How to do well by doing good
To maximise the profits that can come from committing to ESG, venture capital needs to elevate the issue beyond a due diligence consideration, says Seb Murray for the BVCA Journal.
Venture capital is no exception to the trend towards profit with purpose that is currently capturing hearts and minds within the business and investment community.
Even before the pandemic underlined the significance of looking beyond the bottom line, a survey by the European Investment Fund (EIF) found that seven in 10 venture capitalists were incorporating environmental, social and governance (ESG) criteria into their investment decisions.
The trend towards making a positive impact on society and the environment is driven in part by a growing body of research that suggests profit and purpose can go hand in hand. Indeed, the EIF survey asked venture capital funds that had adopted ESG strategies what impact they saw on returns. On average, across five different types of ESG investment strategy (such as active ownership, negative screening or impact investing, which even goes beyond an ESG strategy), 62% of respondents reported a positive impact on investment performance, compared with 4% citing a negative effect.
Bridges Fund Management embodies this new class of investor. “We feel it is necessary for investment to play a broader role beyond the generation of financial returns,” says Maggie Loo, a Partner at the fund manager in London. “But also, fundamentally we think it’s just good investing.” In fact, she says “this is the future of investment”.
Bridges backs for-profit companies with a broader social purpose. A good example is The Gym Group, which the fund co-founded in 2007. The low-cost gym chain promotes healthier lifestyles among a broader demographic than traditional health clubs. Around two-thirds of its gyms are in formerly under-served and often poorer areas. One-third of its members have not signed up to a gym before.
Bridges sold its majority holding in 2013, retaining a 25% stake. When The Gym Group went public in 2015, the IPO valued the company at £250 million and delivered a handsome return for Bridges: almost six times multiple return on its cost.
Gabe Kleinman, Head of Portfolio Services at venture capital firm Obvious Ventures in San Francisco, also sees profit in purpose. “We believe that purpose-driven companies reimagining the largest sectors of our economy will outperform their peers in the long run,” he says.
Obvious owned about 9% of Beyond Meat when the successful plant-based burger maker was floated in 2019. Beyond Meat’s product stands out in the vegan market at a moment when consumers want products that help them lead more sustainable lives.
A nuanced picture of success
Both Bridges and Obvious have proved that it is possible to do good and do well. However, there is nuance to their success. Both are examples of funds that actively seek to generate a positive social or environmental impact alongside financial return rather than screening for ESG as part of the due diligence processes. As Obvious describes it, they see profit and purpose as a virtuous circle.
The EIF report compared how different types of ESG strategy played out for venture capital funds and found that, in practice, active ownership (direct engagement with and provision of ESG expertise to portfolio companies) and impact investing were the two most beneficial strategies in terms of returns. Negative screening (driven by the mitigation of ESG-related risks), despite being the most widely used strategy, ranked last, although still with a positive impact on returns.
A 2019 S&P Global analysis found that ESG can enhance corporate profits and long-term sustainability through reduced costs, risk mitigation, higher productivity and opportunities for revenue generation. A positive approach to ESG can enable companies to make the most of these opportunities, as was the case with The Gym Group and Beyond Meat.
Pressure also continues to mount from consumers around ESG considerations. IBM research from June 2020 shows that about six in 10 people would change their shopping habits to reduce their environmental impact. Those consumers are also shaping businesses through their work choices. “A core driver of outperformance is the future workforce. Millennials and Gen Z are voting with their feet to work at purpose-driven companies,” Kleinman says.
Clean exits
The ESG performance of a company can also be a powerful determinant of exit opportunities. “We are already seeing instances where private equity firms and corporate venture arms don’t want to buy high-carbon assets, which are often being written down or sometimes written off,” says Benjamin Combes, PwC’s Assistant Director of Innovation and Sustainability.
According to McKinsey, 83% of company executives and investors it polled would pay a 10% median premium to buy a company with a positive ESG record. “Even with an IPO, people are looking, increasingly, at the environmental performance of the companies they invest in,” says Combes. Indeed, sustainable equity funds continue to outperform the wider stock market. And in a report stating that climate technology is “the next frontier for venture capital”, PwC found that early-stage funding for it surged by 3,750% from 2013 to reach US$16.1 billion in 2019. The consultancy identified 43 climate tech unicorns, such as Tesla, Nest and Oatly, that have leveraged sustainability to become billion-dollar brands.
