May 7, 2020

What is ESG, really? Is it good for the world? How does EU regulation change things? Is ESG an ethical construct? This is the conversation that first challenge complacent notions of ESG and set the ball rolling on a more sophisticated debate about the role and duty of corporates and investors in non-financial considerations. Recorded in May 2020. Cyril Demaria is a leading thinker on investment practices. He is currently Head of Private Markets Strategy at Julius Bär, and he lectures at top academic institutions, including EDHEC where he is an Affiliate Professor. He is author of the best-selling “Introduction to Private Equity” (Wiley, 3rd ed.) and “Asset Allocation and Private Markets” (Wiley).

Ross Butler: We’re going to talk about ESG, environmental, social and governance – insert noun – issues.

It’s very difficult to find any real critical or analytical thinking on the subject on the Internet. I’m really not sure there is any. And yet it’s huge. I think I read one article that said it counts for 30 trillion in assets. I don’t know how that compares to the private equity industry, but it’s like a multiple of that, I guess.

Cyril Demaria: Yeah, the industry is a bit creative also in counting.

I think there are shades of ESG, let’s call it like this. And so it’s very easy, as soon as you start to apply some form of filter, then to say, oh, it’s ESG. So it falls into the bucket. And then as you aggregate assets, it looks like a force you need to count with and to deal with. The reality is probably a little bit more complex than that.

And also I think that’s why the EU decided to express itself on that in terms of legislation, it’s to avoid greenwashing, because as soon as you start to put a label somewhere, then it just counts.

Ross Butler: So the EU’s proposed regulation has a definition of ESG.

Cyril Demaria: I don’t think that they agree on what it is and that’s actually looping back to your point about the fact that it’s a bit challenging to understand and to have an analytical or critical perspective on that, because nobody really has the same definition.

It’s the same with Sharia compliant products, which, by the way, share 90% of the criteria. With ESG, it depends really which colour you talk to and how you structure your product, and then it might be compliant with one scholar and not with another one saying you have to be more rigorous, and then it’s not compliant. So the EU had a very different approach. They said that if you make a claim, you have to substantiate it. And it’s not just slapping a label, you really have to demonstrate that it does indeed do something. And the idea is really to avoid the greenwashing.

And the industry complained because it’s still fairly theoretical and it’s not that easy to interpret if you’re a product provider.

Ross Butler: So I guess it begs the question, what’s the point of a label that no one can agree on what the label actually says? It’s oversimplifying something that it appears cannot be simplified in a way that allows it to remain meaningful.

Cyril Demaria: It’s an excellent point.

In the Bible they talk about the original sin, and here there might be one, in the sense that ESG has been designed as a series of private initiatives, but without any somehow coordination with the public authorities.

If you don’t agree on the basics, then it’s very difficult to act.

In that sense. You might take an action and I might take one under, let’s say, the goodwill of doing something good. But actually our two actions might cancel each other out because our perspectives are fairly different. So in the first book I published, which was back in 2003, it’s only available in French, but it’s not great literature. Anyway, it was the first attempt to have a look at what it is. And actually, for example, do you have the same approach in private equity and in ESG? Because the durations of investment are supposed to be fairly long. So I thought it would be interesting to learn what ESG means, because it started a little bit before actually modern private equity as we know it started in early seventy s, and private equity as we know it really had its boost in the 80s, essentially.

Ross Butler: It wasn’t called ESG back then, though, was it.

Cyril Demaria: Yeah, it was.

Ross Butler: Was it?

Cyril Demaria: Actually not really. It was sustainable development.

So ESG somehow is inheriting the efforts from sustainability. And sustainability was already environmental, social, but ethical, not governance. Governance replaced it ultimately. So in the book I tried to say, okay, if I can learn something from ESG, it might be helpful to understand what happens in private equity. And it turned out to be a book only on sustainable development because it was so complicated to understand and the definitions are so different.

So you have people on one hand, for example, who say, I don’t want to invest in these sectors. And then on the other hand, at the other extreme, you have people who say, all sector is good as long as I take the best performers according to certain criteria or certain scoring systems. And then later you had different approaches which came up with, for example, what they call triple bottom line. So you should be efficient financially, but you should be efficient also along other criteria. And then the three of them give you this triple bottom line approach. But all of that ultimately doesn’t answer a question what is actually ESG? How do you define a label? How do you make sure that we don’t get sold something which looks like it, which tastes like it, but isn’t the real thing, for example. And that’s a little bit the concern I have because the momentum that you’ve been referring to earlier, this 30 billion, obviously some of that comes from an appetite, a preoccupation, maybe some form of will to act. And I think this shouldn’t be criticized. I mean, if we act for the common good, then it should be encouraged. But I think there is a saying which says that hell is paved out of good intentions. Right?

My biggest worry is that we would do things with good conscience and really goodwill, but it might turn out to be counterproductive or actually a waste of resources, because that’s the whole thing. If I spend one pound in doing something, is this pound really well invested to the best capacity of the ESG purpose? And it’s never demonstrated the hidden agenda and that’s why the EU stepped in.

Is that because people want to do well? Then of course product providers jumped in and say, oh, this is the product you should invest in. But the question is, does it do what it pretends to do? If I invest in the best, let’s say, performers in a sector, but the sector overall is not doing so great in terms of ESG. I will just happen to invest with the less, worse one and it’s not necessarily what we want. So I think that’s the main concern and that’s the main dynamic, and that’s why the analytical part that you were referring to is so challenging.

Ross Butler: Do you think that there is or is supposed to be a link between ethics and ESG?

Cyril Demaria: Well, actually, yes, and I think that’s another part which is a little bit disappointing. When you look at something for quite some time, sometimes you get a little bit frustrated, sometimes you get surprised, and sometimes you get a little bit disappointed too.

Ethics was, in a way, if you think in terms of intellectual levels of compliance, then social and environmental, you can set up some sort of criteria. You can get metrics like number of employment created, suffering at work, number of days where you’re off work because of sickness. This you can measure, you can improve the same for environmental criteria, and we can discuss the validity or not. And actually, I wouldn’t go into that level of details because I’m not really a consultant specialized in that. But the ethics part, and that’s what I like in the original sustainability proposition, is that it forces you always to step back from this empirical, practical, operational steps and say, hold on, does it still make sense?

