ESG's Emerging Leading Role in Capital Markets
Originally published by Morgan Stanley
Company management teams and boards are embracing positive environmental and social impact as an opportunity to drive growth and higher public-market valuations.
There’s no denying that sustainability has permeated public consciousness, our economy and financial markets. Consumer choices keep underscoring that what’s good for society and the environment can also be beneficial for business, while investors are increasingly searching for sustainable investing opportunities and analyzing corporations' environmental, social and governance (ESG) performance.
Helping to make the case is evidence showing that incorporating ESG factors in portfolios could aid investors in capturing above-market returns. Last year, sustainable investment funds outperformed traditional peer funds and reduced investment risk during coronavirus, according to a study from Morgan Stanley’s Institute for Sustainable Investing.
Company management teams and boards are responding by prioritizing ESG in ways that are pervading capital markets. Many are giving sustainability a leading role when establishing their corporate structures, striking M&A deals or raising funds through initial public offerings or bond issuances. It’s an indication that corporates see opportunity for positive environmental or social impact to drive growth and higher public-market valuations, according to Morgan Stanley’s bankers.
“ESG is a topic that investors want c-suites and boards to manage,” says Lavanya Balakrishnan, a Managing Director at Morgan Stanley who concentrates in M&A banking in the power and utilities industry. “Companies that can articulate where their growth can come from in these ways are often rewarded with higher price-to-earnings multiples.”
ESG in Capital Raising and M&A
Allocators are backing companies that can demonstrate how they’d protect against the world’s biggest sustainability issues, such as public health crises, inequality and climate change, which also pose significant business liabilities. In the power and utilities sector, companies and equity investors see potential growth stemming from corporate investments in decarbonization, coal reduction and renewable energy, Balakrishnan says.
Similarly in bond markets, investors are integrating ESG risks into their credit analysis, while companies are heeding growing appetite for green bonds, social bonds and sustainability bonds, which issuers use to fund environmental and social projects. Issuance of sustainable finance bonds has increased steadily in recent years and, in 2020, doubled to a record $554.3 billion, according to data from Refinitiv.1
ESG factors are becoming increasingly important for companies preparing to go public, too. For corporates looking to shore up their balance sheets by tapping public markets through IPOs or special purpose acquisition companies (SPACs), communicating a corporate sustainability strategy has become an essential part of the process, according to a recent report from the Morgan Stanley Institute for Sustainable Investing.
Management teams are also screening for M&A using ESG criteria, as they consider how to reposition their brands. One recent example is Dominion Energy’s sale of its gas transmission and storage business to Berkshire Hathaway, which closed in November 2020. Dominion Energy, which Morgan Stanley advised, announced in July that it would reduce its CO2 emissions by 50% from the sale of its business.2 Three months after the announcement, its forward price-to-earnings multiple—a measure of relative value based on a company’s projected earnings—doubled relative to the utility sector index.
Public Benefit as Viable Growth
To signal their commitment to positive social and environmental impact, some sustainability-conscious companies are pursuing ESG in corporate governance through structures such as a Public Benefit Corporations, or B-Corps. The designation isn’t new, but its growing popularity marks a shift in investor perception of how growth and financial viability could stem explicitly from ESG prioritization, according to Morgan Stanley Managing Director Thilakshani Dias, who advises corporate clients interested in becoming B-Corps.
The B-Corp designation can be beneficial for companies whose founding principles are already based on sustainability, Dias says. Investors are searching for corporations that form strong connections with consumers who increasingly base their buying habits on businesses’ societal impact. The B-Corp structure acts as a kind of certification that a company’s efforts are noteworthy in this regard.
Vital Farms, an ethical food producer of pasture-raised eggs and butter, is one recent example of a B-Corp that’s garnered investor interest. Its focus on animal welfare and fair farmer compensation was a draw for both consumers and investors, according to Morgan Stanley Managing Director Patrick Gallagher, who along with Dias advised the company, which went public in July 2020. “Investors are looking for companies focused on sustainability that do things differently because that’s where the consumer is going,” Gallagher says.
Intersection of Boardroom ESG Issues
While ESG factors in corporate valuations and ratings are becoming top of mind for management teams and boards when considering their capital raising and M&A strategy, it’s also affecting their responses to shareholder activism and their formulations for executive compensation. What’s more, employees are showing greater interest in working for sustainable companies, while regulators are enforcing policies that incentivize ESG improvements.
For all of these reasons, executives now consider ESG opportunities in capital markets as wide-ranging, yet interconnected, which is why Morgan Stanley established its ESG Center for Excellence in June 2020 to coordinate sustainability efforts for clients across investment banking and global capital markets. It’s one of the latest initiatives in Morgan Stanley’s long-standing commitment to integrating sustainability into all of the firm’s businesses. More than 12 years ago, in 2009, Morgan Stanley founded its Global Sustainable Finance group to spearhead the commitment to sustainable investing and sustainability. In 2013, Morgan Stanley extended the commitment further, founding the Institute for Sustainable Investing, chaired by CEO James P. Gorman and dedicated to product innovation, thought leadership and building the next generation of sustainable finance leaders.
“Capital markets are at an inflection point where corporates can no longer ignore the importance of ESG factors," says Melissa James, Managing Director, Vice Chairman of Global Capital Markets and Co-Head of the ESG Center for Excellence at Morgan Stanley. “Investors and corporates appreciate the potential impact ESG can have on valuation and performance. It’s viewed as both a material risk and opportunity, so investors see both potential downside and upside.”
Social Bonds, Diversity and Inclusion
The firm’s work within the ESG Center for Excellence has also informed Morgan Stanley’s own operations. One recent initiative strengthens the firm’s commitment to diversity and inclusion with the issuance of a $1 billion inaugural social bond to fund affordable housing projects for low- or moderate-income individuals or families in the U.S. As part of the process, Morgan Stanley tapped financial firms that are designated minority-, women- or veteran-owned businesses as either joint lead managers or co-managers of the bond deal, including Loop Capital, Siebert Williams Shank & Co., CastleOak Securities, Cabrera Capital Markets, Ramirez & Co., R. Seelaus & Co. and Academy Securities.
“We asked these D&I firms how to best partner, and reacted to their desires to increase their economics, access to, and distribution of, Morgan Stanley’s social bond,” says Scott Ashby, Managing Director, Co-Head of Fixed Income Capital Markets, Americas and Co-Head of the ESG Center for Excellence at Morgan Stanley. The firm will continue to appoint diversity- and-inclusion-focused companies in future syndications for Morgan Stanley’s own bond offerings, he says.
1 https://www.refinitiv.com/perspectives/market-insights/sustainable-finance-surges-in-2020/