The venture capital experience
The problem for venture capital is timing. Companies trying to solve very thorny challenges (say climate change with nuclear fusion) tend to lengthen exit horizons, which impacts returns and fees. “Moonshot projects take longer to develop their technology for market-readiness than the average fund term,” says Fabian Heilemann, a Partner at Earlybird Venture Capital in Europe. “This is a problem the industry has not yet solved.”
But most companies with strong ESG credentials do not have longer lifecycles, he says. Venture capitalists will use ESG scores to vet potential investments, whether to exclude companies with poor performance (negative screening), or to target firms with solid scores (positive screening). The latter “is seen more like an opportunity for value creation”, says Helmut Kraemer-Eis, Chief Economist at the EIF, given the robust investment thesis.
Whichever strategy funds adopt, getting a good return involves gauging ESG credentials, but this is easier said than done. Unlike with listed companies, which are ranked across a range of ESG metrics by rating agencies, VCs are making bullish bets on the future success of early-stage companies. Their infancy means that comprehensive data is hard to come by. “Start-ups are a very different kettle of fish because they are much smaller, less structured. It is less about business operations and more about the impact they are seeking to make,” says Jake Wombwell-Povey, a sustainability investor at the UK’s Vala Capital.
Many founders lack the time or resources needed to benchmark their sustainability performance. With active ownership, VCs can encourage responsible business practices. Their relationships with portfolio companies are intimate, with investors usually taking a seat on the board.
“We hope to provide start-ups with practical tools and training so they can start assessing ESG when it’s easier, as a small company. It can shape their business,” says Christine Tsai, CEO and Founding Partner of 500 Startups, a global venture capital firm. Far from limiting deal flow, she says the fund stands apart from the pack when competing for investment opportunities: “Founders look for investors with ESG expertise as part of their own due diligence.”
Tracy Barba, Director of ESG at 500 Startups, says limited partners (LPs) have outsized influence on adoption since they direct capital flows. “Their role is critical. If more LPs make ESG part of their own criteria for vetting venture funds, they will really move the needle.”
The metric maze
You manage what you measure, but there is little consensus on ESG metrics. Antonia Botsari, a Research Officer at EIF, says reaching agreement on governance is relatively straightforward because best practice has evolved over several decades. Environmental and social considerations have emerged much more recently and approaches vary.
Vala Capital, for example, uses the Impact Management Project (IMP) framework to identify and appraise the type of impact that potential investee companies have. IMP groups investments with similar characteristics into ‘impact classes’.
The fund also uses the B Impact Assessment tool to measure impact through questionnaires filed by founders. An impact report is compared with other businesses and suggestions for improvement are provided.
Companies also adopt metrics from the Sustainability Accounting Standards Board to track and disclose the impact of environmental issues on their accounts. Investments are unique and complex: there is no silver bullet. While the IMP aims to help investors navigate the alphabet soup of standards, some confusion remains for now, increasing the risk of greenwashing, which would shred the credibility of ESG.
“It could become a box-ticking exercise,” says Andrew Elder, Deputy Managing Partner of British investment manager Albion Capital. “To avoid this, it would help to define best practice and share resources across the industry.”
Here to stay
Happily, low or negative interest rates are making venture capital a more attractive asset class for institutional investors seeking impact, according to Paul Miller, CEO and Managing Partner of London’s Bethnal Green Ventures, a B Corp since 2015. He says COVID-19 has accelerated the ongoing shift from shareholder to stakeholder capitalism. “People want businesses to play a role in solving social and environmental problems. Impact investing is going to be a big growth area.”
Another positive signal is the push for diversity in response to multiple factors, including the Black Lives Matter protests against racial injustice. Albion Capital is considering asking companies to disclose ethnic diversity statistics, with research proving that diverse management teams outperform.
For the venture capital industry, such evidence seems likely to reinforce the idea that ESG has a positive effect on investment returns. As Kleinman says: “It’s in our heritage as an industry to back purpose-driven companies solving big challenges for stronger returns. The wheels are in motion.” Time to step on the gas.
This article is from the BVCA Journal spring edition, published March 2021. BVCA members can access the full publication here.
This Spring issue explores ‘how to do well by doing good’ as we examine the environmental, social and governance opportunities for venture capital; and reflects on the work-life rebalance and what this new employee-employer dynamic means for talent retention. This bumper issue also features an in-depth interview with Alice Hu Wagner on what it takes to address structural inequality; a detailed look into what makes Edinburgh such a thriving hub of financial, tech and life science expertise, and much more.
