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In a two-part article, independent ESG consultants Theodora Thunder and Dr Glenn Frommer examine current ESG developments and practices in the global venture capital industry.
In this first part of our article, we explore the business case for adopting environmental, social and governance (ESG) principles in venture capital (VC) fund portfolio development, principally the benefits and costs of adopting an ESG roadmap for a portfolio of funds. The article examines significant challenges to be addressed, those inherent to industry and those closer to the management of the portfolio itself.
The benefits of developing an ESG mindset
The business case for a strong ESG strategy and its integration into a VC portfolio is an increasing industry reality. Regardless of the purpose, size or theme of a fund, its endgame is to create value while mitigating risks across its portfolio of companies and then exit a winner, leaving a sustainable company to pursue its next phase of development. Portfolio alignment to ESG principles and mindsets supports this endgame.
The benefits of developing an ESG mindset in a VC fund can significantly bolster its bottom line and standing within the industry.
Fundraising. A strong approach to ESG can be a differentiator, supporting fundraising efforts and helping a fund stand out in a crowded market. Limited partners (the investors who supply the fund with capital) and international investors increasingly expect funds to incorporate ESG issues into their investments as a risk mitigation strategy and to align with the United Nations’ Sustainable Development Goals.
Screening. Early investment reviews of companies using a fund’s ESG framework should identify excluded activities and ESG-related ‘fatal flaws’. It also confirms the potential culture fit and management style to help target suitable companies.
Exits. The ESG expectations placed on a company will grow as the business scales. VC-backed companies can help facilitate investment from new sources by demonstrating progressive adoption of good ESG practices and the metrics to support performance.
Reputation. The solid adoption of an ESG mindset and its practical application at the very early stages of operations mitigates the trap of negative reputational impacts. Start-ups are particularly vulnerable in this area due to the power of social media backlash and often bad management oversight. WeWork and Uber are prime examples of the damage a negative reputation can do.
Talent attraction and retention. Start-ups typically comprise a skeletal team of overworked founders and management. However, with growth the dynamics change, requiring a socially aware and encompassing approach to talent, especially with the millennials who are now a significant employee component within the sector. A company purpose and culture founded on an ESG mindset attracts, retains and incentivises skilled workers critical to the success of the start-ups that proliferate in Asia.
Regulatory oversight. As the global markets adapt to innovation and technologies that are rapidly changing business as usual, the proactive management of ESG issues can help disruptors future-proof their business models against regulatory changes that are now gaining pace within the industry.
Market access. Strong ESG practices can help VC-backed companies increase their access to international markets. Tech companies often target the more developed global markets, where early adoption of good ESG standards can facilitate market entry and help de-risk the company in the eyes of business partners.
Data challenges
However, a clear-eyed assessment of the cost of these benefits when adopting an ESG pathway requires a substantial internal pivot within a fund’s business model and operating strategy that is often underestimated in practice.
The more standardised approaches applied by traditional financial services markets to manage and analyse companies in terms of ESG risks do not sufficiently cater to the early stage investing model. VC-backed companies often disrupt the status quo by using new technologies or business models, and sometimes operate ahead of local regulatory frameworks. This has led to many VC funds creating their own frameworks for assessing and measuring impact and ESG risks when screening investment opportunities for their portfolios.
Data availability, let alone standardised and verifiable ESG data, is one of the greatest challenges to the VC investor. A significant number of small and medium-sized companies, which are quite often the target of investment, remain outside the scope of mandatory corporate sustainability reporting requirements, such as the European Union’s Corporate Sustainability Reporting Directive 2021. In Asia, adequate regulatory guidelines are in short supply and very few companies offer independently assured ESG performance data. Voluntary disclosures prepared by the investee companies may not contain all relevant ESG data needed for due diligence. They may also be subject to greenwashing and exaggerations of performance, and may be incomplete for the VC fund’s own compliance purposes.
