The ESG Gap

The corporate world is undergoing a transformation. In recent years, there has been a dramatic influx in demand for companies to promote environmental, social and governance (‘ESG’) values. Investment in ESG-oriented mutual funds (green funds), rose globally by 53% in 2021 to $2.7 trillion (Kishan, 2022). Bloomberg forecasts that by 2025 ESG assets may hit $53 trillion—a third of global AUM. Not only are people investing more in ESG, but they are willing to pay higher fees for such investments. A recent study has found that investors are willing, on average, to pay 20 basis points more for an investment in a fund with an ESG mandate as compared to equivalent funds without one (Baker et al, 2022). Yet, these preferences do not necessarily translate into effective corporate actions. As many authors and commentators have noted corporations do not effectively promote ESG goals. Scholars such as Bebchuk, Kastiel & Tallarita (2022); Bebchuk & Tallarita (2022) provide evidence that questions the promotion of ESG by corporations. Echoing the same view, Professor Aswath Damodaran at the Stern School of Business at NYU (2022)  wrote: ‘I believe that ESG is, at its core, a feel-good scam that is enriching consultants, measurement services and fund managers, while doing close to nothing for the businesses and investors it claims to help, and even less for society.’ As Pucker & King (2022) summarize ‘ESG for most managers is total greenwash.’

In this Article, we underscore the structural problems that prevent the steering of the corporate ship toward ESG goals. The promotion of ESG goals requires competence and motivation. Competence is necessary because promoting ESG goals is generally more complex than the furtherance of profit maximizing strategies, and requires a long-term vision. Furthermore, ESG goals are multi-dimensional and uncertain. Weaving them effectively into the culture and operation of firms is a daunting task that only skilled businesspeople can successfully achieve. Competence alone will not do, however, because without strong motivation to achieve ESG goals, no change will happen. Motivation denotes a desire to do what is right, requiring a real commitment to ESG values.  

We analyze the central actors in the corporate sphere that can potentially bring such change on the ground—managers, institutional investors, and activist hedge funds—and demonstrate that none of them have the two central elements required for promoting ESG goals: motivation and competence. We refer to this problem as the ESG gap. Managers have close familiarity with the ins and outs of their firm, and at least in principle, possess the requisite competence necessary for accommodating ESG goals. Yet, managers largely lack the motivation to engage with ESG goals due to their short horizons and compensation structure. Managerial compensation is based on short horizons, and the attainment of ESG goals often requires very long horizons.

In contrast to management, institutional investors possess the motivation for incorporating ESG into corporate activity. As Professor Jeffery Gordon (2022) has recently observed, because institutional investors hold almost the entire market in their portfolio, they are sensitive to systematic risks, and as ‘universal owners’ have a strong interest in reducing inter-firm externalities. At the same time, institutional investors lack the competence for leading such change. The proper integration of ESG goals into a given firm depends on the relevant business model and environment of the specific firm in question. Institutional investors are not involved in the operative level of firms. Their business models prevent them from delving into the specifics of the firms in their portfolio.

Activist hedge funds have the competence to form new business plans for companies. Their engagements are based on their ability to change the course of under-performing firms.   Unfortunately, activist hedge funds do not possess the motivation to incorporate ESG goals into the objectives of firms. Their business model is ill-fitted for the long horizons ESG turnaround requires. Their business plan is predicated on relatively quick ‘fixes,’ such as spin-offs, dividend distribution and R&D cuts. One of the prime reasons for their short horizons is the fact that they are structured as partnerships in which capital investment is locked—there is no secondary market on which it can be bought and sold. Hence, hedge funds must cater to the wishes of impatient investors who cannot freely exit and therefore opt for relatively short-term engagements.

We propose bridging the ESG gap by forming a new entity: the Activist ESG Fund (‘AEF’). The AEF would be an exchange-traded, closed-end mutual fund, uniquely designed for targeted activist investment. The closed-end traded fund structure would enable the fund management to have long horizons by attracting patient money while impatient investors could always sell their shares on the highly liquid stock exchange. In addition, the remuneration structure of the Activist fund’s management would be a carried interest a-la the hedge fund model: it would provide managers with a significant share of its profits, similar to the hedge fund’s conventional 20% cut. At the same time, the AEF would differ from standard activist hedge funds in that it would have an unlimited term of organizational structure (no partnership dissolution date), and even more importantly, it will have a secondary liquid market for its securities. Hence, the AEF would possess both the competence and the motivation to advance ESG goals.

Our proposal faces a critical obstacle under current law, however. The 1940 Investment Company Act imposes heavy regulation on investment companies (including closed-end funds) that in our case would be prohibitive. Specifically, in order to discourage excessive risk taking by fund managers, the Investment Act highly disfavors success fees. This, in turn, sharply contradicts our vision of incentivizing the AEF managers with the same generous success fees that are typical of unregulated hedge funds. Such fees are required to provide the necessary high-powered incentives. The establishment of the AEF would, thus, require one of the following: its exemption from the Investment Company Act or an amendment of the Act’s provision concerning success fees. The establishment of AEFs can be a turning point in the effective promotion of ESG goals by corporations in our society.

Sharon Hannes is a Professor of Law at Tel Aviv University.

Guideon Parchomovsky is a Professor of Law at the University of Pennsylvania.

Adi Libson is a Lecturer in Law at Bar-Ilan University.