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ESG and venture capital – portfolio management in practice

In the second and final part of their article, ESG consultants Theodora Thunder and Dr Glenn Frommer look at the specific application of ESG strategies to portfolio development.


In the first part of this article, published in last month’s CGj, we explored the business case for establishing a strong environmental, social and governance (ESG) strategy and management mindset for venture capital (VC) portfolios. Discussions covered the benefits, risks and unique challenges to VC managers when adopting an ESG strategy in their portfolios. In this second and final part, we set out a practical ESG-guided roadmap that in staged segments mirror the lifecycle of a portfolio: purpose and management framework, deal sourcing, due diligence, portfolio management and exit strategy.

Purpose

An ESG-influenced purpose is driven by an understanding of the megatrends (as illuminated by the United Nations’ Sustainable Development Goals for example) relevant to the fund’s targeted industry and the opportunities arising out of the increasing urgency of environmental and social needs as global markets embrace post-pandemic economies and societies, and battle climate change impact. Limited partners (the investors who supply VC funds with capital) are increasingly pressuring VC managers to include mandates to address these needs, directing their own funding purpose beyond just being the money-making machine of past decades. The exponential growth in ESG investment funds across global markets is testimony to these trends.

It is the responsibility of the general partner (the manager of the VC fund) to understand, define and articulate the portfolio’s purpose and set the expected return on equity for the overall portfolio. With years of basically free money now in the rear-view mirror, fund managers are faced with a future of rising costs and risks to achieve high returns, while managing the downside that increasingly brings non-financial impacts onto the radar. A more stringent risk appetite influenced by ESG factors is emerging that necessarily raises the performance bar over the lifecycle of the portfolio and of the companies within the portfolio. This starts with the governance that drives and integrates purpose across the portfolio.

Once a purpose-driven ESG policy and management framework has been established, management needs to ensure allocation of resources to manage the material issues identified to achieve the desired goals. This includes overall responsibility and oversight at board and senior management level, the clear allocation of responsibilities for day-to-day management, accountability methods and the development of expertise at the operating level, which includes ESG training for relevant employees.

Deal sourcing

As the awareness of ESG materiality recalibrates deal sourcing, it sets up an integrated process in which the parameters for deal choice and fund purpose interact. This demands (and assumes) a level of expertise and the skills to proactively source and identify opportunities through an ESG lens. Using this approach raises the bar for potential candidates at the screening stage. In addition to the standards/criteria of mandated portfolio purpose and return on equity expectations, ESG-focused materiality identifies potential non-financial risks in the business model and strategy. On the plus side, a start-up which has adopted an ESG mindset at its early stages of development demonstrates sector leadership, competent risk/opportunity management and a corporate culture that attracts today’s investor interests.

To support deal sourcing and the management of portfolio companies, the VC company needs to establish a ‘fit for purpose’ portfolio dashboard developed as a competitive advantage. It would include at minimum the standards, systems and metrics that capture ESG performance data to augment the financial reporting to regulators, investors and industry stakeholders. As an active management tool, the dashboard codifies the VC company’s own ESG policy and the framework for assessing and measuring risks, opportunity and impact when screening investment opportunities, as well as managing the overall portfolio throughout its lifecycle. A recent research paper – Dashboarding Pays Off – published by the MIT Centre for Information Systems (see endnote for details), discusses the use of dashboarding to track the what and how of value creation, which is essential to the exit strategy.

Ideally the dashboard would be managed by a dedicated ESG manager who oversees the internal ESG agenda and the mentoring of the portfolio of companies’ management teams. Each company in turn would adopt its own dashboard for similar purposes and use it for peer assessment comparison.

Due diligence

Applying an ESG lens to the due diligence process identifies a broader scope of unforeseen investee-specific risks – what is missing or what poses elevated risk to the portfolio. The ESG lens could capture potential social impact from foreseeable changes in the investee’s business model, the lack of management competencies to manage change, or the gap in resources for oversight of ESG issues and the functional management systems that cover non-financial risks (such as employment, ethics, health and safety, data security and diversity risks). The due diligence process could also include assessing the cultural fit and a potential ESG action plan to address material ESG risks and opportunities following investment. This could also include the milestones and interventions that reflect the VC portfolio’s focus on adding value and improving return on equity. It will also appraise the skills and competencies available within the portfolio, determining areas of strength, weakness and potential.

