Environmental, social, and governance (ESG) criteria is making its way into the venture capital space. From 2016 to 2018, ESG integration increased by 69% across global public and private markets, according to the 2018 Global Sustainable Investment Review. Nearly two-thirds of investors believe that ESG guidance will become essential to alternative assets over the next three years, as stated in the 2019 Preqin Global Private Equity and Venture Capital Report.
The trend reflects a larger shift—in business, consumerism, and investing—toward greater awareness of impact. As consumers are making more socially and environmentally conscious choices, investors are looking to support the funds and companies that drive positive change.
Also often called sustainable investing, impact investing, socially conscious investing, or socially responsible investing, ESG investing has gained significant momentum over the past few years—and the coronavirus pandemic has accelerated its speed. In June 2020, there were 534 sustainability-focused index funds globally, with collective assets totaling $250 billion, according to the Morningstar Passive Sustainable Funds: The Global Landscape 2020. Sustainable assets in the US are growing at a particularly rapid rate; after quadrupling from 2017 to 2020, the US now accounts for 20% of all global ESG assets, per the same report.
However, only a segment of venture funds incorporate impact measurement into their work; the ones that do usually embed impact into their investment theses. Most generalist funds haven’t adopted frameworks for measuring the impact of their portfolio and funds. Furthermore, there are many different approaches to measuring outcomes—no single framework applies broadly across venture capital.
As investors increasingly focus how their portfolios broadly affect the environment and society, LPs are likely to demand that all venture funds—no matter their focus—begin to measure and report impact along with financial performance. Fund managers may need to figure out how to adapt their processes and goals. That starts with understanding what exactly ESG investing is, what types of global ESG policies exist, and what institutional investors expect from fund managers.
What is ESG investing?
ESG investing is the practice of considering environmental, social, and governance factors when making investment decisions. Environmental criteria measure how organizations and companies protect the environment; social criteria examine the relationships between suppliers, customers, and employees; and governance criteria apply to leadership, management, and shareholder rights.
When investors use ESG guidelines to evaluate investment opportunities, they’re not just reviewing financial metrics. They’re also looking at how companies address topics like climate change, gender equality, social justice, and pay equity.
Global ESG policies
Three global ESG policies have influenced how investors measure impact:
The Paris Agreement
An international treaty that went into effect in 2016, The Paris Agreement brought together 196 countries with the common goal of fighting climate change. The agreement depends on countries sharing resources and helping one another both technically and financially to achieve their short and long-term goals.
Every five years, countries submit their respective plans—called “nationally determined contributions”—to reduce greenhouse gas emissions.
United Nations Sustainable Development Goals
The United Nations (UN) Sustainable Development Goals (SDGs) are a series of 17 global goals designed to protect the planet and improve the well-being of everyone on it. The goals range from reducing poverty and fighting climate change to achieving gender equality and making education more accessible.
Since they were adopted in 2015, SDGs have provided a framework for companies, investors, and fund managers to measure their social and environmental impacts. In fact, 73% of investors surveyed in the 2020 Global Impact Investing Network annual impact survey said they use SDGs for at least one measurement or management purpose.
Principles for Responsible Investment
Principles for Responsible Investment (PRI) is an international network of investors supported by the UN. To help investors incorporate ESG criteria into their investment evaluations and practices, PRI developed six principles of responsible investing.
For each principle, PRI suggests a series of actions investors and fund managers can take. For example, for principle one—“We will incorporate ESG issues into investment analysis and decision-making processes”—PRI recommends implementing ESG training and addressing ESG issues in investment policy statements.
How are institutional investors using ESG guidelines?
As more institutional limited partners adopt ESG guidelines, they’re weighing new factors into their decision-making. In addition to considering a firm’s overall portfolio performance and financial metrics, LPs might also look at a firm’s board governance, team diversity, and environmental impact.
The Institutional Limited Partners Association (ILPA) provides a handful of guides and resources LPs can use to better incorporate ESG considerations into their investments. Their ESG Roadmap covers the following areas:
- Organizational policy and infrastructure: ILPA recommends that institutional investors identify their ESG core values, publishing an ESG policy, and appointing an ESG specialist, among other tips.
- Due diligence and investment decision-making: ILPA suggests adding ESG topics to their due diligence questionnaire, requesting ESG policies from general partners (GPs), and incorporating ESG considerations into investment committee criteria.
- Managing GP relationships: ILPA recommends that LPs collaborate with GPs to improve internal monitoring and codifying ESG expectations within side letter agreements.
- Reporting and benchmarking: ILPA says that LPs should request and monitor ESG-specific key performance indicators and encourage GPs to report on ESG performance at the firm level.
- Internal and external communications: ILPA suggests that institutional investors incorporate ESG into annual reports and publish ESG performance on their organizations’ websites.
Many LPs are also starting to use scorecards to assess a firm’s ESG impact. Scorecards—which can be a mix of qualitative and quantitative data—offer a simple, standardized way to compare and evaluate funds. Here’s how scorecards generally work.
- LPs select out which ESG categories they want to evaluate—anything from board governance to environmental impact.
- Using their organization’s own ESG standards and metrics, LPs define what constitutes a low, medium, and high score. For example, if they’re using a one-to-five scoring system for funds, they might deem one as “inexperienced” and five as “a leader.”
- LPs give GPs a scorecard questionnaire to fill out, asking them about their fund’s ESG impacts and processes. LPs then evaluate the answers and assign funds a score according to their system.
What types of impact frameworks are fund managers adopting?
As institutional investors adopt ESG frameworks, fund managers are beginning to think about how to measure the impact of their investments. In parallel, fund managers may see more LPs requesting impact information. The challenge for venture capital firms is deciding which frameworks are suited to venture portfolios.
The Criterion Institute, for example, is dedicated to gender lens investing, which incorporates data and analysis around gender equality into decision-making. The non-profit think tank created a framework to help other organizations develop their own gender lens investing strategies. It looks at investment theses, investment processes, organizational practices, and fundraising strategies.
Another example is the Impact Management Project (IMP), a global organization that sets standards for measuring and reporting sustainability. In order for fund managers to understand portfolio performance as it relates to impact, IMP recommends gathering data five dimensions of impact:
- What: What is the impact?
- Who: Who experiences the impact?
- How much: What degree of impact is there and how long does it last?
- Contribution: Are the intended outcomes better than what would have occurred otherwise?
- Risk: What’s the likelihood that the impact will be different than expected?
Some GPs do qualitative analyses based on these five dimensions, while others use scorecards to assign themselves a score for each dimension.
A path forward for ESG guidelines
ESG is moving into the private market quickly—and there is still a lot of work to be done to identify frameworks that are best aligned to the venture capital model. Finding a framework to measure your fund’s ESG impact helps you stay competitive, satisfy LPs, and create meaningful change in the world. Every framework is slightly different, but each one has the same purpose: to help you forecast your ESG impact. Retroactively evaluating your fund’s impact doesn’t work. In order to make progress, you have to take a proactive approach to ESG implementation and assessment. That means considering your fund’s goals, behaviors, and measurement strategies in advance, then regularly evaluating your performance.