Shareholder value, in the classic Friedman sense, is measured by the size of the dividends shareholders receive and the amount by which the stock price rises. Welfare can be measured in different ways, including how society benefits from, or avoids harm due to, the company’s actions.
Friedman was too narrow in his focus when he should have considered more widely applicable cases, they argue. “Friedman finds a set of circumstances in which maximizing your monetary return and your utility is the exact same thing,” Zingales says. (In economics, utility is a measure of how useful something is to a consumer.) Consider the example of corporate charity. Friedman saw no efficiency in a corporation spending money on philanthropy when it could instead distribute the dividends and let shareholders donate as they saw fit. But for many questions of corporate operation, it does make more sense for a company to take action rather than leave it to individual shareholders, Zingales says.
Friedman’s idea holds true if a company’s actions toward a social goal and a shareholder’s actions would have the same result. In some cases, however, the corporation can make a difference in a way that individual shareholders cannot. Shareholders concerned about pollution can donate their corporate dividends to the Sierra Club. But if shareholders are investing in a company that pollutes, the researchers argue that it’s ultimately cheaper for shareholders to encourage management to stop polluting rather than allow it and then separately fund a cleanup, which takes money, time, and perhaps medical efforts. (For more, see “When it makes sense to pollute—and how to change the equation.”) Of course, shareholders enjoy net profits but don’t pay net costs, so they could come out ahead financially if others in society help to pick up the bill for cleanup. But the researchers’ model indicates that empowering shareholders to vote could help move companies toward more social goals.
And as Friedman wrote in 1970, some people might have objectives other than profit. Many consumers today choose to pay more for organic produce because they consider maximizing their own utility to be something other than maximizing profits (or savings). They spend more on sustainably sourced food and value the health or environmental benefits over their own wallets. This private ethical behavior can be extended to corporate actions as well, the researchers write.
“If a consumer is willing to spend $100 to reduce pollution by $120, why would that consumer not want a company he or she holds shares in to do this too?” Hart and Zingales write.
Many financial researchers agree that divesting is not the most effective mechanism for bringing about change, as the number of shares affected is unlikely to be enough to meaningfully affect the market price of a large, public company. Columbia University’s Harrison Hong and Imperial College London’s Marcin Kacperczyk find that there’s a cost to abstaining from “sin” stocks, and other investors are happy to step in. Alcohol, tobacco, and gaming stocks tend to be 15–20 percent cheaper than comparable nonvice stocks, plus they outperform the others by around 2.5 percent per year. And Zingales cautions that investors lose what leverage they have to enact change and hand decision-making to people with whom they disagree. “If all the socially conscious investors sell oil stocks, the only ones buying oil stocks are the Koch brothers, and the companies end up being run in the most environmentally unfriendly way,” he says.
Instead, he and Hart argue that investors should exercise their rights by voting for directors and proxy measures that speak to their own views, and companies should put many more questions of corporate strategy to a shareholder vote. This would require individuals to vote their shares. Although individuals held 30 percent of voting shares, they cast votes for only 29 percent of those shares in 2017, according to ProxyPulse, a publication that tracks shareholder voting trends.
Companies could initially resist this directly democratic idea of greater shareholder control out of fear that they will have to confront difficult issues, the argument goes. But, led by Europe, which has a stronger cultural emphasis on corporate social responsibility, US companies may also become more open to putting more questions to a shareholder vote. The market would serve as a check on extremist impulses, especially if company bylaws were changed to require that some percentage of shares, say 5 percent, support a proposal before it’s circulated to all shareholders, the researchers write.
An infrastructure for the double bottom line
While academics debate the theoretical mechanics of corporate responsibility, some companies and shareholders have been working out a new set of market rules and expectations. For the markets to consider social responsibility a regular part of investing—as ordinary as putting money in growth funds or value funds—there has to be a framework for how these investments are organized, says Chicago Booth’s Jessica S. Jeffers. For example, if executives or asset managers make corporate or investment decisions with social impact in mind, they need more specific profit and impact goals.
The arguments of Friedman, Hart, and Zingales focus on the public markets, but trails are being blazed in private markets—especially in private equity and venture capital, where funds have been set up to invest the money of limited partners who want to put it toward creating positive social or environmental impact.
This activity is possible in part because many investors in these types of funds are already wealthy, says Jeffers, who says the boom in impact investing can be traced in part to “high-net-worth individuals who say, ‘We have a large pool of capital and we want to invest in social enterprise rather than investing purely for profit and then donating to charity.’” They are increasingly joined in impact investing by institutional and retail investors.
Limited partners, too, benefit from having their profit and impact goals more specifically defined. Investment contracts, which establish the rights and responsibilities of the parties in a fund, establish if the fund is a traditional profit-only enterprise or if it has contractual obligations to pursue impact alongside profit.
The contracts for impact-investment funds establish impact expectations, obligations, and enforcement rights through terms that, for example, specify intended geographic impact or prohibit certain types of harm-producing investments such as nonrenewable energy. These same contracts define the priorities and responsibilities of the limited and general partners—and consequently reflect the balance these funds seek to strike between profit and impact goals.
The contracts establish direct and indirect means for investors to monitor and enforce the dual pursuits. Putting impact incentives and expectations in writing both encourages investment and ensures that agents—the fund manager at the fund level and the portfolio company executives—use their discretion consistent with those expectations and without fear of litigation or reputational harm.
“One immediate lesson from these contracts is that impact investing is not greenwashing,” writes Jeffers, along with University of Pennsylvania’s Christopher Geczy and David K. Musto and Georgia State University College of Law’s Anne M. Tucker. The researchers—having examined 202 documents belonging to 54 private-equity and VC funds and 92 of their portfolio companies—find that contract language highlights how impact-investment transactions differ from traditional investments in subtle but important ways. Terms in the contracts, at the fund level and the portfolio-company level, differ when the fund is specifically focused on making impact investments.
The study points to several differences between the contracts of traditional, profit-only funds and impact funds, including ones seeking market rates of return and those seeking below-market rates. For example, impact funds appear to place more emphasis on participation, via advisory committees at the fund level and board seats at the portfolio-company level. This could reflect an added desire for advice—or monitoring—in a space where opportunities to achieve both profit and impact goals overlap and require manager discretion to navigate and prioritize.