The rising prominence of Environmental, Social and Governance (ESG) considerations reflects a wider ‘sustainable transition’. As part of this transition, the ESG themes at the forefront of investment conversations include climate risk, net zero, and diversity and inclusion. Many business sectors will be impacted by, or have a role to play in this transition, which in some ways has been accelerated by COVID-19 as it has highlighted social and health inequalities. Leaders in responsible investment are using ESG integration to protect value, and increasingly, for value creation.
Venture Capital (VC) fund managers have a unique opportunity to invest in and catalyse the solutions required to tackle the world’s biggest challenges, including climate change and inequality. And over the last 18 months we’ve seen the momentum to integrate ESG rapidly among VC investors: there are now pockets of VCs working together to develop frameworks for ESG integration, last year alone the CDC published a good practice note on Responsible Venture Capital and the Belfer Center produced a report on Responsible Investing in Tech and Venture Capital. Underpinning this momentum is a belief that better ESG management will, whilst creating returns for investors, drive the solutions to meet society’s challenges and will ultimately set early stage businesses up for long-term sustainable success.
In this blog, our Sustainability and Climate Change (S&CC) team have put together guidance which outlines why and how VC’s should start integrating ESG.
Whilst there is a steady increase in ESG maturity across the Private Equity (PE) sector, the topic has only recently started to gain traction within VC. And there are good reasons why!
The available academic and practitioner evidence suggests that successful management of ESG issues leads to enhanced financial performance. Although the current research relates largely to asset classes such as listed equities and fixed income, it seems reasonable that a similar relationship would apply in the VC context.
Since capital raising in the venture space remains competitive, a well-articulated approach to ESG could be beneficial. This is especially apparent from various conversations we’ve had in the last six months, where we have seen an increase in the expectation from investors and Limited Partners (LPs) of VC funds when it comes to ESG integration. At the company-level, ESG performance could increase the prospects for follow-on funding rounds or achieving value at exit, whether by trade sale, PE acquisition, other buyout, or IPO. With regards to exit by IPO, the tendency for stock exchanges and listing authorities to require more stringent ESG disclosure continues to trend upwards.
The nature of innovative, disruptive tech and business models, often core to many VC-backed businesses, means they are sometimes playing in an unregulated space. It’s highly likely new regulation will be introduced to control the risks and/or impacts associated with these types of advances and innovation. With that, there is real benefit in getting ESG ‘right’ to be better prepared for future regulatory changes.
Reputation is also critical, particularly in the tech space - without it it’s impossible to scale and attract investors. We are seeing a shift in consumer expectations, both on the individual and corporate level: Millennials are factoring in sustainability in their purchasing decisions and procurement departments are factoring in human rights in the supply chain and are increasingly considering GHG emissions of their suppliers and how that contributes to their net zero targets. Let’s not also forget that purpose and sustainability is something that can attract talent and help retain talent, see more on that in our global workforce of the future findings.
ESG integration is fundamental in order to manage risks appropriately and protect value, it can be a mechanism through which you can identify opportunities for value creation.
While VC funds typically take on a minority share in companies, there’s an opportunity for VC to engage companies on ESG topics and set them up for long-term sustainable growth. VCs have the chance to help companies integrate ESG factors during the companies’ formative years, embedding ESG performance into the culture of the company as well as its operating principles as the business scales. This means that ESG risk and opportunities are appropriately addressed and that it meets the ESG expectations that later-stage investors will be looking for. VC has the opportunity to leapfrog the basic compliance and risk-based approach to ESG (which is where PE originally started) and consider a more mature approach, one of value creation and in particular sustainable value creation.
VC investors have a pivotal role in supporting the sustainable transition by investing in solutions that will help society overcome challenges ahead, such as climate change. And we see this already happening with many VC firms’ investment strategies focused on climate tech as well as impact. A recent PwC analysis found that VC and corporate investment in startups developing climate tech solutions grew at a faster rate than VC investment as a whole, reaching 84% CAGR between 2013-2019. In this constantly evolving environment, knowing how to mitigate the risk of ESG-linked value erosion as well as how to identify and act on opportunities for sustainable value creation is crucial for investors.
So where to go from here? We have set out below eight ESG considerations to support VC investors to start considering ESG factors as a lens for enhanced risk management and for opportunities for value creation.
Do you have an ESG / responsible investment policy? If so, have you translated commitments into concrete action, for example, by ensuring ESG matters are integrated throughout the investment cycle?
Is responsible investment a core component of your risk management approach, or is it just an add-on? Is ESG considered in Investment Committee papers?
Are you able to distil key facts and challenges on material ESG issues, such as climate, human rights, or AI ethics? Do you understand what is important to the suppliers and customers of your portfolio companies?
Do founders understand their alignment with wider sustainable transformation and how this may impact their business model? Or is the company providing solutions?
How do you keep engaging on material ESG issues throughout the investment lifecycle and do you monitor the company’s ESG performance?
How can you use ESG to identify opportunities for value creation? How are you setting up your companies for future success (e.g. attractive to later stage investors like PE, as well as customers and clients)? How are you communicating your value creation story at exit?
What are the right ESG expectations as the business scales? The integration of ESG must be proportionate to the scale of the business and the trajectory of growth, but also the approach needs to consider the size of your investment size and your level of control.
How are you communicating your approach and successes to your stakeholders, including investors? Are you collecting the right data to tell your story?
As ESG integration in VC is growing, we’ll continue to share more insights, including the VC related data from Global PE Survey Responsible Investment Survey 2020/21 due out in the coming months. In the meantime, if you would like to talk to us about how we can support you in developing and implementing ESG strategies, then please contact Nicky Crawford, Kim Woehl or Jihea Kim.