Venture capital (VC) investors and the start-ups that they invest in are latecomers to ESG and sustainable investing which has swept the finance world in recent years. Getting companies on the right track from the earliest stage is logical, but investors paradoxically do not give this enough focus. Understanding why this is the case when their private equity buyout cousins have embraced ESG and impact investing over recent years needs to be better understood.
However, over the last year, we have observed increasing interest in the topic, mainly driven by European VC funds working towards building an active community to push forward the adoption of ESG in VC.
The PRI has also seen a growing number of VC firms becoming signatories over the last year and will be increasing its efforts in the VC space. These include a VC discussion paper to be released in November and case studies to be gathered and launched in the first quarter of 2022.
While researching for the VC discussion paper, the PRI has collaborated with VentureESG, a new global initiative, co-founded by Houghton Street Ventures and GMG Ventures, of currently over 170 VC funds working together to push the industry forward.
ESG incorporation in venture capital
To capture current trends around ESG adoption in the industry, the PRI and VentureESG undertook a survey of VC firms in our respective communities. We wanted to understand who is driving the desire to incorporate ESG? What are funds already doing, and how are they developing further? What is holding them back, and where is support most needed?
In advance of the discussion paper, we wanted to share some initial insights from the survey results based on more than 100 individual fund responses that we received.
One important caveat to keep in mind is that most VC funds involved are likely already more involved in ESG efforts than the average VC fund - either because they are already PRI signatories or part of the VentureESG community. Hence, our survey findings are skewed positively and will likely overstate what the VC industry is doing overall.
Key findings of the survey
We detail below some findings from the survey that indicate the state of the industry:
- DEI is a focus area, but ESG overall is not well integrated with investment teams: Common current ESG incorporation activities include basic actions such as using exclusion lists to negatively screen out investments during due diligence and gathering a small number of ESG datapoints from investee companies. It is also clear that diversity is a substantial focus area. However, ESG is still primarily conducted in a silo and rarely contributes to systematic and thorough analysis and/or investment decision making.
- High adoption of pre-investment screening: Current leading practices include ESG portfolio company DDQ’s used by the investment team (including risk and opportunities as part of ‘ESG screening’), ESG term sheet clauses, ESG portfolio support through platform teams, ESG KPIs tracked over time (and reported on to LPs), and VC internal ESG scrutiny (e.g. DEI of investment team). However, the tools used are not always well-tailored to VC. For example, many pre-investment screens include business activities that are unlikely to be encountered in VC and do not include many activities that are likely to be found. (e.g. responsible product design, data management).
- Asset Owners (LPs) are not a driving force behind ESG adoption: most respondents were keen to notice that it was them personally or their fund that embraced ESG as a set of values and was the most crucial driver. However, only a minority felt that LPs or their portfolio companies or founders were pushing them. Notably, most respondents also believe that considering ESG factors improves their investments’ risk/return profile.
There’s much to work on to improve responsible investment in VC, and the understanding of it across the asset class is finally slowly developing.
Practice is highly focused on certain areas of ESG
There is often a lack of understanding around key terminology in VC. For example, many VC impact firms have been established with a blend of impact and ESG practices, but the difference between the two is not well understood. In addition, a comprehensive view on and approach to ESG is generally lacking, with specific ESG topics being focused on and others not being addressed.
Climate is not given enough attention. For example, many VC investors in our survey reported tracking their own scope 1 and 2 emissions, but very few VC investors in the mainstream market measure Scope 3 emissions, for example, portfolio company emissions. This needs to change, particularly for later-stage VC investors as their portfolio companies scale.
Social issues are often boiled down to diversity, equity, and inclusion (DEI). 74% of the VC investors are tracking DEI across their portfolio companies, but only 25% scrutinise the supply chain. For example, when it comes to working conditions, more focus on other social issues is needed, particularly human rights, according to a recent report by Amnesty International that slammed the VC industry for doing very little on that front.
Governance means ‘board’ issues for most VCs. Tax and anti-bribery issues are only considered by <35% of investors in our sample and ownership structures such as dual-class shares (which have already caused issues for IPOs of, e.g. Deliveroo) are under-scrutinised.
What is holding the VC industry back?
Unlike other asset classes, VC has come under little scrutiny by the responsible investment movement. However, there are several structural barriers that the PRIs discussion paper will explore further.
To start with, time and resources are essential to dedicate to ESG incorporation, and VC firms are often small and lean. As a result, they rarely have dedicated resources in-house to focus on ESG. Not only that, but the lack of VC-specific guidance, expertise and knowledge is a barrier.
We see this quite clearly in the market. There is an opportunity for PRI and others such as VentureESG to help convene VC investors and improve practices. Therefore, the PRI is launching a new VC collaboration, including quarterly calls to convene VC managers and asset owners that allocate to VC. Signatories and non-signatories of the PRI are invited to sign up here.
Additionally, the PRI is calling for signatories interested in submitting a case study on how they incorporate ESG as a VC investor (either as a GP or LP); if this is of interest to you, then please get in touch with Peter Dunbar.
This blog is written by PRI staff members and guest contributors. Our goal is to contribute to the broader debate around topical issues and to help showcase some of our research and other work that we undertake in support of our signatories.Please note that although you can expect to find some posts here that broadly accord with the PRI’s official views, the blog authors write in their individual capacity and there is no “house view”. Nor do the views and opinions expressed on this blog constitute financial or other professional advice.If you have any questions, please contact us at firstname.lastname@example.org.