Of course, ethics is philosophical, and a lot of people in business say philosophy is great if I loved it when I was in high school, university. But now we are here to get things done and we cannot debate forever.

But the fact that ethics was replaced by governance, which is a much more actionable part in governance. I can also say how many union people sit at the board, how many employees can actually contribute, how many stakeholders can contribute to the governance of the company, including the extended perimeter, like suppliers, clients, et cetera. That’s all fine and great, but the great thing about ethics, it had this infinite feedback loop telling you, it’s like your mirror.

How do I look? Can I do something better? This was great. And this disappeared. It was an equivalent of a little bit the preamble of a constitution. I know that in the UK it’s a bit different, but on the continent we usually have constitutions, which really tells you what are the fundamental rights. But the first part is the preamble, and it’s a little bit philosophical, this ethical part, it’s like you have to look at the rest, including the laws and the regulations, all in this perspective of the initial principles which were guiding us. And the ethics were this part. And I think that was great for business, but business is not necessarily comfortable with that. That’s why they swept it away and they replaced it by governance.

Ross Butler: Yeah, you’re right to say we do things differently in the UK.

We don’t have a written constitution. And I think it’s for the same reason that your preamble is so important. It’s that when you’re dealing with something that’s very complex, it needs to be applied with judgment, not hard and fast rules. And so we’ve gone a step further and not written anything down. You have a preamble that can be interpreted in different ways. And I think allowing that flexibility when you’re dealing with very complex things. And ethical judgments are always complex because they always inhabit shades of grey. And I think the fundamental problem that I have with ESG is that it takes away that ethical dimension, because in its aim to ensure that everything can be measured, it makes everything black and white and good and bad.

And it means that fundamentally, then whatever is good for profits over the long term, let’s say, must be good. It must be ipso facto sustainable. And in that sense, I find it quite an extremist ideology. I mean, it goes way further than Milton Friedman ever did in terms of putting profits first. And yet it cloaks itself in virtue words. So I find it very challenging to analyze ESG.

Cyril Demaria: It’s a very important point, what you mentioned.

It’s not really spelled out like that very often.

It’s like having a critical perspective on ESG.

First of all, it’s like criticizing something or even just questioning something which is supposed to be good and people don’t like it. So it’s very surprising. Every time you come, it’s like, oh, yeah, but global warming is there. We have to do something about it.

Yeah. Okay.

Is ESG, for example, as we do it now, the relevant one? We are going to be judged by the future generations. That’s the original idea of sustainability and the definition of what is sustainable investment. We are going to be judged. And yes, our good intentions are one thing, but then you have actions. And the fact that we don’t criticize it is one problem. But then it loops back even further to what you were describing, which is, even though I would be able to criticize ESG, I would then start to criticize a whole system. And I think that’s the most difficult challenge now, because if you look at ESG, it’s inspired from other initiatives which are coming essentially from the US, which were about promoting minorities, which were about setting criteria to measure up a target versus the statue score. And unfortunately, it didn’t seem to work. In the US, minorities are still struggling. There are a few visible ones. There are some more efforts about the promotion of some gender minorities, for example, which actually happen to be the majority. If we talk about the female population and it’s all good and, well, you cannot be against promoting people who deserve it, but there are few things which are extremely challenging, and you cannot actually criticize it in the open, which is, is it the right way? The way we do it is quotas. A good thing is an ESG box to tick, the good way to approach, and you have a whole industry which is built on that, consultants, auditors, et cetera. People love what they can measure, but it doesn’t mean that it’s the right way to do it.

That’s paralyzing our thinking. And the thing is that it costs resources. We’re so careful about resources today, right? We say, oh, we should save this, and the money is there, but we should use for that purpose. One example is the bailout of the airlines, and it’s a little bit beyond my remit because I’m only in private markets. But now we start to have comments about, oh, should we have bailed out airline companies without setting up new targets which are more stringent?

It’s like we are running the machine reverse. First of all, what do we want to achieve then? Is the airline the best way to achieve it? And then what are the elements of implementation that you would like to think about before saying, oh, you should reduce your carbon emissions by x by this date, and then we give you the money? What if they can’t?

What if fuel that they burn cannot be burned safely, made out of something else? Or what if something else is actually not efficient? There is a big debate, for example, about the way that we’re moving from a fossil fuel to electric cars. And if you take the full account of how much does it cost in terms of resources and pollution to extract the rare earth and all of that, it might actually not be effective. And we’re just jumping into it. And the cruddle to a cruddle approach is actually to take this into account and say, well, there might be some lobbying behind. If I’m an electricity producer, I’m very happy, but suddenly everybody jumps on a scooter or buys an electric car. But the fact is that it might not be beneficial to the wider community, it might be beneficial to the western societies, but it might not be too beneficial to the less developed societies, which are extracting that and cope with the consequences which usually we are not equipped for.

If I look at open sky mines, that’s not necessarily an environmental success, is it? And we don’t really think about that, but collectively, it has a consequence.

Once again, it starts to be very theoretical, and people hate that. But it doesn’t mean that we shouldn’t think about it.

Ross Butler: Yeah, I think you’re completely right. So there are two things for me that come out of what you just said. One is the decision making authority around these, let’s call them ethical judgments, and the other is the competency around it. So in terms of the decision making authority, for me, ESG subverts the correct hierarchy that there should be in a free society. In a free society, democracy, we all vote, and we vote for politicians who create rules, whereas ESG puts corporate executives, who are, for the most part, merely agents, in the driving seat, and that allows them to make these decisions. So there’s one point which is it subverts the decision making authority. But then the other point is that these individuals, who are maybe very good at managing airlines, are not necessarily competent to make judgments about, let’s say, the environment.

Cyril Demaria: Exactly. And once again, straight. Really, that’s very important point.

