ESG, which stands for environmental, social, and governance, has been around for decades, but it has emerged as one of the significant trends shaping the VC landscape over the past few years. Driven by regulations, external pressure from investors to report CSR efforts, and the emergence of sustainable investing as a mainstream investment class for institutional and retail investors, ESG became a compliance and statutory issue in many developed countries.
With the global shift towards sustainable business practices and increased public awareness on ESG factors, it's time for ESG adaptation for venture capital funds and their portfolio companies.
SRI, ESG & Impact Investing - What are the differences?
Socially responsible investing (SRI) is an investment strategy that considers environmental health, social justice, human rights, diversity, and sustainability. Thus, the investments are limited to industries and businesses with positive social impact rather than perceived solely by financial returns.
The idea of Impact investing, a subset of SRI, however, is to invest in companies to create positive social change while still making a profit.
ESG Investing is about internal principles and processes within the funds and portfolio companies regarding Environmental, Social, and Governance criteria.
VC funds should think of ESG as a framework for assessing how to invest responsibly and integrate sustainability into investment decisions by considering an investment's financial risks and rewards and the societal and environmental implications. ESG investors and startup founders also should evaluate how these broader factors might affect the company's stakeholders, including employees, customers, shareholders, and other members of society such as those living nearby or downstream from the company's operations.
Why is ESG so important? – Advantages for VC funds and startups
The investment type plays a significant factor influencing the degree of ESG engagement and strategy. The EIF survey found that as investment stages become more mature (seed vs. early vs. growth), participation in ESG integration is higher as more information is available meaning it's easier to integrate ESG factors. Growth-stage VCs with higher capitalisation are much more likely than their early-stage peers to consider environmental issues through active ownership or cross-shareholding agreements (for example, 31% of growth-stage investors adopt these strategies vs. 19% for seed or early stage).
According to an EIF survey, for both Venture Capitalists and Business Analysts, ethical or social considerations are the most common motive for ESG engagement. In addition to encouraging responsible business practices at investee companies and integrating ESG into formal investment policy, the top drivers of ESG include: the attractiveness of sustainable investments from a financial perspective, and external pressure on investors to address sustainability issues.
Venture capital and investment firms have started to give attention to ESG criteria as part of the investment process. However, mainstream investors are still waiting for proof on the efficiency of ESG criteria under long-term investments as a shareholder value driver due to no historical data available and inconsistent methodologies. The implementation of ESG criteria is still a work-in-progress stage, and various challenges must be resolved, like the lack of reliable resources, expertise, capabilities, adequate tools for measuring ESG performance, or fear of lower returns on the portfolio, to name a few.
According to EIF, larger venture capital funds have already incorporated ESG criteria and monitor its portfolio-level performance. These findings underline the visible advantage of the later stage VC funds that are better equipped in resources or personnel expertise compared to smaller ones, enabling them to develop formal procedures and deal with different challenges during the implementation process.
Venture capital firms need to evolve their selecting and screening capabilities, rethink valuation models, design term sheets with ESG considerations and develop specific tools and frameworks for assessing, monitoring, and advising on the ongoing performance, risk mitigation, and value creation. Promoting ESG among startups requires enhancing its legitimacy by VC funds through integrating its goals into their operating models via processes and structures. Procedures needed for applying ESG measures differ from those involved with large firms - the costs of measuring, monitoring, and reporting on ESG factors are higher for younger ventures due to their significant constraints regarding resources. Startups often change their business model over time and hire new team members aggressively, making it even more difficult to set firm objectives on ESGs.
Also, traditional startup evaluation criteria aren't enough for VC funds which need a corresponding assessment capability of adequately integrated ESG factors. Only this way, it will be possible to mitigate risk and spot arising opportunities allowing portfolio companies to facilitate positive societal impact and create unique, innovative products that scale up quickly, build substantial competitive advantage, and become sustainable. Also, startup valuations should consider the social and environmental impact that ESG will have on long-term company performance. Investors need to develop a whole new toolkit for the investment process and subsequent portfolio monitoring with the core objective of generating high financial returns while also creating positive societal impacts.
