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Commentary

From Tango to Salsa – or Silent Disco?

Transmission mechanisms hold the key to adapting asset allocation models to dual materiality, contends Joseph Naayem, Managing Partner, Kalmus Capital.

In the good old days of single materiality, investors could afford to incrementally take a linear approach to how they integrated sustainability into their decision-making processes. As we enter an age of double materiality, allocators all along the investment value chain may find themselves having to go back to first principles and rethink their entire approaches to asset allocation, portfolio construction, fund and security selection and engagement.

If we separate the definition of sustainable investing into ESG integration, or ‘outside-in’, where the focus is on how the outside world affects financial risks and opportunities, versus impact investing, or ‘inside-out’, where the main focus is on how economic activity affects the outside world, we can single out an important parameter that had never held much importance in allocation models: transmission mechanisms.

The art of investing is based on how we allocate risk and accordingly deploy the appropriate resources to oversee it. In the old world of single materiality, relative size was everything: the larger the exposure, the greater the capital at risk, the greater the importance, the more resources, time, fees, effort and sophistication it deserved. It is little wonder that the maturity of sustainable finance, mirroring typical allocation models, started with listed equites, then fixed income before percolating through private markets and finally touching hedge funds last. This assumption – that size equals importance – has underpinned every capital allocation model to date.

Differing transition mechanisms

As impact takes on more importance in a dual materiality world, size is no longer the overriding determinant of importance, be it assets under management, relative portfolio weight, value at risk exposure or revenue line. Each asset class, investment strategy or fund structure has a different transmission mechanism that traces the causality of how capital can influence outcomes rather than just be aligned to them. This causality extends beyond the basic difference between primary investments and secondary market transactions. The level of ownership, levers of influence, credibility and knowledge when engaging on specific topics as well as level of concentration and holding period all play a pivotal role in enabling fund managers to shape outcomes on the ground.

Regulations such as Europe’s Corporate Sustainability Reporting Directive are laying the foundations for how dual materiality is measured and reported, but like many other disclosure-related regulations these can only go as far as shaping how activity is ‘perceived’. How activity and impact is shaped however, depends on where on the dual materiality spectrum an asset owner’s mandate lies. On one end of the spectrum, for those where external impact is a ‘nice-to-have’ by-product of existing investments and whose ambitions are underpinned by the old mantra of ‘what gets measured gets managed’, no structural change is required. They will mainly contend with implementing measurement ex-post and continue taking an incremental approach to how they evolve their investment process and operating model. Any additional resources will be allocated to prioritising perception and mitigating reputational risk by focusing on how to best measure, contextualise, aggregate and report.

On the other end of the spectrum, for those whose mandate encourages them to prioritise the largest possible impact whilst respecting their long-term return targets, asset allocation decisions will evolve significantly. Here, focusing on the desired impact ex-ante reframes the approach to fund selection around the available transmission mechanisms and levers of influence at their disposal. Sharpening the lens on causality counterbalances the inhibiting importance of some risk parameters such as liquidity, duration, complexity, concentration and fees. This not only repositions alternative investments within the investor’s overall asset allocations, but also in its composition and approach to partnerships.

Small niche; large impact

To illustrate, let us take the example of a distressed debt hedge fund strategy. A small niche within the smallest asset allocations for most institutional pension funds, such strategies are surely low on the priority list for most sustainability teams, allocators, or general scrutiny where prioritisation is size-determined. Yet these hold some of the most powerful transmission mechanisms and levers of influence that can drive positive or negative impacts. Some obvious levers are in their ability to take control over a company in distress, replace the board, executive team and even impose a different corporate strategy as part of an operational turnaround.

Traditionally this was predominantly done through the lens of financial reorganisation by leveraging superior talents in corporate finance, litigation and financial engineering. Complementing their talent stack to also include scientific and regulatory expertise as well as clever use of AI to contextualise the plethora of non-financial data now available, these strategies offer sophisticated investors an opportunity to seed and design innovative and impactful strategies, acting as partners with such managers should they have the mandate to look past thresholds such as minimum track records size. The return potential for such an evolution in their strategy is staggering, particularly when we look around the corner to the supply chain implications of upcoming regulations such as the Corporate Sustainability Due Diligence Directive and Carbon Border Adjustment Mechanism on entire business models.

At a more subtle level, distressed debt hedge funds’ traditional role as a liquidity provider of last resort can be extremely powerful, particularly in periods such as 2009 when it was most needed. In many instances, these aggressive managers were the only investors at the table bailing out many of the solar bellwethers that would have gone bankrupt otherwise. There was no ‘intentionality and measurability’ or even awareness of the impact they had on holding up an industry that had taken decades and billions in subsidies to get to scale.

Asset owners too fixated on perception may have undoubtedly found their methods and approach somewhat unpalatable, let alone their high fees outright objectionable, even if many were posting triple digit returns into 2011. This cuts both ways of course, as unless designed with an impact lens, this also means that no matter how many exclusion policies are implemented by every other fund, it only takes a small distressed manager to take control of a deep sea driller for pennies on the dollar for there to be no change in the negative impacts that larger players may have absolved themselves of. Fast forward a decade later and we see the same opportunity for influence in the private credit and secondaries market, where new entrants acting as liquidity providers can act as price givers and enjoy greater levels of influence during a period of rising rates and dislocated valuations.

Similar transmission mechanisms are available within every asset class or even macro allocations such as gold, risk overlays or even digital assets. In each case, the same old adage: ‘size isn’t everything, it’s what you do with it’ rings just as true. This applies at the fund level, where the most moveable needles are often among the smallest holdings. Here, a fund may represent a larger proportion of a small cap’s equity or debt. Resources, however, are predominantly allocated towards the largest positions where a manager may have an insignificant share of voice.

The reality of impact is not just complex but fraught with ugly choices and unpalatable trade-offs that push us to the brink of the agency / principal problem: When selecting a fund manager, do we prioritise how it is perceived and what their disclosures may do to our weighted average metrics we will then need to report, or do we double down on getting past the marketing and clean metrics, roll up our sleeves, risk getting our hands dirty to get stuck in and fix things? Oh and by the way, that’s where all the alpha lies.

‘Perception vs action’ mismatch

Asset owners have tackled various types of asset-liability mismatches over the years: Liquidity, time horizon, incentive structures. As we go back to first principles and question the assumptions driving the age-old principal-agent problem, one that dual materiality opens up that had never been questioned before is the ‘perception vs action’ mismatch. In a single materiality world, this was never an issue, there was no ‘action’ needed other than ensuring proper governance at AGMs to ensure we got our dividends. This left perception management unchecked where transparency, reporting, and monitoring was a one-way flow of information and the eternal tango between marketing poets and due diligence cynics was just an accepted part of the game.

The implementation of multiple regulatory standards seeking to improve the transparency of funds’ and corporates’ sustainability performance are set to change the tune. Ideally, this would lead to a salsa that intensifies the multi-faceted dialogue needed to optimise action. However, the unintended consequence may resemble a silent disco, with each actor gyrating to their own legal and compliance tune.

Transmission mechanisms are the key to successfully navigating the dual materiality landscape. By rethinking asset allocation, engagement, and fund selection, investors can fulfill their fiduciary duties, scale sustainable impact, and secure robust financial returns. The evolution of asset allocation lies in leveraging these mechanisms to balance both financial and societal outcomes effectively.

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