Institutional trustees have had to live with tradeoffs between impact and investment returns up until now.  Her starting point for identifying locally-based public corporations was the Bloomberg Bay Area Index.  She then matched the ESG scores for portfolio candidate stocks to criteria defined by a given non-profit's mission, and then ranked the stocks for optimal fit.  Several iterations of sample portfolios revealed which combinations of local concentration and ESG score minimized tracking error.

The Bay Area Council's Family of Funds has sought double bottom line impacts for several years.  Enthusiasm for ESG investing is not limited to the Bay Area.  The California Economic Summit's Capital Action Team is pushing triple bottom line results all over the Golden State.  The California Financial Opportunities Roundtable has outlined solutions for growing local businesses.  The Community Reinvestment Act encourages the formation of investment companies that implement its principles.  Community development financial institutions (CDFI) certified by the US Treasury's CDFI Fund can use equity equivalent investments to give non-profits lower capital costs.

Private sector thought leaders in ESG analysis are few and far between.  Changemaker Capital Partners is driving impact private equity investing.  Collaborative Economics is helping to seed the civic ecosystem with "innovation brokers" who can drive multidisciplinary change.  I've done similar work as a knowledge management professional but I had no idea there was a term for an emerging field.  The Stanford Social Innovation Review and Ceres publish leading edge think pieces on sustainability and ESG.  The Global Environmental Management Initiative (GEMI) is taking this subject's tools worldwide.  Now I've got some high-quality sources for future blog articles.

I'll close out this intense, multidisciplinary discussion with my own proposed social capital innovation.  I see a massive disruption opportunity in sustainability for a business development company (BDC) that is chartered to provide capital to small and medium enterprises meeting ESG criteria.  I believe such an entity that is majority owned by investment professionals from traditionally disadvantaged demographics (women, ethnic minorities, disabled military veterans) could register in the Altura Capital Emerging Manager Database and qualify for capital from institutions with a mandate to diversify their sub-managers.   Such a business may also qualify as an SBA-designated Small Business Investment Company (SBIC), giving it additional advantages.  Domiciling this enterprise in a HUBZone would be the crowning glory in a pitch for local investment.  I do not know whether this ESG / BDC / SBIC plan is workable but I am very willing to work with other finance professionals who want to explore it and give it a shot. We won't know until we try.  Maybe some ambitious innovation broker from 85 Broads or the Wall Street Warfighters Foundation is willing to help me make this happen.

Full disclosure:  No positions in any securities, funds, or enterprises mentioned at this time.