While ESG practices are becoming increasingly central to the investment processes of fund managers looking to deliver consistent and long-term returns, it is becoming apparent that this acronym could be broadened out to ensure a wider range of factors are included within the investment process.
As a result, internally we look at sustainability through an ESG-R lens, which includes regulation alongside environmental, social and governance factors. Many of our investment companies have held leading industry positions and, as a result, regulation is one of the greatest risks they face.
A rapidly evolving industry
A practical example of where regulation can be seen to be disrupting an industry is within the video gaming space. With market revenue estimated around $135 billion in 2018, the sector is already larger than the music and movie industries combined. Over the past 10 years, the video game business has undergone a metamorphosis. Not only have a large proportion of users migrated from arcades, PC and consoles to mobile (estimated 46% of video game revenue in 2018) as processing power rose and bandwidth became cheaper, but the business model has also evolved.
A decade ago the main revenue generator for gaming companies was selling software on discs. In 2018 a significant proportion of global video game revenues are generated through in-game purchases after the game has been obtained. This allows games to be downloaded for free, or lower than traditional prices, while reducing physical production, transport and piracy costs. The amount of revenue generated from a game is driven by the number of players, average amount of time spent playing, and the attractiveness of making a purchase.
In-game purchases account for relatively high proportions of revenue for some companies such as 54% for Activision (calendar-year 2018 estimate by Bernstein research), and 38% for Electronic Arts.
In Asia, in-game purchases make up even higher proportions of video game companies such as Netease or NCsoft, given the greater popularity of free-to-play games.
There are three main types of in-game purchase. A direct saleprovides a set price for a specific item such as outfits or tools for a character; a battle passenables users to gain new features or move up a level to encourage more playing time; and loot boxesallow purchases where the content and value are randomly generated. They may be of great value, although probabilities can be very low.
The first two approaches have not attracted any ESG-R attention. However, user excitement from randomly generated potential wins from loot box purchases has led to concern that this could be considered gambling and not suitable for children (or some adults). Loot boxes became a visible issue following Electronic Arts release of "Star Wars: Battlefront II" in late 2017. Gamers were unhappy with the low probabilities of being up on a loot box purchase, and there was an impression that the company was over charging gamers. About the same time the question started to arise—Are loot boxes considered gambling?—the perception of loot boxes had changed.
Ripe for regulation
The UK Gambling Commission has announced that 15 gaming regulators across Europe (including France, Spain, the Netherlands, Ireland, and Norway) along with the Washington State Gambling Commission are going to work together to address the blurring lines between gaming and gambling - including loot boxes.
In Korea, which has a large market, the video game companies worked to self-regulate with the publication of odds of receiving goods of certain rarity from loot boxes, which then became mandatory in April 2018. In China loot boxes are covered by rules from the Ministry of Culture and SAPPRFT (State Administration of Publication, Press, Radio, Film and TV) and may not be acquired with real money or virtual currency.
Decisions by management can lower or raise a company's exposure to ESG-R related risks, and this increase in regulatory concern has already provoked a clear response from the management of the sector's leading players, with a number of games having dropped loot boxes and moved revenues towards direct sales or battle passes. Notably, the big game title "Fortnite," from unlisted U.S. gaming company Epic Games (40% held by Tencent), does not use loot boxes.
One company we have monitored closely is Electronic Arts. Bernstein estimates almost all 34% of their in-game purchases were through loot boxes in 2018. However, EA is becoming less dependent on loot boxes, as recent game releases either lack them entirely or sell them in limited capacity and only for cosmetic items (i.e. items that do not provide players functional advantages).
Sudhir Roc-Sennett is executive director and senior portfolio adviser of Vontobel Asset Management
These alterations, in the ways in which gaming companies are changing their earning structure, serve to underline how just how significantly regulatory changes can impact businesses.
We believe deep analytical work needs to be carried out on each individual company held or under consideration to understand the potential threats; and as asset managers, it is our fiduciary duty to provide sound stewardship over the funds entrusted to us.
As owners, active engagement with managements brings benefit to both parties and we only invest when we are comfortable with not only the ESG risks involved but also the potential regulatory threats as well. It is by understanding and engaging on such issues that we can deliver value to investors over the long term.