Last but not least, LPs should play a crucial role in adopting ESG in the venture capital industry, e.g., by including ESG in fund principles, investment process, and reporting while allocating LPs money among various VC funds (for example, diverse fund management). With capital raising in the venture space remaining competitive, a well-articulated approach to ESG could pay back. Being one of the first movers as an ESG-oriented VC fund can become the source of advantage and attract LPs and many high-quality portfolio firms addressing real-world issues. The ESG performance can also be beneficial from a portfolio perspective as it increases chances for follow-on funding rounds or better exits, especially through IPO as stock exchanges and listing authorities demand stricter ESG disclosure. A 2020 study by McKinsey & Company found that in a hypothetical M&A scenario, investors would be willing to pay about 10 percent more for a company with an overall positive ESG record.
Adopting ESG rules can be very beneficial for startups. Various researches show that more and more millennials are highly engaged in sustainability issues while making purchasing decisions. Thus, ESG can become a significant advantage in helping startups stand out from the competition, show their commitment towards society and the environment and attract both investors interested in startups with high ESG scores and customers who care about social and environmental factors. Some of the most important benefits for companies that adopt ESG to their investment strategy are an increased ability to attract top talent, reduced ecological footprint, and long-term value creation. Employees with specific values might be more likely to work for a company that shares their views, resulting in better business overall performance.
Another great advantage for companies that adopt ESG is the environmental impact. A company’s carbon footprint can be very costly in climate change and environmental pollution. By incorporating ESG principles into the business model, the adverse effects on the environment can be minimized or eliminated, reducing many other costs related to these issues, such as legal fees and government penalties. Long-term value creation also plays a significant role in startup growth. Companies that adopt sustainable practices look better on paper and are more likely to thrive over time because of lower costs and vulnerability during economic downturns due to their independence from unsustainable resources.
In the long haul, the increased focus on ESG will enable firms to comply with global regulations and lead to greater transparency and compliance among VCs and portfolio companies. Also, ESG investing requires a different approach to assessing the risk that might lead to new trends or financially attractive strategies but was not previously considered.
Adapting ESG to an investment strategy can also lower risk for investors. Every dollar invested in ESG companies will potentially yield a better return on investment due to lower risk. Although there is no sufficient data yet to back the assumption that ESG companies are more likely to outperform non-ESG peers on financial and non-financial metrics, it is reasonable to expect a positive correlation between the increase in ESG adoption and better business performance. Moreover, the increased scrutiny required to meet ESG criteria might lead some companies to better care of their stakeholders, improving the reputation and long-term sustainability prospects. This is true for domestic and international companies and includes transparency, reporting, and stakeholder engagement issues.
On the other hand, ESG investing is not an easy game for VCs. One of the main obstacles of adapting ESG by VC funds and startups is limited resources and lack of expertise. Also, rapidly growing market volatility and global attempts to adapt solutions reducing friction in startup investments stay in contradiction to ESG compliance, which could become a double-edged sword increasing the paperwork and transactional costs that, in the aftermath, will affect the profitability of the VC investment. Finally, ESG can conflict with investors’ other interests or strategic goals at different points in the company’s life cycle. ESG could be a value driver in VC and startup investments, but we still need more extensive studies on the topic. Nevertheless, we should adapt to this irreversible trend taking into account new regulation, combined with increasingly comprehensive measures, starting to force investors and startup companies to consider, implement, and report on the effects of ESG.
Useful to know
If you are interested in ESG and would like to dive more into related topics here are some valuable sources worth following:
- Venture-ready ESG measurement framework, providing an entry to ESG scoring, developed by ESG_VC - click here.
- Impactful initiative aiming to push the VC industry on ESG, supported by 250+ VC funds and Limited Partners - click here.
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Related Posts:
Trends That Will Shape VC Scene In 2022 (by Olga Chechłacz, Editor, Vestbee)
Startup Fundraising: Due Diligence (by Ewa Chronowska, Partner, Next Road Ventures, Vestbee)
