This research was produced by the Predistribution Initiative (PDI), a multi-stakeholder project working with institutional investors and their stakeholders to co-create investment structures and practices that better address systemic risks such as climate change and inequality. In this paper, PDI explores the negative impacts of asset allocation practices of institutional investors engaged in environmental, social and governance (‘ESG’) investing, impacts that conflict with their ESG objectives. PDI finds that institutional investors and their ESG frameworks do not focus on these impacts, being focused instead on company operations. Through this research, PDI encourages investors to consider how they can better manage the risks that arise from these impacts. PDI regards institutional investors, as universal owners, having the greatest potential for creating sustainable change through their investment choices.

In the first part of the paper, PDI identifies the actual asset allocation practices in question, observing that for the past two decades institutional investors have leaned towards higher-yield asset classes in order to gain higher short-term returns. Such asset classes include private equity, venture capital, private debt, high-yield bonds, leveraged loans and collateralised loan obligations. PDI examines the growth in uptake of these investment products, finding that with low interest rates and quantitative easing, investors and companies have been further incentivised to increase their exposure to such high-risk debt and resulting inflated asset valuations.

PDI examines how the allocation of capital to these asset classes leads to negative impacts on investors’ portfolios and society more generally. First, investments are consolidated with the largest asset managers and invested in a smaller number of companies inflating their value. This means that smaller, innovative and more diverse fund managers and companies are starved of capital. This decreases competition and diversification into investments that are more resilient and undervalued. Inflated asset prices disproportionately benefit those who are already wealthy as opposed to those who do not own any stocks.

Other consequences relate to impacts on stakeholders such as workers who might lose their employment or have their wages cut due to action taken by companies to service their debts, avoid bankruptcy and meet investors’ expectations. In the case of social infrastructure investing, that same action could result in reduced quality of goods and services and increased costs for end-users in health care, housing, water and power.

These societal adverse impacts create systemic inequality which can result in economic decline and market destabilisation. High debt levels create risk across capital structures also making companies, the economy and market stability fragile. This fragility could be increased by a rise in interest rates and other unplanned challenges notwithstanding government support to companies to avoid bankruptcy, such support itself funded by sovereign debt. These systematic risks impact on governments, workers, communities and investors themselves, thereby undermining their ESG objectives for sustainable returns over the long term.

In the second part of this paper, PDI advances potential solutions focused on diversifying asset allocation to more regenerative investment structures and asset classes, building an enabling environment through adjustments to team incentive structures, performance reviews, benchmarking and valuation methodologies and field-building.

1. Institutional investors dominate financial markets holding over 40% of global market capitalisation of listed companies. These investors have fuelled the exponential growth of private equity and other related assets. Their allocation of funds to these asset classes has potential negative impacts for workers, consumers, the economy and financial market stability.
2. Institutional investors’ asset allocations have left corporate debt burdens and leverage ratios historically high. The riskiest firms accounted for the highest increase in debt in recent years prior to 2019. A rise in interest rates or other unplanned events, like the COVID-19 outbreak, will increase the potential for negative impacts from these investment practices.
3. There has been a trend of institutional asset owners and allocators consolidating their investments with some of the largest asset managers in private asset classes. Compensation of these asset managers often exceeds banking executives, weakening the incentive to make strong returns, enabling them to influence policy making contrary to ESG objectives and systemically growing economic inequality.
4. Environment, social and governance (‘ESG') frameworks used by institutional investors focus on company operations. Matters relating to investment structures, leverage ratios and resulting asset allocation are not typically within the realm of ESG-related responsibilities. The negative consequences of highly leveraged investments have been underexplored when it comes to ESG investing frameworks and practice.
5. Institutional investors’ ESG and investment professional teams responsible for financial performance, may have competing objectives. Investment teams’ performance reviews, evaluation methodologies and benchmarking need to be aligned with ESG goals focused on controlling systemic and systematic risks to achieve sustainable long-term returns.
   
6. Investors need to refine their financial analysis techniques to include measurement and management of not only financially material risks to a company but also systematic risks that manifest across portfolios. This would involve reinterpreting the understanding of risk in evaluating portfolios to price in negative societal impacts and market risks arising from investors’ capital structures.
7. Institutional investors need to develop more flexible asset allocation models that contribute to the maintenance of the economy and market and produce strong returns. This would mean turning away from more standardised traditional products and investing in smaller and emerging managers, sustainable infrastructure, affordable housing and regenerative agribusiness.
8. Asset owners and allocators can be many degrees removed from workers and communities at the portfolio company level. They need to engage with stakeholders to receive information about how their investment activities may create negative impacts on the ground where portfolio companies operate.
9. For an improved form of capitalism that works for all stakeholders, both corporate governance-led and public policy solutions are needed. This includes field building in which there is space for research and development of reforms undertaken with institutional investors, academics and other stakeholders. Such research could involve the co-creation of metrics to measure and manage against systematic risks.
10. This report contains a bibliography of all sources of information and research on which the report is based. It also contains a number of charts, graphs and diagrams relating to the various asset classes discussed in the report, corporate debt and vulnerabilities in the non-bank financial sector.