There are two elements in what you say. The first one is the role of the citizen, who happens also to be a consumer. But something else. The fact that sustainability was captured basically by the private sector and somehow put in the background the public authorities means that we don’t have any control on, and the agenda is not set by us anymore. And we cannot even voice anything we could demonstrate, but it’s fuzzy and it’s short lived. And, Daniel, there is this never ending series of demonstrations, but doesn’t mean that we can voice a solution or we can set a framework. The other thing is that, and I agree with you, the fact that you are a corporate executive may be a brilliant one, doesn’t make you a very effective policymaker. And it goes very far. If we look at the airlines, and I don’t want to pick on them, I have no special judgment on it. It’s just an illustration, right? But one of the things we could have worked on is the carbon market. The carbon market has been a failure because it was badly designed. But if there was a price for the ton of carbon, which would actually reflect something, then we could start to think in a cradle to cradle approach and say, look, I’m an aligner. I need to burn high octane fuel so that I can bring someone from a to b in a safe environment, in an economical and way as well. Because plane tickets are supposed to be expensive, they might actually be more expensive in the future. And I cannot make it without emitting carbon. Okay? Which, by the way, it’s around 6% worldwide. So means that 94% come from somewhere else. But maybe I can engineer something upwards or downwards, not necessarily planting trees, which is what, by the way, you can do when you pay an extra contribution on your ticket to offset. It can be carbon capture, it can be a lot of other things. But if you don’t have a viable carbon market, which is, by the way, an efficient market mechanism, then of course you don’t price your ton of carbon correctly. And this is the part where this dynamic gets very strange, because public authorities step back so much from the debate. As far as I could see, unless you’re on the green versus non green debate, but it’s a different purely political phenomenon, then the discrepancy between the public authorities getting backwards and stepping back and the private one stepping forward and basically capturing the agenda and setting it up is actually very disturbing because you don’t get this balance of power, you don’t get this didactic approach, which is sometimes dysfunctional. You have all this lobbying, et cetera, but it’s part of a democratic process. And maybe I’m not comfortable, and to be honest, I’m not really comfortable about shifting from fossil fuel to purely electric, because I know that there are alternative to electric, which might be better, but for some reason there was a choice which was made somewhere where I did not have even a voice. Maybe it’s just one person to say, look, I’m not comfortable with this shift. Maybe I want that we go from fossil to purely hydrogen vehicles and not electric, but that’s a different strategy, that’s a different innovation, et cetera. Maybe nuclear power is not that bad if we go to the next generation, but if we don’t invest in it, then we will never know. So all these choices are very disturbing. And as you said, you can be a brilliant executive, but not a good policymaker. And the reason we know that is that sometimes some people make the jump from business to politics, and then we discover it doesn’t necessarily work.

Ross Butler: Yeah, well, I’ve always thought that the reason that the private sector is so much more efficient than the public sector is not because it has brilliant people in, and the private sector attracts brilliant people, but that they have this massive advantage, that they have a very simple organizing motive, the profit motive, and that falls away as soon as you go into the public sector. And therefore the environment is far more complex and you’re dealing with far more complex issues. So I’d agree with that. And I think effectively the scenario that you describe happens because people get frustrated that progress doesn’t happen fast. Enough on these important issues. And free countries of the world can’t seem to corral themselves and get their acts together in order to address them. And so I think, perhaps understandably, the private sector or the corporate world decides to take things into their own hands. But I think the outcome of that is actually ultimately poor because there are no shortcuts to solving complex issues. You just either kick the ball down the road or you make things worse because of these unintended consequences. And I think the ESG industry is a formalization of that shortcutting approach.

Cyril Demaria: I agree.

It’s very interesting because one of the things that people would tell you when they talk about, let’s call them ESG topics, is the very long term nature of these issues. There is these projections. If by then we have increased the number of degrees on average, by that the consequences will be this and that. What we know is that the corporate horizon is actually fairly short. So if your target is beyond, let’s say, six to twelve months, and we know that anywhere in any corporation, unless you’re in very large utilities or very, very specific industries, which think over the next 20 to 30 years, like the nuclear industry, but most of the corporations, like banks, even car manufacturers, their time horizon tend to be fairly, fairly short compared to these very long term targets. So there is a discrepancy between an executive which has a very specific target over a specific time horizon, and the very long term issue that you want to address. The fact is that there is a fair amount of executives which will change jobs. So their targets are going to be reevaluated changes by the next person. And usually whatever the previous one did is usually reviewed and then changed again. So all these constant changes make it very difficult to match this long term target. You can have a very long term plan, but if your successor doesn’t stick to it, it was just a good intention. So the public authorities have been suffering from two ills. The first one is that the complexity you refer to is very difficult to absorb by the general public because they are not necessarily as involved in the day to day activity of administration and politics. And the more complex the issue is, the more helpless they feel and the more likely they’re going to vote according to their, let’s say, guts more than their knowledge, because accumulating knowledge is very challenging and resource consuming for them. The second thing is that the long term target, even on the political side, requires a massive effort, because most of the, let’s say, members of parliament, are elected at least for five to seven years maximum in our modern democracies, I would call it like this, and then projecting for so long in the future is extremely challenging for them. So in that respect, it’s a bit like that. The government suffered from this double whammy of the lack of alignment between their time horizon is very long term targets, because you have to show voters that what you did is efficient, and then that they renew your mandate. And if it’s 25, 30 years down the line, it’s very challenging to align that. And the second part is the fact that, as I said, it’s very challenging for them to make things so complicated, understandable, so that actually the citizen can act and vote and commit. And the commitment of the citizen is crucial, actually. But what I’ve been looking at, for example, in the private market side, is that it’s even worse. At least on the public side, we try to somehow get the approval, because by construction, we get it from the citizens regularly. You have to ask them, right? And maybe their answers are flowed, that’s fine, that’s the nature of democracy, but at least they had a chance. On the private sector, we usually don’t get asked anything. I remember a long time ago, I even wrote emails to companies saying, can you do this, can you do that? And they never even replied. But it’s even worse today. It’s like you get bullied, basically, with a lot of innovation. For example, it’s like you see that it’s been designed to quarrel you.

You’re maybe a very nice sheep or a very nice cow, and for them, you’re just this. And then we want you to go in this direction, and then we will do everything to coral you there.

Ross Butler: Sorry, Cyril, are you talking about the relationship between a private market fund manager and their investee company?

Cyril Demaria: No, it’s more like, for example, the nature of innovation or the nature of business as it’s designed today.

Their perception of who you are as a client is very normative, and for that, you cannot even contribute on the ESG level.

