The origin of the modern day meaning of sustainability can be traced back to a publication from October 1987 in a report entitled “Our Common Future,” the culmination of an immense amount of work by the UN World Commission on Environment and Development.1 In that report, the first known reference to sustainable development (and ultimately the UN’s sustainable development goals) can be found:
“Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs.”
At Zeo, in our effort to break through the noise and get to the heart of why material ESG factors affect a company’s creditworthiness, we thought long and hard about how this original meaning of sustainability applied to credit analysis and recognized in it a foundational philosophy of our approach to fundamental investing:
Sustainable business practices are practices that enable management teams to meet the needs of current stakeholders without compromising the ability of future management teams to meet their own stakeholders’ needs.
That is, a company is not creditworthy if it is not behaving in a way that makes it long-term sustainable. This is not new, and it is certainly not a trend. This is a simple prerequisite for a fundamental investor. For example, in early 2012, shortly after Apple executive Ron Johnson was hired as CEO of J.C. Penney, we asked the company for a call to discuss their capital markets strategy. To be successful and sustainable, a retail company such as J.C. Penney not only needs to satisfy its shareholders and customers but also its bondholders. With Mr. Johnson’s clear signal that he wanted to “upgrade” the customer profile of the company, it became clear that he was not necessarily adapting to the differences between his new employer and his previous one, where customers were significantly more affluent and demand was largely inelastic. From a governance standpoint, paying attention to other key stakeholders is important in general but is mandatory for a company as dependent on access to capital as a leveraged retail business. The response from the company to our request (made in March) was that we could attend their roadshow for bondholders… in September.
This fundamental failure of governance by the company’s board in hiring an executive unprepared for the job and by the management team in virtually ignoring two classes of key stakeholders (customers and bondholders) was a key driver in prolonging the company’s financial woes for years. The consequences of Mr. Johnson’s actions as CEO persisted long after he departed the company in 2013 and would eventually lead to the company’s undoing in May 2020, albeit years later than we had originally anticipated when the company did not have the flexibility to manage through even the initial impacts of the global pandemic. Sadly, this was not due to Mr. Johnson’s strategic decisions; partnerships and business initiatives that he set in motion in 2012 remain with the company today and, in some cases, perform well. Rather, this was due to his and his team’s governance decisions.
Notably, this anecdote predates the recent and rapid increase in awareness of sustainable investing among those in the credit markets who don’t prioritize ESG issues. But it highlights the link between creditworthiness and a company’s approach to long-term sustainability that has underpinned our approach to credit since the founding of Zeo. However, it is only recently that a focus on ESG issues has become mainstream. Just a few examples from the last few months show this to be true:
Environmental: On March 3, the SEC’s Division of Examinations released their examination priorities for 2021. This is an annual release to give compliance managers a sense of what the SEC is focused on when they do routine examinations of investment advisers. Here is an excerpt from the press release accompanying this year’s Examination Priorities:
“This year, the Division is enhancing its focus on climate and ESG-related risks by examining proxy voting policies and practices to ensure voting aligns with investors’ best interests and expectations, as well as firms’ business continuity plans in light of intensifying physical risks associated with climate change,” said Acting Chair Allison Herren Lee. “Through these and other efforts, we are integrating climate and ESG considerations into the agency’s broader regulatory framework.” (emphasis added)
This quote should send shivers down the spine of any investment manager whose primary approach to ESG is through negative screening or any issuer who views ESG reports as marketing rather than disclosure. Why? Because we believe the SEC is sending a clear signal that ESG issues are increasingly being viewed as aligned with investors’ and stakeholders’ best interests.
Among the consequences to this is that investment processes, not just individual investments, will need to be justified and that corporate sustainability reports will fall under the SEC’s mandate to ensure full and fair disclosure. While the proxy voting focus of the SEC this year is a potential headache for equity managers, the natural evolution into fixed income is inevitable. Portfolios which rely on issue-specific characteristics (e.g. “green bonds” issued for image-building special projects with little impact relative to the issuer’s size) rather than issuer behaviors overall are likely to come under scrutiny in the future.
