ESG Continues To Gather Steam In Venture Capital Investing

ESG frameworks (at least at some level) have been around for some time in the private equity space. However, we have seen a continued move away from ESG being a box-ticking exercise as part of the side letter process to a critical area of focus and part of the investment process for investors, managers, portfolio companies and consumers.

Venture capital is sometimes perceived as a relatively slow adopter of ESG frameworks when compared to other private equity strategies such as buyout…but there is a good reason.

Venture capital managers generally have smaller teams with more limited resources as well as immature portfolio companies lacking the means to adopt best practices in ESG. Venture capitalists would argue, however, that ESG is built into the investment process; it’s just not explicit. Some firms have made it explicit though, drawing up ESG frameworks of their own that mesh better with their particular investment processes and strategies and that they feel work better than the generic industry frameworks.

With the market beginning to show a correlation between ESG implementation and high-performance the industry is beginning to adapt:

1. Investor Level – during the fund due diligence process some investors will avoid managers that do not implement ESG into (a) their investment process or (b) the running of their own business (for example by having a clear diversity and inclusion policy). They will simply exclude the manager. Consequently, we are seeing venture capital groups step up their ESG efforts and put in place clear frameworks for delivery and reporting of ESG metrics.
2. Fund Manager and Portfolio Company Level – venture capitalists would argue ESG has always been part of the investment process, but this is now far more explicit in investment decision-making. Not only does a robust ESG framework help manage risk; there is also clear evidence that portfolio companies with good ESG scores outperform others. That is not to say that VCs only invest in companies that already have ESG policies in place, but that they are also looking for companies that have an ESG ambition and vision. Critically, in the Venture Capital space, early-stage companies that imbed ESG principles will be better positioned for IPO and therefore generally more attractive. Additionally, portfolio companies themselves may lack the in-house knowledge and expertise to create and live by ESG processes, so venture capital firms are well placed to give those companies with an ESG ambition some specific KPIs that help them achieve it – and then stick to it.
3. Consumer Level – increasingly consumers want ethical products and will exclude companies that do not have regard for the environment and social impact of their businesses. In an increasingly competitive market, there is no choice but to listen to the consumer.

Venture Capital & ESG – Where Are We Today?

According to surveys by the UNPRI and our own observations at Crestbridge, there have been some real moves towards ESG within the industry, with tailored exclusion policies, the addition of ESG clauses and KPIs in deal documentation, and post-investment enquiries monitoring the risk exposures and ESG policies of portfolio companies.

The “Great Resignation” has also created a highly competitive job market in many industries. This competition for talent is shifting company policy at both the fund manager level and portfolio company level to align more with staff. Within funds, VC CFOs and COOs having to outbid each other for good staff, increasing salaries, but also offering extra benefits like carry to those in roles who aren’t traditionally offered carry. Participants also discussed how they’re handling diversity and inclusion, and the progress made at their own firms in attracting diverse staff.

The Venture Capital Market Today

Venture Capital deal activity in 2021 – 2022 has picked up compared to the pandemic years and we are seeing some interesting trends.

The upheaval of Europe’s energy policy following the conflict in Ukraine favours bold start-ups in the green energy and climate sectors. The market is expecting a marked shift of investment capital and debt in that direction, making venture capital and venture debt investments and lending respectively, more environmentally focused and climate-conscious. This is a trend that is unlikely to reverse itself anytime soon and should persist well after the Russia-Ukraine conflict abates.

There is also an ongoing focus on sub-strategies/niches such as supply chain technology where, for example, artificial intelligence and robotics are being deployed – be it in driverless lorries or enhanced/live tracking of shipments. We also continue to see strong investment in the biotech and pharma sectors as health remains at the forefront of our minds. A further development is the ongoing diversification of typical private equity (buyout) and debt managers. We are seeing such managers enter the venture capital space (building or buying expert teams) as they hunt for yield.

So, the acceleration of investment in healthcare and technology continues through 2022 and its important and encouraging to note an increasing sense of responsibility within the industry and to consider that a lot of this investment will likely benefit the planet and each of us in the years ahead.

Alex Di Santo is Group Head of Private Equity at Crestbridge