The parallel I’m trying to make, maybe, which is not that clear, is that in a democracy, when you get as a citizen to choose, you can also align your behavior according to your principle and your standards and your voting pattern. Right? So I recycle, for example, because maybe I believe that recycling is a good thing, and maybe I vote accordingly. If I’m a private client of a corporation, the only thing which I’m offered is, do you want to buy or not? End of the story. And then there is no behavior, there is no principle.

It’s challenging. There is not even a way that you can contribute saying, for example, instead of doing this, can you do that? Instead of sending me pet bottles, can you do glass again?

Maybe I’m ready to pay the price.

It’s very challenging to see that. And ESG all. It’s a very top down approach. ESG. There is no grassroots there. Of course, you have attempts, like with these cooperatives, or back to the roots and farmers market. That’s all great, and I’m not criticizing that, but I think it lacks the scale, dimension and systematism that would be required to make a difference. On the private side, there is no feedback loop. That’s the idea of the cradle to cradle, is that if you want to have a top down approach, fine. Maybe that’s the way business is organized, as you said earlier, and maybe that’s the best way we can do so far. But then this top down approach has to have a cradle to cradle approach. It’s like a full circle. Where do I start? Where do I end? Where is the feedback loop? And then where do we start all over again? And so because of that, we are missing that. It’s very challenging.

Ross Butler: Yeah, but it’s not a top down approach. It’s a corporate top down approach, because the top down approach is the authorities.

Cyril Demaria: Correct.

Ross Butler: And then, so what you really want is to cut out the middleman. You do want the consumer activism and the customer awareness, but that’s slow, as you’ve correctly described. It’s slow and it’s imprecise and you have to stop buying goods. But then it takes ages for people to interpret, why have you stopped buying them? But it does happen eventually. Like, as you mentioned, farmers markets, like the whole organic food movement. As far as I’m concerned, that was a very bottom up. That’s what people wanted, and it came through very slowly. But you’re right, it’s kind of frustrating.

But then you’ve got politicians who are there to, and who are generally very good at interpreting what people want. That’s what they do. But it’s the people in the middle, the unelected agents of corporate shareholders, taking unilateral decisions, which seems to be the most efficient way of getting this stuff done.

That’s the danger, I think. And of course, you’re in Switzerland, where I don’t know a huge amount about swiss politics, but I understand that you have a lot of referendum on things, depending on which canton you’re in. So you know how difficult it is to get your head around complex policy questions. Presumably because you have to do it all the time, is that right?

Cyril Demaria: All the time? Maybe not, but fairly frequently. I would say on average, every two to three months, we have to formulate an opinion on some questions which we can ask ourselves or which are asked to us, which is a good way. I don’t want to idealize any system, but one of the great thing about this approach is that it helps cultivate this knowledge at the citizen level. So you’re informed and you have to think. And sometimes some of the questions are actually not that easy and straightforward.

But the great thing about it is that at least you have had the chance to talk and to think about it, and you can discuss with your friends, for example. That’s what I do. And usually the different parties also have a very clear position that is explained, so then you can start to think about it. The other thing is that it forces you, but also the whole system to think over the long term. And that’s one of the very strong benefit of this approach.

Some time ago, we voted about setting up a minimum wage, for example, in Switzerland, and it was rejected. And that was a very strange decision, if you think about it, because everybody would vote and would implicitly benefit from it. But the reason why it was rejected is because a lot of voters realized that might actually be including some rigidity in the economy, and that’s not the best way to do it. It’s a very strong decision.

It might hurt even yourself if one day you have to work in this kind of job where unfortunately, you have to fall back onto this minimal wage. And so the whole dynamic is really to say, okay, do I think responsibly, is it viable for me, but also for everybody going forward over the long term?

It has also some drawbacks. For example, decision taking might be longer.

The reason why, for example, we suspended somehow the parliament is because the government could take decisions which normally would have been debated for a very long time. So we had this state of unusual things where the government could decide without asking the parliament. And the other thing is that sometimes when you have to have a very strong stance, it gets a little bit diluted because you need to find compromise. The swiss system is based on the idea that everybody has to get on board.

So not only it introduces delays, but also it can dilute sometimes some decisions which have to be fairly bold. But the voting thing that you were referring to is a way to avoid dilution. So you can ask people, vote yes or no on this because we don’t want to go into this lensy and diluting process.

So it’s one approach and that’s why also, I would say sometimes from this perspective, you see that there is a kind of implicit bullying aspect in DSG. Someone decided for you and they decide without asking you and it creates a friction, if I can say, like this.

Ross Butler: Yeah, that’s exactly right. It may be difficult and time consuming to have to talk these topics over with your friends all the time, but if nothing else, it gives the entire country an understanding that there is no right answer to many of these problems and that they’re very complex. And so it will make people wary when people come up with facile slogans and labels. And that’s precisely what seems to be happening in one of the most sophisticated industries in the world.

Cyril Demaria: Yeah, it’s exactly true. It’s interesting what you just said because it also highlights the fact that as you go through this discussion process, there is some sort of, I mean, that’s a bit of a grandiose wording, but it’s like nation building in a way, because it forces you to discuss. Of course you can read the document on your own vote and then that’s it. But most of the time there are some issues you’re not very clear about. And then you start to talk around and then you can exchange opinions. It’s fairly diplomatic. We’re in Switzerland.

But at least sometimes I change my mind, actually, because I discussed with someone. I thought, actually, yeah, it’s not what I thought, which was the correct approach, so I voted differently for that. It creates some sort of very strong sense that collectively we took a decision. Maybe it’s not the best one. Maybe retrospectively we should have done things differently. But at that time, I remember that I took this decision and actually I discussed it with a few people, and that’s how we built our decision collectively. And so I think that’s important because there is another thing which we are experiencing today. It’s this historical revisionism.

Some of the decisions which were taken 1015, 2100 years, 200 years ago tend to be judged according to the common current standards, and then you get blamed for that. Of course, you could say people were living 200 years ago, they don’t care anymore. And maybe in a generation’s time we won’t care either because we will be out of the loop.

But it’s a bit disturbing because it forces us to take decisions which are maybe not the relevant ones, since we are so sure that our current values are the correct one, because we’re judging people harshly because of that. It doesn’t help us to be self critical or to think maybe we don’t know much or enough, and what we’re doing today, it might not be the best option. And so it doesn’t help us to progress this lack of self criticism or distance.