Whether one agrees with the SEC’s focus on this area or not, the foundation has been set for the “broader regulatory framework” they have promised, one which places ESG standards and disclosures on equal footing with the financial standards and disclosures required by the SEC since it was established in the Securities Act of 1933.
Social: The day before, on March 2, an interesting research report from Bank of America was released entitled “Everybody Counts! Diversity & Inclusion Primer.”2 In short, the analysts cite research conducted at the San Francisco Fed that gender and race inequities in education and the workforce have cost nearly $70 trillion in economic output over the last 30 years. That’s a big number, and while it does seem worthy of skepticism, any doubt is undermined by an independent study by the World Bank from 2018 quantifying the cost of gender inequality alone to human capital wealth at $160.2 trillion globally, which the Bank of America report cites as well.3
But the point of highlighting this research is less to start a debate about the benefits of D&I as a social good. Those who read our letter from last quarter know our position in favor of diversity and inclusion in financial services, as well as our view that the slow pace of gains in this area is due less to difficulty and more to a lack of commitment on the part of those who currently benefit from institutional advantages. That debate won’t continue in this letter. Rather, the point of highlighting this report is to note its source.
This report was not written by an ESG analyst. In the not-so-recent past, that would not only have been the case; it would have been the only way such a piece could get published. Most banks have hired ESG analysts to satisfy those clients who value sustainability while allowing the bulk of their business to go along its merry way unconcerned with what the ESG folks were up to over in their corners. At some point in the recent past, the ESG research teams got emboldened by large clients who started asking questions about where the banks as a whole stood on ESG, and little by little, the awareness of their work slowly crept into their colleagues’ field of vision.4 ESG became inescapable to the point that it is now the domain not just of analysts dedicated to it but of the teams responsible for global research and strategy across all asset classes and themes. Indeed, this report was written by BofA’s global thematic research team; the authors include just one ESG strategist but no fewer than four general equity strategies, three general equity & quant strategists and two US economists. This was a mainstream report sharing mainstream strategic views by mainstream analysts about a social issue.
They were not alone. A global economist at Citigroup published a similar report highlighting an analysis of the drag on GDP of racial inequality in the United States, with a similarly staggering price tag of approximately $16 trillion over the last 20 years. Again, this is not coming from ESG analysts. This is coming from global strategists, whose research helps drive the overall direction of both the firm and the advice the firm gives to clients.
It is worth pointing out that both reports came after the horrific injustices earlier in 2020 that led to a heightened awareness of the Black Lives Matter movement. So we do appreciate that there may be some skepticism that these changes only happened out of fear and will not last. However, it is ok to envision a future in which there are some motivated by fear, while others are motivated by ideals. Especially as it pertains to the very sticky issues that fall under the social pillar of ESG, those who want to see change must be willing to embrace both.
Governance: There are many ways in which owners, boards, companies and executives can be held to account for negligent governance. The most common comes in the form of shareholder activism. Often, governance issues shine a light on a lack of representation and diversity on corporate boards and in the executive ranks. However, more insidious governance failures can also be found in the incentive structures and resulting behaviors of companies and their boards as well. And there are more than just activist shareholders who are sensitive to and take action to address these issues.
In June 2018, BC Partners, the private equity owner of pet supply retailer PetSmart, came under intense scrutiny for using loopholes they embedded into the company’s credit agreement. The company announced a transfer of approximately $1.65 billion of value out of the lender’s collateral (in the form of 36.5% of the stock in its recently acquired subsidiary Chewy Inc.). The secured debt balance was just over $6.6 billion, so this move took away collateral that was worth approximately 25% of face value. The move was opposed in court, and though the actions taken were contractually allowed, the parties ultimately reached an agreement to allocate value from the diverted assets to repay the lenders if the Chewy stock was sold later.5
Fast forward to November 2020 and we are faced with an unexpectedly friendly credit market, allowing many issuers to raise debt at record-low interest rates even though the underlying financials have never been more uncertain due to the still-unknown long-term effect of the pandemic on the US economy. Put another way, very few companies were turned away by debt-hungry investors, let alone one as large and well-known as PetSmart.
