Good Honest Dollar $$

This article is the sixth in a series on Socially Responsible Investing (SRI), otherwise known as ethical investing.

In this post, I would like to discuss the consequences, from a company’s point of view, of being successful or otherwise in attracting ethical investment.

Some commentators argue that attraction of the ethical investment dollar provides an incentive for firms to adopt positive ethical behavior. But is attracting ethical investment really important to a firm? Does attracting SRI really matter?

In order to understand the consequences for a company of attracting socially responsible investment, we first need to examine two issues - the nature of these consequences and the magnitude of such consequences.

In this post, I will examine the nature of the consequences for a firm in attracting ethical investment – the question of why it matters.

The following post will deal with the magnitude of such consequences – the question of how much it matters.

Why SRI matters to a firm
The consequences for a firm in attracting socially responsible investors differs according to whether we are referring to investment in primary markets or  investment in secondary markets.

Accordingly, the two different categories of investment and their differing effects are discussed below.
 

Investment in primary markets
Investment in primary markets occurs where investors provide money directly to a firm, in return receiving either equity or a credit instrument, or a combination of both.

This, in turn, occurs when the company attempts to raise capital.

There are direct (and easy to understand) consequences for companies in attracting (or otherwise) ethical investment in primary markets. By attracting funds from ethical investors, the firm increases the amount of funding it can raise and/or improves the terms upon which it can raise the required capital. The reverse applies to firms which are shunned by ethical investors.

Consequently, ethical investors may have a direct impact upon a company’s ability to raise capital and the terms upon which it is able raise such capital.
 

Indirect investment
Indirect investment occurs when investors do not provide money directly to the firm, but instead purchase a credit or equity instrument on a secondary market. The most common form of indirect investment is the purchase of shares on the stock market.

In such cases, the investor does not transact with the firm itself, but rather with the seller of the credit or equity instrument. Accordingly, the firm does not receive any money directly from the investor, and the consequences for a firm in attracting ethical investors on secondary markets are less obvious.

Nevertheless, such consequences do exist, and they stem from the effect upon the firm’s share price.

The share price of a firm is determined predominately by the level of demand for the shares concerned. By attracting funds from ethical investors, a firm increases the overall level of demand for its shares, and thus, the price at which its shares trade on the market. The reverse effect occurs in cases where firms are shunned by ethical investors.

Accordingly, other things being equal, a firm which attracts ethical investment will attract a higher share price than a firm which does not.

The effect of a lower share price, in turn, does not have an immediate impact on the operations of the firm. However, it does result in a number of flow-on effects.

 
• Failure to maximize shareholder wealth.

In many western countries, the principal objective of the firm is to maximize wealth for its owners. This, in turn, is achieved by maximizing its share price. 

In cases of firms which repel ethical investors, the ability of the firm to achieve the goal of the maximizing shareholder wealth is inhibited.

 
• Becoming a takeover target

Firms which fail to maximize their share price (due to an inability to attract ethical investors) face a greater risk of becoming a takeover target than firms which succeed in that regard.

 Moreover, shareholders of such firms do not receive as much value for their company in the event of a takeover as shareholders of firms which are successful in maximizing their share price.

 
• Adverse effects on employment and remuneration of senior staff.

In cases where an inability to attract ethical investors results in the failure of a firm to maximize its share price, the effect is felt not only by shareholders, but also by directors and senior staff.

Directors and senior staff are accountable to shareholders. In addition, they often hold substantial shareholdings themselves and their remuneration can be substantially influenced by the share price.

Accordingly, failure to maximize the share price may have an adverse impact upon the value of their shares, their remuneration and even their employment at the firm.  

 
So, does SRI matter to companies?
Yes. Success or failure to attract ethical investment has an affect upon a company’s ability to raise capital funds on primary investment markets, and the terms upon which it can do so.

On the secondary market, it does not directly impact the operations of the firm, but the subsequent effect on the share price has flow-on consequences for both owners and senior employees of the firm.