And that’s what I wanted to emphasize earlier. I was implicitly referring, for example, to the venture industry. Often you hear entrepreneurs coming to you and say, oh, I want to change this, and because it’s going to be better. But that’s an implicit conclusion that what you think today is the best way. But maybe what was designed over the course of decades is the result of trial and error, which were not disclosed.

And then the optimum we get today is unsatisfactory. But maybe it has its reasons to be there. And then you’re going to kick into it, destroy everything and replace by your solution. But who tells us that it’s effectively the better one? And it’s very disturbing, because now it’s very much entrenched, this idea that break things and get away with the rules and do your thing and then think about the consequences later. Well, the consequences might be that drivers are forced to drive unprotected and might be infected by the virus, for example. And it’s a bit late to think about it now. And maybe they’re going to starve if they don’t drive, which interestingly enough, is a problem coming from the less developed countries, but now is reemerging in developed countries. So it used to be at a time, if you were a taxi driver, you were employed, and then if you didn’t work, then you would be elected to be on an employment program, which is not great, but it’s better than starving. And today we’re coming back to the almost victorian time where basically it’s either you work or you die because you’re hungry.

So it’s either you take the risk to be contaminated or to be hungry. If you’re in a rig show in India, as we saw on tv, I understand that because unfortunately, we’re still in this progressive state of reaching a more developed stage. But as modern societies, I’m not sure that it’s something we should accept. I’m not sure that it’s ESG compliant, for example.

Ross Butler: Yeah, we don’t always move forward when we introduce innovations in English. There’s a phrase called Chesterton’s gates. It’s after GK Chesterton. It’s the idea that if you come across a gate and you don’t know what it’s for, don’t automatically remove it. Just because you don’t know what it’s for, it doesn’t mean it doesn’t have a purpose. And I don’t know if you’re also familiar with Herbert Simon’s idea of satisfying, which is that for certain problems of sufficient complexity, there is no optimal solution. And therefore, a solution that is good enough may well be the best possible solution there is, and attempts to impose efficiency on that system and find efficiencies can backfire. So your example of the taxi driver being a perfect one, you may not realize why the system seems a bit inefficient, but there may well be good reasons for it that have been time proven.

Cyril Demaria: Yeah, just to complement that. Because usually when I take this example, people get very emotional. And I’m not here to defend any lobby or industry. The point I’m just trying to make is that if you think in terms of system, even though having lived in Paris, I know exactly what does it mean to be waiting forever. A taxi which doesn’t arrive, or lack of taxis, or the fact that they’re extremely rude, et cetera. So I understand, let’s say, the very visceral reaction, because somehow, sometimes I got the same. But if you think in terms of system, then you realize that actually, that’s one of the few jobs that you can do if you’re not, let’s say, particularly intellectual, where you can have a decent living, et cetera. So it has consequences. I’m not saying we should encourage this very locked system with very strong rigidities, et cetera. But instead of destroying it altogether, maybe the first step would have been to see, is there a way to improve it incrementally. And that’s actually a very interesting thing, because what you referred to earlier is a very european way of thinking. In a way, we’re very self loathing, saying, oh, we don’t get these disruptions right? We don’t get the next Google and all of that. Okay, maybe. But who said that incremental innovation is a bad thing? If it creates resilience, for example, in a society, if it creates some sort of these positive externalities that we’re all after with ESG, what if we produce them as a society already because they are so difficult to measure? I understand that it’s frustrating. But instead of expansively generating them through an ESG process, maybe we generate some which are worth preserving just by tinkering with the system instead of destroying it. When you have this creative destruction that Schumpeter was writing about, which is a very interesting concept, et cetera. It doesn’t necessarily mean that you have to wipe off everything and then rebuild. Right. It’s more like you have a creative destruction when you go during a marathon in your muscles. They’re self destroying and rebuilding a bit, but they don’t wipe out your legs and then replace them with bionic ones. Right. You’re just improving over time. Right. I think the image is not necessarily that far with our strengths as Europeans, but of course it’s less visible. You don’t dream about someone who improved a way to make a windshield on a car. You dream about Google or whatever. Yes, okay. But there is still innovation, and the way it’s done might be more absorbable. I think ESG also highlighted the fact that there is a discrepancy between the speed on the economic system and maybe somehow within there with technical progress kind of acceleration. Even though it might be overstated, there is some form and the fact that society has its own way to evolve. At the end of the day, we’re humans. We didn’t change radically physically, but also intellectually. There is accumulated knowledge, but it still takes time for the social practices to absorb some of the innovation and to absorb some of the progress from the economy. And this discrepancy between these two areas, I think, is underestimated. And the fact that here you want to have ESG and here you don’t make so much faster progress means that you take the risk that what is done here doesn’t get absorbed properly there, or correctly, or it might even, as I said, cancel each other out.

This, for example, is something we should think about collectively. It’s very difficult to put on a table and say, let’s invite experts and think about the decent equation between technical progress and social progress.

It’s not that easy. I understand that, but the fact that we don’t even discuss it is actually a problem.

Or if it’s discussed, it might be in the confines of very academic circles and it doesn’t seem to get out anymore, or we don’t get fed with it. I’m just a normal, average observer of the market, but I don’t get this inflow anymore, or if I ever got it, or there is no transmission. And it’s very, very surprising.

Society produces things in terms of norms, values and evolution. But how does it overflow on the corporate world? At the moment, ESG is about overflowing in society the other way around. This is less visible unless you have these grassroots phenomenons that you were referring to, which show that there is a will.

But sometimes there is also, of course, a strong political sense into it. And I think that’s where corporations are uneasy. They don’t want to choose side or go green, go left, go right, et cetera. And that’s probably where they’re a little bit wary about adopting this kind of social innovations because they don’t know how politically marketed they will be or how they will be perceived. This I understand, but there still should be a dialogue.

It shouldn’t happen in the World economic forum only. It should be a little bit different.

Ross Butler: Yeah, that’s so interesting. I think on the creative destruction point, I think it’s very polarized.

I think on the one hand you’ve got, as you kind of described, the Silicon Valley style all in approach, and on the other you have kind of the leftist socialist parties that want to protect the status quo at all costs.

