Building Resilient Portfolios: The Case for ESG in VC

Investing in companies with a moral compass is good for business. Looming global risks affect businesses directly or indirectly, making the consideration of Environmental, Social, and Governance (ESG) factors increasingly crucial. For venture capital (VC) funds, integrating ESG principles can significantly influence both opportunities and risks, ultimately shaping the sustainability and success of their investments.

Assessing ESG Factors

Startups are all about innovating, adapting, and solving problems in a meaningful way to add value and generate profit. Having a blind spot to the three ESG pillars and not incorporating them into the growth strategy can prove to be lethal for a startup's very existence. Sustainability is the epicenter of a business, and most often, businesses overlook these pillars. As Fred Wilson says, “Sustainability is all about figuring out how to be in business forever. It is about business models that are win/win and lead to happy long-term customer and supplier relationships.”

Threats to VC Funds Ignoring ESG

VC funds face significant threats if their portfolio companies fail to incorporate ESG into their strategy:

• Reputational Damage: Negative environmental or social impacts by portfolio companies can cause reputational damage to VC funds, affecting their ability to raise capital and attract investors (LPs).
• Regulatory and Legal Risks: Non-compliance with ESG regulations can lead to fines, penalties, and legal actions, impacting VC funds' financial returns and reputation.
• Market and Customer Demand: Customers increasingly demand products and services from companies that prioritize sustainability and social responsibility, risking market share loss for non-ESG-compliant companies.
• Operational Disruptions: Poor management of environmental and social risks can lead to supply chain disruptions and business interruptions, negatively impacting financial performance.
• Financial Underperformance: Ignoring ESG risks can lead to long-term financial underperformance, affecting VC funds' returns and their ability to raise future capital.

Increasing LP Expectations for ESG Compliance

An increasing number of limited partners (LPs) expect ESG compliance, which can:

• Increase Profitability by Lowering Tail Risk: Sequoia, Paradigm, and Temasek had to write off close to $200 million in FTX post its debacle. Similar situations like Theranos and Yunniao could be flagged in an ESG audit.
• Align Investments with Values: LPs increasingly want to finance companies that make the world a better place, avoiding those involved in negative ESG practices.
• Key to Meaningful Exits: ESG performance is crucial for raising follow-on capital or exiting to larger PE funds, strategic investors, or through IPOs. ESG disclosure requirements are increasing globally.

What’s Good for Your Portfolio Company is Good for You

A strong ESG proposition links to value creation in five essential ways:

• Top-line Growth: Attract B2B and B2C customers with more sustainable products and achieve better access to resources through stronger community and government relations.
• Cost Reductions: Lower energy consumption and reduce water intake, avoiding unnecessary waste and higher disposal costs.
• Regulatory and Legal Interventions: Achieve greater strategic freedom through deregulation and earn subsidies and government support.
• Productivity Uplift: Boost employee motivation and attract talent through greater social credibility.
• Investment and Asset Optimization: Enhance investment returns by allocating capital for the long term and avoiding investments that may not pay off due to environmental issues.

Recommended Actions for VC Funds at various stages

1. Deal Origination: Screen for ESG-related ‘fatal flaws’ and incorporate ESG clauses in legal agreements.
2. Due Diligence: Analyze ESG issues, assess performance, and consider site visits for higher-risk businesses.
3. Portfolio Management: Engage on material ESG issues, adopt a risk-based approach, and re-assess risks and opportunities.
4. Reporting and Compliance: Monitor key performance indicators, comply with standards like BRSR, GRI, TCFD, and SASB, and ensure ESG practices remain post-exit.

ESG integration is no longer optional for VC funds; it is a necessity. By adopting robust ESG practices, VC funds can enhance their reputation, improve financial performance, and contribute to a sustainable future. The time to act is now—embracing ESG not only safeguards investments but also paves the way for long-term success and positive societal impact.