It is a truth universally acknowledged that an early-stage investor’s goal is to start working with great companies while they are young to help them grow, and to reap the rewards when they succeed. But here’s a question almost universally ignored: should VCs focus on investing responsibly and sustainably?
I’m not talking about ‘impact investing’, which is a different field altogether. I’m talking about how VC investors can — and should — measure their impact on, and commitment to, environmental, social and governance (ESG) goals.
ESG commitments are common in other industries, and in other asset classes. ESG can create real business value — yet implementation in VC remains uncommon. But the impact, and the upside, could be huge.
Why should VCs care about ESG?
Of course, VCs should care simply because ESG considerations matter. If a VC investor embraces ESG in their investment process, it means that the companies in which they invest are more likely to create sustainable value, make a positive contribution to the world and lead the way in terms of diversity.
But there is a financial case for ESG too. Companies that implement ESG typically perform 4.8% better than those that don’t; according to Harvard Business School, they perform better when considering accounting rates of return.
According to research conducted by Deutsche Bank which evaluated 56 academic studies, 89% of these studies showed that companies with high ESG factors outperformed the market in the medium- (3–5 years) and long-term (5–10 years).
“Companies that implement ESG typically perform 4.8% better than those that don’t.”
And of course, portfolio companies need to sell their wares to the market. When it comes to the end users of VC portfolio companies’ products and services, the purchasing decisions of customers (especially millennials) are increasingly ESG values-driven. In light of climate change, gender and racial inequality, consumers of today demand solutions that not only mitigate the negative impact on the environment and the society but also contribute to improving the global situation. Having such companies in your portfolio can thus be highly beneficial.
Another solid reason that VCs should care about ESG, is that your investors want you to. In fact, limited partners increasingly expect VC funds to demonstrate a meaningful approach to responsible investment. According to a 2017 survey conducted on 22,000 investors by Schroders, 78% felt that sustainable investing was becoming more important, and 64% had increased their sustainable investments over the previous five years.
What are ESG goals, and how can they be applied in VC?
As a VC, you will likely want to monitor the ESG impact of your fund, and that of your portfolio companies. With this in mind, the first important question to ask is: what kind of impact do we want to make?
Answering this question will help you outline responsible investment standards and requirements, and create measurable goals. Having goals is critical, as setting both quantitative and qualitative targets will define ESG accomplishments.
Quantitative goals include tracking things like number of jobs created, number of women employed in white-collar roles, estimation of potential contribution to GDP, effect on climate change, emissions etc. Qualitative targets can include taking a public stance on important issues such as labour conditions, or rates of diversity in a particular industry.
“Track things like number of jobs created, number of women employed in white-collar roles, potential contribution to GDP and effect on climate change.”
Once you’ve decided what you want to measure, you need to ensure that ESG implementation and monitoring is incorporated into your investment decision-making and portfolio tracking processes. How do you capture data about yourselves and your portfolio? And, importantly, how is this meaningfully assessed? This cannot be an afterthought.
At Antler, we conduct ESG due diligence ahead of all investment decisions that we make. This takes the form of questionnaires that are completed by our investment team. We are also in the process of setting an ‘ESG code of conduct’ as part of deal documentation. When this is implemented, our team will use an ESG scorecard to capture data, and also recommend how any ESG ‘red flags’ could be rectified.
Going further, some LPs may require you to provide an annual ESG summary, so it is useful to develop best practices. If they don’t already require you to report on ESG — do it anyway.
Reporting on ESG ensures that a fund is accountable for its decisions. It is very easy for a VC fund to ‘mean well’, but until it puts positive policies in place, this is no real use. Reporting standards, such as ESG, ensure that best practices and good behaviours are enforced. VCs can also become signatories to the UN’s ESG standards: the UN Principles for Responsible Investment (UNPRI).
How does ESG work with portfolio companies?
As far as portfolio companies are concerned, ESG starts with deal flow. When a fund is screening companies, its aforementioned ‘standards and requirements’ should exclude startups that would raise ESG issues.
Examples of these are companies that are affiliated to industries such as weapons manufacturing, or use child, or forced labour. Many VC and PE funds already steer clear of these. Finance institution CDC has a good and clear exclusion policy, which omits technologies such as face recognition used by the military, or gaming software used by gambling firms. Perhaps unsurprisingly, VCs are distancing themselves from tobacco, alcohol, and weapons products too.
Once a company has received investment, or ideally before, they should be introduced to the fund’s ESG practices. As a fund, you may want to help your portfolio companies draft their ESG policy, set their ESG targets and provide them with the education and tools required to succeed in tracking and achieving those targets.
“Not only does ESG help companies and investors create a better world, but it also helps drive performance.”
To use two examples from the Antler portfolio, PowerX’s target is to optimise every heater in the world, in order to save over 100m tons of CO2 every year. Yayzy wants to cut emissions in half within 10 years.
Both sides need to be committed here, so I would recommend that information rights on ESG and code of conduct are incorporated into legal documentation.
ESG is currently rare in VC, but we believe that it will become commonplace. Not only does ESG help companies and investors create a better world, but it also helps drive performance. For us, it’s a no brainer.
Dilan Mizrakli Landgraff is cofounder and chief strategy, people and culture officer at global early-stage VC firm Antler.