Portfolio management

The objective of good portfolio management is to create high performers within the stable of companies while achieving overall portfolio value creation. As the portfolio grows and invested entities mature, risks and opportunities can increase in magnitude and scope, impacting the targeted exit strategy and ability to guide value creation. The significant challenge is to understand to what degree the investor can influence performance within the target company based on the minority/majority stakeholding.

In practice, this proposes a series of essential management tools.

  • Establish and lead the development of an ESG structure within investee companies. Having an overarching portfolio ESG framework serves as a benchmark to guide development when working with investee companies’ risks and opportunities and the ESG pathway. Aligning this framework requires designated roles and responsibilities within the portfolio fund management team to ensure compliance and company performance development, as well as nurturing the ESG values-based culture.

  • Engage with company management on material ESG issues through the holding period, addressing due diligence findings and encouraging ongoing ESG management as the company grows. Consider ESG action plans that are flexible and rolled out in a staggered approach throughout the company’s development. This includes formulating a set of agreed targets and key performance indicators (KPIs) against a performance timeline. Reassessment and adjustment of the risks and opportunities should be triggered when the company passes KPIs or other thresholds. Against this, the VC fund independently sets its own thresholds in relation to the portfolio ESG issues and exit strategy. Engagement can be facilitated through capacity building in which stakeholder interests and material issues are identified and prioritised at the early stages and reviewed on a regular basis.

  • Verifiable and relevant data is at the core of management decision- making. Choice of data points and their collection needs to reflect what is important to the individual business and to the portfolio, how it supports the ESG strategy and how the metrics can be of genuine use to measure impact. Timely engagement, monitoring and reporting informs on progress and points to possible interventions that can mitigate negative impact on the exit strategy, or conversely leverage unforeseen opportunities to add value. Prime candidates for this approach to data management is the acquisition of companies to build a digital asset ecosystem.

  • With new funding rounds, consideration should be given to follow up on ESG risks and opportunities (decline of influence over company, business model changes, new product development, new markets entry, etc). Next-stage investment requires the review and update of the ESG strategy and action plan to ensure continued alignment with future performance expectations.

The exit

There are no standards to guide the exit strategy, let alone a strategy shaped by ESG principles. Rather, it is the story of how the fund manager has methodically created and reported operational value within the company guided by the portfolio’s ESG focus and value creation framework.

The portfolio manager is tasked with two responsibilities to secure a successful exit. First, to achieve (or come close to) the portfolio’s expected return on equity while leveraging opportunities to add value and keep risk within set parameters. And second, to ensure the continued pathway of value creation that attracts potential investors or trade buyers. There are no shortcuts, but rather the multi-year discipline in building a clear, transparent and evidence-backed equity story detailing the individual company’s potential to the next owner or investor. This is where the practice of an ESG strategy within portfolio development aligns to the megatrend of demonstrating social and environmental purpose behind investment.

This practical roadmap is not a static framework, but rather functions as an iterative process designed to build in resilience and sustainability in the portfolio’s companies. The successful exit demonstrates the viability of this roadmap as a means to achieve competitive advantage in the increasingly high-risk stakes of venture capital in Asia.

Theodora Thunder and Dr Glenn Frommer

This article was first published in CGj the monthly journal of The Hong Kong Chartered Governance Institute, May 2022, and is reproduced here through the kind permission of Theodora Thunder, member of the Red Links Sustainability Consortium and independent consultant.


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This article is for information only and is not intended to be a comprehensive review. Obtain direct and tailored advice before applying anything contained in this material to a specific scenario. For more information, contact Red Links. External links are included for readers’ convenience. The inclusion of these sources is neither an endorsement of that provider nor intended to provide readers with any assurance as to the completeness or accuracy of the particular material linked.