Editor's note: This article first appeared in the Q3 2021 issue of Morningstar magazine. Click here to subscribe.
Vanguard recently made separate announcements: that it was hiring environmental, social, and governance professionals for an ESG product push and that it would soon offer clients access to private equity investments. Vanguard’s endorsement lends further credence to the merit of both of these trendy investment themes—and stands in contrast to the firm’s hesitancy to date to embrace cryptocurrencies.
Vanguard’s unique cost advantages and Jack Bogle’s legacy of investor-first behavior put Vanguard in an uncommon position among asset managers and brokerage firms. The firm has much more to risk from embracing a gimmicky concept than from being late to participate in an enduring one. As such, its decision to jump on the ESG and private market trains simultaneously bodes well for the future of both, but it also raises an interesting question: These areas are rising in popularity at the same time, but are they really compatible?
Sustainable investing and private markets spring from very different roots and appear to gravitate in opposite directions. Sustainability leans left. Its proponents argue that the investment world places too much focus on maximizing shareholder value and that more concern must be given to a broader set of stakeholders—a company’s employees, its partners, its clients, the communities it serves, and the environment from which it takes resources and into which it dumps its trash.
Private equity, on the other hand, has long pulled to the right. Its modus operandi concentrates shareholder power in an oligarchy driven to (re)focus management on increasing shareholder returns, often at the expense of other stakeholders, such as employees who have suffered layoffs and gutted pension plans or consumers whose healthcare costs have risen in the wake of private equity investments in hospitals or pharmaceutical patents. By its inherent nature of privacy, private equity purposely shuns the sunlight of disclosure, transparency, and accountability upon which ESG assessments depend. Thus, while ESG seeks to diffuse shareholder power through the inclusion of more voices, private equity by definition concentrates shareholder power through the exclusion of potentially dissenting ones, starting with public shareholders.
Clearly, the ESG and private equity trains run on different tracks. Not surprisingly, the fields also have markedly different advocates. One is beloved by the Marxist economist railing about unpaid labor and the unpaid cost of environmental exploitation. The other is the darling of the right-wing business school professor who gushes over the superior returns private equity generates by making tough decisions, cutting fat, and making companies lean, mean profit machines.
Just as these opposed economic views coexist (at times contentiously) inside academia, so too may they soon cohabitate in an individual investor’s Vanguard account, which may hold an ESG-themed mutual fund, some green energy stocks, and a private equity fund. Large endowments and pension funds already show such potentially incongruous behavior. Endowments that have long promoted social justice and advocated a broader stakeholder perspective are now among the biggest funders of private equity and venture capital firms that are judged primarily for their ability to maximize shareholder value.
How long can the private equity and ESG fields operate on different wavelengths if they increasingly have the same owners? One way or another, the playing field will have to grow more level as public and private markets come together. Surely, endowments that prize stakeholder capitalism and want to use their power to advance social and environmental causes can’t carve out a separate set of standards for their private market investments. They cannot ignore the collateral damage done by the shareholder-first practices of the leveraged buyout and private market practices of yore. More likely, rather than ESG concerns yielding to traditional private equity standards, it will be the private equity world that must adapt to today’s calls for greater ESG accountability.
But if private equity becomes less private—if it is forced to adopt higher standards of accountability and transparency—can it still generate the superior returns it has in the past? Or will private equity go the way of big mutual fund managers whose investment returns regressed to the averages once Regulation Fair Disclosure blocked their privileged access to corporate management or follow the downward trajectory of the Yale investment model whose relative returns regressed during the past decade as more players adopted the same playbook? Level playing fields tend to level results.
Private markets and sustainable investing remain two of the hottest areas in finance. So far, they have been on independent paths, but as each grows, their Venn diagram will increasingly overlap. This potentially contentious intersection will likely be the focus of some of the most heated investment debates of the next decade—the smithy where the very soul of capitalism or its potential collapse may be decided. Will either shareholder or stakeholder concerns emerge victorious, or will some sort of Hegelian synthesis emerge? Vanguard has prudently hedged its bet, leaving the decision where it belongs: in the hands of investors. It’s up to us whether we forge a new consensus or, as with politics, we bifurcate into hostile camps.
Don Phillips is a managing director at Morningstar. He is a member of the editorial board of Morningstar magazine.