And these two are kind of ideologies and you very rarely allow them to meet through. And it’s a complex issue and it’s hard to say who’s right. So you need to discuss it. And it’s context specific.

Cyril Demaria: Exactly.

I think you put your finger in a much more synthetic way than me on something which is also something I observe. I’ve been 20 years now in the venture sector as an investor, as an observer, as a writer. I still do venture investments. And what I observed is two things. The first one is that the industry shifted massively from a function of control on an investment to something that they call entrepreneur friendly.

It’s a little bit like parenting, right? It used to be that parenting was about discipline rules, and now it’s like, oh, we should move them this direction because otherwise their psychological development is going to be hampered. We shouldn’t set limits, et cetera. Maybe that’s a good thing. Maybe that’s not a good thing. So there is a bit of that in the industry. And the other one is… It’s like you cannot criticize the venture industry, but first and foremost the innovation in the venture industry and the fact that they’re financing the startups, because otherwise you’re against progress, you’re against everything which is going to get better. Basically, you’re someone who is not able to grasp that. And questioning it is being part out of the club. And we saw the extreme to which it went. Some of the worst outcome in terms of governance. Since we were discussing that and it’s been replacing ethics have been appearing in the full light. It’s Terranos, it’s Uber, it’s wework.

Let’s be honest, these are disasters.

The governance issues there, I mean, Therranos, it’s even worse. We put the help of people in danger because of this messianism.

This mean you could even say that they took a playbook from the communist dictatorships. And then they applied with this cult of the leader, and it’s extremely detrimental. And ventures should be in the governance business. Private equity is supposed to be the governance superstar. That’s how they outperform. That’s why they managed to do all of that. But in these three cases, it’s actually terrifyingly worrying to see how bad the investors have been and how unprepared, how weak.

Ultimately, there were reports which were extremely worrying of the corporate culture in what is now a listed company. And I don’t see that they have changed dramatically.

It’s extremely worrying. And the venture industry should be one of the best. I mean, when you have to control 20 people, that’s the moment where you build a corporate culture. That’s where you set in stone some principles. That’s where the good recruitments are done for the long term. And we don’t seem to see that in some of what are the largest corporations which have been built by the industry recently. But it goes very far. You still have a dual shareholdership in some of these companies which have been listed. And so it shows that this cult of leadership still exists even after they have been public. So it’s not that the venture industry itself is a little bit, let’s say, is less efficient at what it used to be. It’s that the lack of initial power remains, and this very strong leadership remains in place for the very, very long term. And I think that’s highly producible. Prejudicial.

Ross Butler: Prejudicial, yeah. That’s a difficult one.

Yeah, that’s interesting. It sounds to me like it’s a moral failing, actually, because my sense is that the private equity venture capital governance model is a robust one and can work very well. And from what you describe, it sounds like a moral failing to put in the correct cultural correct culture leads to a diluting of the governance mechanism, whereby you end up with governance mechanisms that aren’t robust. And I think that is really telling when it comes to ESG, because it means that governance is actually a second order issue, not a first order issue.

It’s ethics come first, and a sense of what’s right and what’s right is context specific. And so it’s not a first principles analysis, a first principles analysis is the one that you just gave, which is, what are we actually trying to achieve here, and how do we achieve it?

Cyril Demaria: Yeah, it’s a multidimensional question that you just asked now, and I think that’s probably the most central one in the industry.

What we know is that we have very powerful governance instruments in buyout in venture. All these instruments are very well known.

They are very powerful. It’s like having drones. Right. You can do a lot of things with drones today. It’s very impressive. You can deliver to people, but you can also shoot them from 100 km with very high precision. Right. So we have these instruments which are extremely powerful.

And then the question is, what do you want to achieve with it?

Are you sure that you have all the context and the background to use it to the best possible action? Right. And what I observe, for example, is that the due diligence time in venture has been compressed dramatically. When I started to work 20 years ago, I had six to nine to twelve months to do a due diligence. Today I have at best three months, but often it’s a question of weeks. So I have to use these very powerful governance instruments as an investor. But my information background is actually very weak. And so it tells us two things. The first thing is that if I have to think about ESG within this compressed time, it’s going to be very challenging, almost an afterthought thought. Sorry.

The second thing is that because of the lack of information, I cannot check everything and adjust the instruments to the best use possible.

Let’s be more concrete, because now I sense that I’ve been a bit too theoretical.

If I get six to nine months to speak with an entrepreneur, but also the key collaborators in a company, I will get a sense of what’s going on there, how do they work, what are the behaviors?

Maybe then I will set my governance framework saying, look, they might need some help here. Maybe I will ultimately have to change that person, because I don’t feel that he or she is able to step up to this kind of issue. Or maybe we should have an initiative which is going to control for a specific need from the management that I will have identified. If I’m in a three months compressed time, I will just check. Do they have this? Yes. Do they have this? No. Then, okay, they don’t have it. I will just put this standard close, because I know that this is how it works, and that’s a very bad way to control your risk, but also bad way to impulse positive change. And so the ESG would require, actually extra information, which we know is very expensive to produce. But it will also probably have this needed alignment of interest between the investors. My perception of ESG as a VC investor might not be the same than the next one. And then the question is, how do you add this extra level of governance on top of something which is already complicated to negotiate? The instruments are powerful, but they are complicated to negotiate. And to set an equilibrium between everybody around the table is complicated. The other thing that we have to remember is that ESG might be a concern from investors, but less from the founders. I mean, there is this philosophy of getting rich quick and making it and all of that, faking it, until you make it, as they say, often. And then you wonder, where does ESG sit there? I mean, what’s the sense of faking ESG?

It’s a bit weird to set this in the context.

Having said that, I don’t want to sound too negative. There is, of course, other investments where they do that. There was this B corporation framework, where your social targets, for example, or environmental targets would be part of the bylaws of your corporation. And then you have to live up to these expectations. There were examples like Zappos, which this very innovative holocratic management. I don’t know if it works out or not. So there are some attempts. I’m not saying that everybody is bad, and we should always criticize the industry, but what I’m trying to highlight is that we can be creative, but we have also to learn from what works well and what doesn’t. And for that, we need a more systematic approach, probably a more generalized best practice approach.

