3 min read 22 Jul 20
Summary: With the growing interest in Sustainable investing, many funds and indices are increasingly relying on ESG ratings to indicate the extent of a company’s adherence to, or engagement with, ESG concerns.
However, recent allegations of fraud at German payments provider Wirecard, for example, highlight the pitfalls of relying solely on ratings to determine a company’s ESG credentials. At a number of ratings providers, the stock earned a median-grade ESG rating (these ‘middling’ ratings also varied given the different emphases by providers on each of the E, S and G factors). The stock was also included in several large ESG-focused exchange-traded funds (ETFs) and, at least at issuance in September 2019, the company’s debt was considered investment grade.
The scandal raises questions about the efficacy of a passive approach when investing in businesses committed to sustainability. It certainly makes sense to rely on more than one ratings provider, and also drill down from the headline risk ratings to try to understand how a company is performing across a number of factors.
The relative strength of an active management approach is in the implicit accountability in the investment decision-making process. If an active manager invests in a business with poor governance credentials, for example, they must readily be able to explain and justify that decision. This overarching framework of ‘stock picking’ accountability, necessarily requires a rigorous due diligence process and ongoing engagement with investee companies.
A thorough due diligence process is designed to identify any red flags which, if found, will prompt questions requiring effective answers. Wirecard had been mired in controversy for some years, almost since the Global Financial Crisis. More recently, the FT raised concerns in 2015 and, again, in 2019. In October 2019, under pressure from investors, an independent audit was conducted by KPMG and, by June 2020, Wirecard had announced missing funds of EUR1.9 billion – later acknowledging that the money probably does “not exist”.
While fraud can be notoriously difficult to identify, perhaps in Wirecard’s case there were some notable ‘red flags’ that warranted further investigation. The payment sector is capital light and cash generative; naturally high growth with strong underlying revenue growth through e-commerce and the ongoing cash-to-card trend. Yet, the company was engaged in regular M&A activity, some of which required capital raising; despite reported cash generation and profitability.
From an investment perspective, these are good reasons to dig a little deeper and question management to find out whether its capital allocation decisions reflected a cohesive, ambitious growth strategy or something altogether different – potentially masking underlying weakness in company fundamentals.
No risk assessment can guarantee total immunity but, for active managers, there is no substitute for diligent fundamental research and frequent engagement with investee companies to fully understand a firm’s long-term strategic vision, provide feedback, and monitor progress towards achieving stated goals. For dedicated ESG investors, this qualitative oversight and scrutiny is that much more important to ensure investee companies are ‘in practice’ consistently working towards meeting their sustainability objectives and targets.
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