Venture funds are increasingly recognising the opportunities that can be created by having a value-add ESG strategy embedded in their investment approach, according to a recent report. While venture continues to lag behind the progress made by private equity firms in relation to environmental, social and governance considerations, some VCs are now taking firm steps to developing policies and methodologies.
Produced by consulting firms ITPEnergised and Orbis Advisory, the second annual ESG Transparency: A Private Equity and Venture Capital Index 2021 analysed 122 VC firms for the first time, in addition to 155 private equity firms. The index looked for evidence that firms were addressing and implementing four ESG criteria: ESG policy, in-house ESG, pre-investment due diligence and ESG benchmarks.
The researchers found that 16 percent to 24 percent of the VC firms showed evidence for each ESG consideration, with pre-investment due diligence being the most common. However, nearly three in four VC firms (72 percent) did not indicate any ESG considerations on their websites and just 10 percent satisfied all the criteria.
“The private equity space has blossomed in this area, with a lot of firms responding to stakeholder pressure and to research that shows ESG is a great tool for value creation,” says Harriet Assem, technical director at ITPEnergised.
“With venture capital, there are similar drivers but a lot more focus on the opportunity because of the areas they work in. Venture firms are the disruptors out there, investing in the companies with the ability to drive systemic change and come up with solutions to climate change and inequality. There is a real opportunity for funds to build on this and create messaging around it.”
Assem adds: “ESG also helps VCs de-risk, differentiate, and attract investment.”
One of the 11 VC firms identified as a top performer in the report is Scottish Equity Partners, a growth equity firm focused on tech companies in the UK and Europe. Chief operating officer Catherine Simpson says the firm has had a responsible investment policy since 2012, and in 2020 it became a signatory to the UN Principles for Responsible Investment.
“A significant recent development has been the creation and implementation of our bespoke assessment framework aimed at addressing the most material aspects of responsible investment for the growth stage technology businesses we invest in,” Simpson says. “This has three core pillars – governance, culture and society. New investment opportunities are assessed against the framework as part of pre-investment due diligence, identifying key opportunities and any potential concerns.”
Simpson notes that portfolio companies contribute key performance indicator information annually to Scottish Equity Partners and that data is captured across 100 individual questions to identify areas of strength and opportunity. The firm published its first ESG report in 2021 and has established a group to review its own sustainability practices and objectives, she adds.
Simpson says investors are looking for VCs to act on ESG. “Responsible investment is now seen as mainstream and a core part of a firm’s value-creation strategy,” she says. “LPs are, rightly, looking to see that reflected in strong engagement across investment teams and demonstrable track records of impactful investment. A rising number of LPs now measure and monitor diversity and climate-related metrics on an annual basis and we now see
ESG data submission and reporting as an integral part of the GP/LP relationship.”
But LP enthusiasm for ESG is just one element. “Market data is highlighting that, managed well, these non-financial ESG areas can help improve business growth, while, managed badly, they can result in reputational damage, regulatory fines, business interruption, the loss of customers and revenue reduction,” Simpson says.
Why is progress slow?
Despite these drivers, there are many reasons why the venture space has not kept up with the pace of ESG change seen in private equity. Investing in growth-stage companies, typically as a minority investor, can make it difficult for funders to influence the direction of companies.
Outside of social impact funds, ESG is rarely a significant component of investor due diligence, says Peter Werner, co-chair of law firm Cooley’s global emerging companies and venture capital group.
“There are two principal challenges, and both of those are challenges to the portfolio companies and therefore to the funds,” Werner says. “First is the fact that the cost of this is more of an acute issue in venture-backed companies than in later-stage, private equity-backed companies. These businesses are trying to be incredibly efficient and lean, and that means being very careful about spending money on things that don’t advance the growth of the business before it is clear there is an actual business to be built.”
