How does ESG support long-term success in venture capital?
How does ESG support long-term success in venture capital?
The world is quickly changing. Devastating hurricanes, droughts, and wildfires throughout the United States in the last few years demonstrate the detrimental and powerful effects of climate change while racial and gender inequality has thrust long-standing social and economic issues into the civil spotlight. On top of it all, a global pandemic has dramatically changed the way we work, travel, socialize, and live almost overnight.
These growing injustices and natural disasters have created a stronger need for responsible investment and have impelled investors to seek out ESG (Environmental, Social, Governance) investing as a means of controlling risk while continuing to reap strong financial returns.
In 2020, investors in mutual funds and ETFs invested $288 billion globally in sustainable assets, a 96% increase over the whole of 2019 according to GBI Research. As more investors begin to favor ESG it begs the question: how have the venture capital (VC) markets responded?
Venture capital firms focus on investing in startup companies that have a competitive advantage in the market. Ideally, VCs want their portfolio companies to generate sales and profits before competitors enter the market and reduce profitability. While VC is a relatively new asset class, it’s already reshaping large sections of the global economy.
Successful VC-backed companies have strong potential; they can create a large number of jobs, deliver impactful services, and strong returns, particularly in emerging markets. While the attention given to ESG issues has never been greater, VC has trailed behind other asset classes in the adoption of ESG practices. However, this may be changing as VC companies learn how ESG considerations can contribute to long-term success and benefit financial returns.
The rise of ESG in venture capital
Consider this: the total US-domiciled assets under management using sustainable investing strategies grew from $12.0 trillion at the start of 2018 to $17.1 trillion at the start of 2020, according to the Forum for Sustainable and Responsible Investment Biennial Trends Report.
However, Different Funds estimates that only 11% of VC firms in the US invest through an ESG lens. While this number has been growing, VCs are still lagging behind other asset classes.
ESG considerations can be critical to the long-term success of both start-ups and venture-backed companies. Some evidence shows that understanding and incorporating ESG policies into work practices can help VCs become more attractive to early-stage investment companies. For example, companies and entrepreneurs tend to favor and seek investments from VCs with a demonstrable track record of ethical behavior.
Conversely, reviewing early investments through an ESG lens helps VC portfolio companies weed out potential risks. ESG principles touch on issues such as diversity, board structures, labor rights, data ethics, and environmental impact that help mitigate risk and identify new opportunities. For example, the impact of WeWork’s governance problems or the reputational damage of ride-sharing apps over the rights of gig economy workers are examples of material ESG issues that had a negative impact on investments.
The positive impact of ESG on venture capital
VCs often target disruptive companies and technology firms. However, tech companies and businesses utilizing disruptive approaches typically haven’t developed a responsible approach to ESG issues. These companies can lose out when regulation policies are enforced, or a social media crisis threatens to destroy the reputation of a promising start-up.
Unless VCs begin systematically integrating ESG into their investment decision-making process, critical risks could be overlooked. For example, the adoption of corporate governance frameworks, workplace policies, and regulatory systems can help mitigate risks and provide a strong structure for inexperienced company founders.
While VC portfolio companies are just beginning to assess the most important ESG measurements across early-stage and late-stage investments there are three key areas that can be greatly affected.
VC companies represent one of the riskiest types of investment. However, VCs don’t have a systematic approach to societal risk management. Typical VC risks include uncertainty around the readiness and performance of new technologies, managing regulatory uncertainty, developing fair terms for customers, suppliers, and business partners, and governance concerns such as establishing a strong board of directors. ESG frameworks can provide a set of risk-management tools entrepreneurs and fund managers can use to address risks and societal impacts earlier in the company’s development.
While ESG data and ratings exist on public companies and the financial performance of VC firms, there is no independent assessment or reporting ESG database available for risk and performance in the venture capital market. Data is critical to any investment decision-making process.
ESG data provides insights into management practices, diversity and inclusion within the workplace, tracks environmental efforts and outcomes, and provides comparable information on best practices within an industry. These insights could help VCs create a risk-mitigation filter that leads to better financial outcomes.
According to Harvard Business Review, women-led startups received just 2.3% of VC funding in 2020. While the VC industry has launched initiatives to improve diversity in fund leadership and founder teams, an ESG lens and transparent data could support these goals. By utilizing ESG monitoring and reporting tools to advance diversity, VCs can ensure their investments include more ethical and well-rounded workplace cultures.
Looking ahead: Laying the foundation for strong venture capital investments
Once companies are operating at scale it can be difficult to change. By incorporating ESG thinking early on, VC investors can resolve issues when they start and lay the foundation for strong, sustainable, long-term growth. ESG action plans for early-stage companies should be flexible and be rolled out in a staggered approach that addresses material ESG risks and opportunities throughout the company’s development.
A clear commitment to social welfare, environmental stewardship, and ethical governance appeals to everyone. Utilizing an ESG approach, companies can entice increasingly selective consumers, attract and retain top talent, and attract investors through a profitable, scalable company. And not only does ESG performance support stronger investing strategies, but it can also support exits too. VC funds that can show a thoughtful approach to ESG management can also gain traction with a growing number of limited partners.
The strategic value of ESG materiality assessments
With investors inquiring more and more frequently about what your company is doing in regard to responsible investment, how you treat employees and vendors, your dedication to sustainability initiatives, and other activities that fall under the ESG umbrella, it’s important to have answers to these questions.
An ESG materiality assessment empowers you to easily report on your current state and outline future initiatives while taking into consideration your business goals and risks. Download our guide to creating and extracting the maximum strategic value from an ESG materiality assessment.