VC managers increasingly reference the impact investment approaches of private equity around ESG risks management for guidance. However, in contrast to private equity, which often buys in at the proven stages of performance, a VC model typically invests at the early stages when companies are still testing and refining their business models as they grow. Such uncertainty, while stimulating innovation and agility in anticipation of outsized rewards, invites higher degrees of risk. A start-up, for example, can easily shift direction as it develops products and/or services in response to market demand, creating a new set of ESG issues and risks for the fund manager. Its brand can also be significantly damaged due to a lack of governance policy and expertise to attract and retain top talent as it grows. Poor ESG risk judgement is costly in terms of return on equity, reputation and the ability to raise future capital.
Structural and process challenges
When establishing a fund’s internal framework, further structural and process challenges arise with the integration of an ESG mindset into the fund’s operations and those of its portfolio companies.
Influence. VC funds often take minority stakes that are diluted through future funding rounds, just as the level of ESG risk grows. Fund managers may therefore become reliant on the strength of their relationship with a founder or management team to exert informal influence over ESG alignment. Additionally, they may be in conflict with later stage investors’ parameters for risk management, which may differ from the VC fund’s own ESG strategy.
Governance. Early stage companies in Hong Kong and perhaps across Asia largely lack formal governance and compliance processes, with little or no oversight or management competencies for ESG at the board level. VC fund managers themselves generally have comparatively small teams and may not be able to support all companies with the governance oversight needed.
ESG expertise. During the early stages of development, a VC-backed company’s whole business model can shift direction in response to the market and value creation opportunities, potentially opening new and unforeseen ESG risks and opportunities. Unexpected changes in strategy or direction can be problematic for funds that have their own limited scope in ESG expertise and the ability to quickly assess any new risks as they come on the radar.
Timing of ESG actions. It is particularly challenging for VC funds to time ESG interventions within its portfolio of high-growth start-ups. There is a fine balance between allowing companies the room to manoeuvre and innovate and adding portfolio value by formalising processes to support the fund’s exit strategy.
ESG strategy
Establishing an overall ESG strategy and management system is foundational to the life cycle of a fund. At a minimum, the following core elements of an effective ESG strategy are necessary to address the emerging industry challenges and the individual portfolio risks.
ESG policy. Each fund should develop an ESG policy, outlining a core set of responsible investment principles and summarising the fund’s approach for integrating ESG into its investment processes, locking onto both the aspirational and the actionable.
ESG requirements. Fund managers should identify a set of ESG requirements or standards relevant to the scope and purpose of the portfolio. This should include adherence to all applicable ESG laws and regulations as a minimum. Be mindful that the fund’s limited partners will often have their own ESG investment criteria, which will contribute to the baseline of the portfolio’s ESG requirements.
Roles and responsibilities. Clear allocation of responsibility for the ESG system and portfolio action plans is critical. This includes the allocation of resources and the expertise for day-to-day implementation (matching the fund’s risk appetite) and the competencies and training of individual managers assigned. While many firms manage ESG through their investment teams, it is not uncommon to see ESG advisory committees attached to the board of directors and senior managers.
Reporting and disclosures. Publication of annual ESG performance to stakeholders provides the transparency and accountability increasingly demanded of institutions as a barometer of progressive performance. It also provides peer comparability in performance and supports limited partners and other professional investors’ risk management strategies.
Managing failure. Many VC-backed companies will ultimately fail. VC managers take an important role in helping to ensure that these companies are wound up responsibly. This could include supporting the transparent communications to stakeholders and developing a common retrenchment framework aligned with international standards.
The big picture
In summary, adopting an ESG mindset and enacting an internal framework and processes for portfolio sustainability is gaining traction with today’s smart money. The shift to integrating responsible investing via an ESG strategy is firmly on the VC investment radar for two broad reasons.
Sustainable investment practices are now tacitly credited for having a material impact on investment valuations and have recognised value with fund managers, not only in achieving environmental and social change and impact, but also in reducing costs, minimising risks, accessing talent and driving sales.
In today’s climate-challenged operating environment and post-Covid social justice awareness, stakeholders display increased expectations of companies, not only for taking responsibility for their internal footprint, but also in terms of what and how that company contributes to the future well-being of the planet and societies.
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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