He predicts that VCs will engage more once easily replicable and less costly ways of measuring carbon footprint and other ESG metrics are developed and deliver meaningful results
“The second issue is the measurement itself,” says Werner. “Being able to accurately measure the carbon footprint of a business across all sources, and being able to identify solutions to mitigate that takes a lot of work and conviction. We are going to need to come up with efficient ways for leanly funded companies to do things that actually make an impact and move the needle.”
Only 11 firms surveyed fulfilled all four ESG criteria (listed in alphabetical order):
- Balderton Capital
- Cambridge Innovation Capital
- Equinor Ventures
- Frog Capital
- Lakestar Ventures
- Molten Ventures
- Oakley Capital
- Oxford University Innovation
- Scottish Equity Partners
- Vickers Venture Partners
Source: ESG Transparency: A Private Equity and Venture Capital Index 2021
Despite these challenges, Werner says there are plenty of motivations for venture funds to act that go beyond LP pressure and doing the right thing. He sees historical precedent for provisions coming into venture deals that recognise the standards that companies will be held to when they go public, particularly in relation to governance, and seek to establish a pathway to that compliance.
“There is now a pretty standard term in venture documents that a company represents that it has controls and procedures in place that are sufficient for the company’s stage of development,” Werner says. “That acts like an upstream manifestation of what will eventually need to be in place when the company goes public.”
The other motivation comes from movements such as #MeToo and Black Lives Matter that have led investment funds to include provisions in documents for anti-harassment and diversity, equity and inclusion.
Frameworks are helpful
Another top performer identified in the study is Vickers Venture Partners, an international firm focused on early-stage and growth capital investing, with £2.25 billion ($2.96 billion; €2.67 billion) in AUM across the technology sector.
“As early-stage investors, we invest in our companies through the time of their biggest uncertainties, which also means their periods of most significant change and growth,” says Vickers vice-president Petros Farah. “We believe that having an ESG framework in place helps guide our companies through this phase to achieve long-term, sustained growth.”
Vickers associate director Chris Ho adds: “We recognise that venture capital, as an asset class investing in very early-stage companies, has the potential to make outsized impact in the sense that we are deciding which technologies get funded and which don’t.
“In the last couple of years, we have set up an ESG committee and tried to codify some of the things we have already been doing in alignment with our investment thesis.”
He notes that one of the challenges is working out the right level of ESG focus to bring to bear on early-stage companies. “We don’t want them to get distracted from their core mission of developing new technologies, but we want to provide them with some guidance because we do believe ESG policies are key to long-term success,” Ho says.
“Although the focus is often on the E part of ESG, this is less relevant when you only have a handful of people in your business,” Ho continues. “The G part is the most important early on, to make sure you continue to grow within a good framework, but that is much harder to quantify.”
Ho says the venture community is working together to share thinking on how to move ESG forward across the asset class.
“My general view is that this will grow in importance and people will spend more time on it,” he says.
“I wish ESG wasn’t viewed as a separate item distinct from everything else in the business, because if you want to build a company that isn’t short-sighted, a company that is thinking beyond the next quarter and is going to be around attracting talent and generating value for the next 30 years, you have to integrate ESG principles into all your decisions.”
Simpson of Scottish Equity Partners adds: “We are noticing some key themes right now, namely around diversity and inclusion, workforce wellbeing, cybersecurity and community engagement.
“There is also increased interest in B-Corporation status, with companies seeking to demonstrate their ongoing commitment to high standards of social and environmental performance, transparency and accountability.”
Rupert Clark-Lowes, director at Orbis Advisory and co-author of the report, says VCs are increasingly seeing the value-add that a strong ESG framework can provide to their firms and stakeholders.
“Many of the top VC performers highlight the competitive advantage and reputational benefits that they have seen from integrating ESG into the core of their firm,” Clark-Lowes says.
“VCs also understand that for their portfolio companies to thrive, physical and transitional risk and resilience frameworks need to be integrated from the early stages of a business. There is no doubt that this move toward ESG and sustainable investing will only increase, and we are excited to track the developments over the coming years.”