Venture capital increasing adoption of environmental, social, & governance (ESG) principles

Increased adoption of environmental, social, and governance (ESG) principles has been empirically linked to improved financial performance, but venture capital (VC) has fallen behind other sectors in embracing such measures. With more than $100 trillion in assets under management (AUM) already being managed according to the ESG framework globally, a recent article by Johannes Lenhard and Susan Winterberg provides some guidance on how VC can improve in adopting ESG principles, while also giving some pointers to limited partners (LPs) in VC funds, regulators, and company founders — the groups that have been the drivers of what little ESG adoption VC has experienced.

Introduced in a landmark 2004 United Nation’s report, ESG was at first largely dismissed by leaders across many sectors as a values-based framework rather than as a framework for identifying and mitigating material risks not identified in traditional financial statements, but which may have significant impacts on financial success regardless of the asset class. Yet, as the public’s appetite continued to grow for more socially and environmentally conscious companies and investments, many sectors saw increases in the adoption of ESG principles, and Lenhard and Winterberg point to the growing body of research that continues to attest to the financial benefits of increasing ESG commitments. Emerging studies (McKinsey, HBR) are also showing that VC, specifically, may benefit financially from supporting high-ESG companies, as other sectors have that were quicker in adopting ESG.

VC was particularly dismissive of ESG initially, taking it as a strategy for which investment companies are chosen, rather than as a framework for which the funds themselves are managed. Lenhard and Winterberg recently found that only five of the top 50 VC funds mentioned ESG or a commitment to sustainability on their websites, while only a few dozen VC firms worldwide have made public commitments to adopt ESG principles. An Amnesty International report found almost no evidence for any of the world’s largest VC funds having considered human rights in their investment processes, while only one of many ESG topics — diversity, equity, and inclusion (DEI) — has seen widespread focus among VCs.

PitchBook’s 2020 Sustainable Investment Survey, found that the biggest challenges to increasing ESG adoption in VC include 1) a lack of clarity on how to define and measure ESG performance; 2) a lack of ESG data on private companies; and, 3) persistent perceptions that ESG investing strategies generate lower returns. The top two challenges remained the same in PitchBook’s 2021 report, while the third issue surrounding prevailing perceptions of the negative investing impacts of ESG fell to fifth place. While perceptions of ESG have begun to change, difficulty benchmarking nonfinancial goals and understanding the wide breadth of sustainable investing options have become more pressing challenges. Additionally, a lack of diversity among fund managers and limited pressure from LPs to adopt ESG for fear of losing allocations in top-performing funds have contributed to the sector’s sluggishness in adopting ESG.

However, Lenhard and Winterberg provide evidence for how ESG principles have been able to begin taking root in VC. They draw on evidence showing that changing attitudes toward ESG by company founders and some limited partners; increases in social impact funds and targeted DEI funds; and, the current clean energy tech boom are all contributing to changing the culture of VC and the prevalence of ESG principles within the sector. Lenhard and Winterberg’s final recommendations for increasing ESG adoption in VC are based on this analysis of the industry’s strengths and weaknesses, the challenges outlined above, and the empirical evidence for the financial benefits of increased ESG adoption to provide a roadmap towards increased ESG adoption.

The roadmap provides instruction on a player-specific basis with the authors providing guidance tailored to the following four groups:

1. VC Funds: Funds should start by simply adopting ESG principles themselves and then apply ESG considerations to investment processes. Once the fund has adopted ESG principles, managers can implement ESG throughout investment and company lifecycles by writing ESG requirements into term sheets, incorporating ESG into acceleration and other business development services, and reporting on the status/progress of portfolio companies’ ESG efforts.
2. Limited Partners: should consider ESG in allocation decision-making, incorporate due diligence questions focused on funds’ ESG processes/principles, and make follow-on investments dependent on ESG performance.
3. Market Research, Data Providers, and Ratings Agencies: These organizations should include ESG stats in trends reports and provide ESG ratings for late-stage companies with a valuation.
4. Regulators: Government should increase its support for ESG and increase regulation for reporting on private capital and VC.