The most challenging part, that’s why the venture corner is so interesting, is that since the corporations are so small, since the resources are so limited, and since the entrepreneurs tend to be new, there are very few repeat entrepreneurs. By the way, when I started 20 years ago, the figure of the repeat entrepreneur would be around now. It became that I’m a good entrepreneur, I make it, I become an angel or a venture investor. So this idea that you get repeat entrepreneurs is a little bit now in the background, it’s less relevant. So it means that we deal with a lot of newcomers all the time. But since we have this compressed time, we cannot get them up to speed. You would be surprised to see how many entrepreneurs don’t have a proper business plan. The best you can get is a vague PowerPoint presentation.

So it’s also reflective of the lack of background, I would say, the lack of diffusion of the best practices.

That’s not reassuring. When you want to implement an ESG environment.

Ross Butler: You say a more systematic approach to ESG. My sense is that you’re really talking about governance.

So I once worked with a growth capital investor and it was focused on sustainable technologies. And my sense was that both the manager and their investee companies were very frustrated with the highly systematic approach that institutional investors take to ESG because they were all scoring averagely to pretty low when they thought that they should be. In terms of the big aspirations of ESG, they should have been right at the top. And the reason, of course was that they were small and they were investing in innovation, I. E things that don’t exist yet. And the ESG model is all about tracking and measuring and recording, and you can’t track and measure something that doesn’t exist, that is theoretical, that might not ever work.

And they’re looking at your carbon footprint when there’s actually just four guys in an office, and to boot they’re all kind of white males, it all looks terrible. And yet what they’re trying to do is save the planet. And so you can have a systematic approach that’s just completely inappropriate.

Cyril Demaria: I agree. And it’s because in many respects just become a risk management tool.

It’s a reputational concern. Did we show that? We did something in the topic? What are the box to tick and the boxes to tick? And as you said, then it becomes a very strange exercise where you have to contort yourself to fit in a kind of mold, and the mold is predefined, it is not very flexible. And so in that respect, it’s a very strange exercise. And I agree with you. I usually take this example.

If tomorrow I have a health problem and someone has to open me, will I care if he or she is a man or woman, or will I care where they come? In terms of background, what I want is the best surgeon possible because I have a problem and I want to make sure that they can fix it. The rest is just secondary. Now, if we have to think in terms of ESG here, it’s not about making sure that you have quotas or et cetera. It’s about the fact that the surgeon will operate in the best context possible with the best ambition possible. So what would it be? It’s a very interesting case, actually. What would be an ESG application?

A real one now, not just box ticking to a surgery.

That would be probably a kind of acid test, right? Because now we say that, yeah, the background doesn’t matter. It’s all about technicity, education, up to speed and able to solve the problem. But there might be some dimensions in terms of how do you operate, how do you deal with, let’s say, the aftermath, and how do you minimize, for example, the consequences? What kind of arbitrage do you do as a surgeon between maybe go for a certain procedure which might have long term consequences, versus another one which might have different long term consequences? Of course, they think medically, and I think that’s the priority. And the image with the corporation is the same. Corporation still has to make money, but the surgeon can also think about the long term consequences for the social life, the environmental part of the patient. So his family life and all of that. This can also somehow feed in the medical decision. Today, we tend to think about the patient with a very specific context, with a very medical perspective. If we extend it, and that’s the value of ESG, saying, maybe the procedure will be changed because this person lives alone, and on the long term, he or she cannot really make it without additional support, then the medical decision will be adjusted. It won’t be a better or worse, it will be a different one. And I think that’s where the acid test of ESG comes in.

It’s not necessarily that ESG is going to make things better, but the fact that we find you used the term optimum with this philosophical reference earlier, and I think that’s the relevant one, actually, because all these ideas of reducing growth or growth zero, et cetera, doesn’t make sense. So we know that companies and societies have to grow in terms of GDP and create more, but then the optimum might be different, and ESG is here to contribute to that. And I think that’s where the externalities and all the rest feed in, even though we don’t know how to measure it, as you said, and your example is perfectly relevant.

Ross Butler: Great. Let’s try and round this up a little bit.

So there’s this whole ESG industry, obviously, which is proactively investing in ESG type stuff, but there’s also some pressure on all mainstream fund managers to sign up to ESG principles. There’s the PRI, the principles for responsible investment, which is a whole other thing, which we haven’t had a chance to discuss.

But their approach to ESG is very much the one that I personally think doesn’t make a whole lot of sense because it doesn’t allow for these ethical conundrums to be fully assessed, or at least it just excludes them from their view of the world. And what’s your view of how mainstream let’s call them generic fund managers should approach, I don’t want to say ESG, but more ethical conundrums in the round. How should they be communicating about them? Should they be adopting these top level schemes?

What do you think would be best practice?

It’s a really tricky one.

Cyril Demaria: I’m sorry. It’s very challenging.

I think the UNPRI are somehow, as you said, it’s a bit toothless.

You can sign it. It involves a bit of reporting, a bit of extra work, and then you do it. Does it hurt? Probably. It costs money. So it creates barriers to entry, to the small managers. And if I had to start today, a fund manager from scratch, and I have to add that up to all the rest, of course, extra work, and that might actually limit my capacity to launch.

So it indeed creates some sort of, I would call it barrier to entry, or at least to limitations. So every time we add a layer of regulation, we know that it entrenches interest and creates some barriers to entry.

What kind of output does it create?

It’s difficult to estimate, I think, and for that, it’s a first step. But I wouldn’t say that it’s a magical or massive progress. The second part of your question is much more challenging.

And actually, when I published the book in 2003, that was one of the first questions people asked me. It’s like, you’re very good at criticizing, being French originally, and also swiss, but what do you recommend? French are always criticizing, but when they’re very short, they’re very good at criticizing, but very short in solutions sometimes.

And I must say that actually, it’s a very difficult solution. It’s not that I have a magical wand that I could wave and say, oh, this is the answer to all our problems.

The thing which you highlighted, which I think makes a lot of sense, I usually run a business case, I happen to do a lot of trainings.

I usually try to play a little bit on the ESG dimension.

And the business case is about a mid market buyout structure in the UK that we have to analyze as fund investors.

