It’s not just that environmental, social and governance-focused investing is on the rise, a lot more people are talking about it too.
But ask most LPs and GPs what ESG is all about, and you’re likely to get a range of answers that cover impact funds, diversity and inclusion, and sustainability investing. Then there’s the question of how GPs are enacting ESG principles.
So Venture Capital Journal reached out to Nidhi Chadda, founder and chief executive of Enzo Advisors, a New York-based sustainability consulting firm that works with early-stage companies and institutional investors to codify ESG processes and incorporate them into their business operations.
First off, tell us about Enzo Advisors.
We help corporations and investors incorporate best-in-class sustainability practices into their business models.
We view ESG not only as a risk-management tool, but as a long-term value creation opportunity. As ESG practices are so integrated with the operations of a company, those companies with robust ESG practices tend to also have higher-quality business models, and therefore, are relatively more resilient to unexpected shocks, as we saw during the pandemic.
We also recognize that every firm is on a different journey when it comes to ESG integration. Therefore, we take a customized approach in assisting companies and investors with the development, structuring, implementation and communication of their ESG programs and strategies.
What are the top misconceptions that the venture community has about ESG?
The first is that it’s too early to consider ESG. There is a general misconception that given the skewed exposure to early-stage technology, ESG frameworks are not as relevant.
That is not the case, as there are number of key factors across E, S and G that are applicable to early-stage companies. We have also seen a number of late-stage ventures face a host of governance issues.
Last year demonstrated that it is never too early to integrate sustainability into one’s investment process. As VCs support the seeds of innovation, they have a unique opportunity to shape companies from the beginning by advising founders on how to become capital-efficient, create positive and lasting brands, grow teams and support diversity in recruiting, build a more resilient supply chain, and eliminate operational waste to drive returns, all of which are material ESG factors to consider.
When these companies mature and eventually exit, they will face additional ESG-related scrutiny across all levels, and therefore, it is beneficial to evaluate these risk factors and opportunities early in the lifecycle. There already appears to be more of a valuation premium in the market for those companies incorporating a more refined sustainability impact framework that falls within the broader ESG landscape.
It seems that people often equate impact with ESG. Are they interchangeable?
ESG, socially responsible investing and impact investing are often used interchangeably, but there are distinct differences that could impact how portfolios are constructed and which investments are suitable for meeting these goals.
We view ESG as a broader umbrella, and SRI [socially responsible investing] and impact investing as segments within the broader world of ESG as they have a pretty targeted focus. SRI often refers to negative screening – excluding oil and gas, tobacco and the like – while impact investing is looking for not only returns but a way to measure societal impact.
Venture has historically supported the seeds of founder-led innovation which has transformed society in a meaningful way. Electric vehicles are only a recent example of such innovation that is now disrupting markets globally and falls within the cleantech umbrella.
The rise of ESG investments across cleantech, climate tech and the public health sectors further supports how ESG within VC may have been referenced with other names.
What’s your advice for VCs?
As venture capitalists are conducting their due diligence and onboarding portfolio companies, they should think through the various risk factors and opportunities based on global standards and frameworks as it applies to the value chain for each company, benchmarked against peers. The typical ESG frameworks could still apply, but the level of relative importance may vary by sector or maturity / life cycle.
The standards do vary by geography, which adds in an additional layer of complexity for firms in adapting ESG frameworks.
Talk about returns. Does ESG investing mean sacrificing returns?
The events of 2020 from the global coronavirus pandemic, the weather extremes and the social unrest have only further reinforced the importance of sustainability for corporations and investors alike. According to a report from the US SIF Foundation, one in three dollars of overall assets under management in the US is now subject to some type of sustainable investment strategy.
Sustainable funds have attracted a record $51 billion in 2020, more than twice the previous record set in 2019 and the group has seen a 4x increase over the last decade according to Morningstar.
Academic research suggests that ESG–focused funds outperform the market and have demonstrated lower volatility. Morningstar research says that sustainable funds have also outperformed on a one-, three- and five-year basis relative to their categories. In 2020, three out of every four sustainable equity funds finished in the top half of their Morningstar category, and 43 percent posted top-quartile returns. The results are similar on a five-year basis.
According to a recent study by Blackrock, over 75 percent of sustainable indices have outperformed in the last 4 downturns.
How should a venture fund begin to think about crafting an ESG strategy for their portfolio?
ESG frameworks should be considered in the VCs’ entire investment process, from sourcing deal flow to due diligence and portfolio management. These standards enable the identification, measurement, management and communication of business-critical risk and opportunities.
To establish a firmwide ESG policy, VCs must create ESG and impact goals, defining what aspirational goals best reflects a firm’s beliefs, and what degree of impact the VC fund aims to create and where on the impact investing spectrum they fall.
Also, create an ESG roadmap. After assessing the level of impact a VC fund aims to achieve, the VC must build an ESG roadmap that incorporates a detailed assessment of the material risks and opportunities relevant to a company in its given sector, benchmarked versus peers, which will help unlock potential opportunities to drive long-term value.
And monitor and benchmark the portfolio. A VC should define metrics to track progress against the initiatives outlined in the roadmap. Alongside returns, VCs could include additional key performance indicators linked to their ESG roadmap and to measure progress against their impact goals while benchmarking progress against peers, for the overall portfolio.