Unfortunately, BC Partners never learned their lesson. They decided that this was the right market to raise debt for the purpose of separating the Chewy business from the legacy PetSmart retail business. If not the same move as in 2018, this one certainly rhymed. The fingerprints of the 2018 attempt to separate the very valuable Chewy business for the benefit of shareholders at the expense of bondholders were unmistakable; not even an unexpected market frenzy could erase the lenders’ memory of that battle. As a result, the debt deal failed, and while that does happen from time to time, in the frothy credit markets of late 2020, it is as close to a sign of the apocalypse as we’ve seen in a long time.6
Notably, investors aren’t the only ones taking governance matters into their own hands. On February 28, the New York Times published an opinion piece about a different company’s board of directors agreeing to a sale of the company to a firm which saddled it with too much debt, and the company later filed for bankruptcy. What’s the big deal? Capitalism at work, right? The twist in this story is that a judge held the company’s board liable for approving the transaction even though the bankruptcy happened four years later!7 Though this decision may be a one-off, it puts boards and leveraged buyout firms on notice that their practice of bleeding companies dry through leverage, even if the market will bear it, has a lower bar for malfeasance in the eyes of the courts. That a judge sees this as his domain is as notable as the SEC’s apparent decision to plant a stake on climate change.
In all of these examples, the primary players are not activist investors, and the results were not motivated by mission-driven objectives. Rather, these were decisions and actions taken by people in the mainstream – the SEC, traditional investment strategists and bond investors, a federal judge in New York – because they did not see ESG issues as separate and extraneous, as some investors believe them to be. Rather, they saw them for what they are – indigenous risk factors, with the same material consequences as other risk issues which are well understood to affect a company’s ability to operate consistently over the long-term… or, in a word, sustainably.
By Venk Reddy
1 Interested readers can find the report here: Our Common Future: Report of the World Commission on Environment and Development (un.org).
2 The actual report requires access through a Bank of America representative, but Saijel Kishan at Bloomberg wrote a story about it that readers can find at this link.
3 For those who want to read the original World Bank report, it can be found at this link.
4 We’d like to think this goes without saying, but this colorful caricature of the history of ESG analysts on Wall Street is just that, a caricature: part exaggeration, part dramatization and part factual with a goal to share observations that are solely our own. Maybe, however, there is at least a little truth lurking in the humor.
5 It is outside of the scope of this letter to analyze the lawsuit and the outcome, but some readers may recall we analyzed this situation in early 2019 as part of our case for hidden risks in the syndicated loan market, a theme we reiterated in our Q4 2020 letter, which can be found at this link. For those interested in the details, S&P Global published a well-written summary of the covenant issues that allowed this collateral diversion to happen. Be warned: This is a dense and technical document that may put you to sleep if you don’t enjoy covenant analysis as much as we do!
6 The coda to this story is that PetSmart decided to capitalize on the issuer-friendly debt markets in a much more traditional way: by refinancing its debt with new bonds and loans. Notably, the company was able to reduce its interest expense somewhat, but the shenanigans from the past loomed large in requiring them to agree to higher coupon rates than may have been achievable if they had not eroded the trust of the capital markets. In other words, poor governance can lead to higher cost of capital, which has a very real effect on the company’s financial situation.
7 The piece by William Cohan can be found at this link. Mr. Cohan makes a good effort to summarize a complicated situation, and investors should take notice of his conclusions. Typically, if a company files for bankruptcy four years after it raises debt, there would be plausible deniability. After all, a lot can happen in four years. It is true that the company had too much debt for its circumstances in 2018. But was that true in 2014? This seems to be one of the first visible signs that the judiciary has directly linked a board’s (and private equity sponsor’s) actions to a credit event so long afterwards. The excess leverage that killed the company had an accomplice - bad governance.
Important Disclosure Information
Zeo Capital Advisors is a fundamental investment manager with a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk Reddy authored this piece and is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.
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