And the team is composed of fairly know, or middle aged, let’s call them like this, white gentlemen. And of course, one of the ESG dimension is, well, where are the women, where are the minorities and all of. And what I usually want people to experience is the difficulty of doing it from the investor side and from the fund manager side, because this is the status quo and there is no magical way of changing that. Are we satisfied with the status quo? Probably not. But what are the solutions. And this is where I think you can start to experience not only the challenge but the nitty gritty part of it. Because if you start to promote too fast some individuals, it creates some rent, which we know in economy is not necessarily good. It creates some disincentives as well, because maybe some people got promoted for reasons which are beyond their intrinsic quality. That’s the surgeon issue I was referring to earlier.

And then there is also a question of readability. It’s like, is it going to be the trophy executive that we always put forward just to say that we comply with certain set of predefined rules which we don’t necessarily agree with, but we have to because otherwise we cannot work anymore.

Unfortunately, the industry has been institutionalizing a lot. When I started 20 years ago, you could discuss with people and say, look, I just didn’t happen to find anyone to fit in this position. The best professional I have is here. And so if you find someone else, tell me. We’ll look at it. Definitely. But that’s the best we can do today. This kind of reasoning doesn’t fit in boxes.

You fill these questionnaires which are kilometers long, have you been arrested? Blah, blah, blah. And then there is next section, ESG. Do you employ x percent of this? There is no space for commenting here. There is no space for thinking and reasoning. And the worst part is that if someone decides to invest in your fund and you didn’t tick the box, he or she will be on the hook. And then they could always explain that at that time it made a lot of sense. As I said, there is this constant revisionism which says that, no, it wasn’t correct. You should never have done that at that time. The fact is that at that time it made sense and there was no alternative.

Ross Butler: So for this reason, my view of ESG and the PRI is that it’s not just doesn’t work, it’s actually amoral or potentially immoral because you are forcing people to make decisions that they actually think might not be the right ones in order to comply with what looks good.

Cyril Demaria: Yes, and the worst part will be if one day there is a major revision of these principles. Fortunately, they’re drafted in a way that it’s not going to happen, but where a major part of the puzzle will have to move and will be replaced by a new one. And then we will reset the whole filter, and then some of the decisions will appear as completely misconstrued or completely wrong. That’s actually one of my biggest worry, because since it’s a very pragmatic, operational, process driven approach. And there is no ethical part anymore. There is no principle, there is no value part anymore, which is explicitly something you can rely on even though they’re in the background. There is still this process which is the prime aspect. Then it means that you’re right. If one day we change our perspective, then it’s going to be very challenging to handle the past decisions.

Ross Butler: Yeah, I think it’s very unfair on those managers that choose not to adopt this stuff because of their ethical position and then get punished for it.

We should come up with an alternative principles that reflect the complexity and nuance in the world that allow them to carry a badge.

Cyril Demaria: I agree with you. Normally the industry should be well positioned to do that because we know that we are not living in a quant world in the private market sector, so we should be well equipped to do that. The fact is that the freedom, or let’s say the room for interpretation, the margins have been reduced dramatically. It’s more of a processing approach now. And that’s related to the institutionalization of the industry.

It had some drawback when it was a cottage industry, forged on relationships because we heard about strange stories or there were even some scandals. There is always, in any case, in any system, a part which is dysfunctional. Does it mean that it was worse than what it is now? I’m not completely sure.

The fact is that besides the institutionalization, most of the important stuff happens outside. It happens when you meet people, when you discuss, you hear about this story and that story, and then it forces your opinion. Besides, what is said is in the private placement memorandum or in the very polished communication that you received, you know that this manager shift or this one is planning to retire, and that’s going to change the dynamics. And that’s not something you can extract from a very process oriented fund selection approach.

The invisible part is actually what matters.

Unfortunately, that’s something which tends to be more constrained today.

So if I had to take you up, and I think we agree on what would be the idea, it would have been to reintroduce this part. But reintroducing the human in a process oriented approach is actually against the grain of history. Right? We always want engine software and all these very reassuring aspects. And when you say, I want to put back the Humans. Whoa, whoa, whoa. No. We’ve been trying to eliminate that, to make scientific decisions, as we call them.

And humans are supposed to be not scientific, apparently.

But I would agree with you. That would be the logical way.

Maybe we will find a way. I mean, we have to be optimistic. Maybe ultimately, as humans, we can also define new systems where we would be able to discuss and document that and say, look, we took a stance, maybe the history will judge us harshly, but these are the reasons, and then we stick by it. But for that, you need rewards.

There is one thing about ESG.

What is my reward?

I mean, collectively, we might be better off or not, but what does it bring to me to stick my neck out and to take a risk and to say, look, that’s what we should do, because it’s the correct way.

You cannot be evaluated on external, sorry, positive externalities.

If you save 10 million carbon tons of carbon, are you going to be paid in saved carbon tons? I mean, how does it work?

Ross Butler: Well, I think this is the whole point. It sits above rewards.

These are not financial considerations, and therefore they must be treated as exceptional items and they should be treated not as PR and things to brag about, but things to account for yourself and explain why you took this decision against your primary goal.

Cyril Demaria: And now I think actually that’s where the industry could work, because this industry is built on governance and incentives. And so if you say this is above financial incentives, which I tend to fully agree with you, it means that we need to define a system where the approach is slightly different. And that’s where the industry is probably with the brains and the power that they have. They are probably some of the smartest people in the financial industry work in our segment of the industry. So if they sit down, they would probably come up with something which makes a lot of sense because it’s not anymore about carried interest or management fees, it’s about something else. But we could think about a system there and where people can stick their neck, and then there is an incentive to do that still and not just playing politics or playing it safe and to take some risk, because this industry is built on taking risks, ultimately. So that would be great.

Ross Butler: Actually, when we follow up offline, if anyone listening to this is interested, they can get in touch with us.

Cyril Demaria: Of course. Yeah, it has to start somewhere. I’m not sure I’m well equipped to lead this kind of discussions, but probably you are, because you seem to have given a lot of thought. But I would say that the industry counts probably some of the brightest elements, and so if they take the time and a little bit of the effort, they might come up with very interesting solutions.

Great.

Ross Butler: Well, this sounds like the start of the conversation rather than the end, but Cyril, thanks so much for your thoughts. It’s been really fascinating.

Cyril Demaria: Thank you very much.