Friday Letter: Embracing ESG leads to more collaboration with founders, say VCs

ESG has become the latest flashpoint in American culture wars, but that hasn’t stopped private funds from factoring environmental, social and governance issues into their decision making. ESG is very much top of mind for venture funds focused on late-stage and growth investments, judging by comments made by partners on a panel at affiliate title PEI’s Responsible Investment Forum in San Francisco last week.

All of the panelists said ESG is important to their firms and they all consider ESG factors before making an investment. But they noted that much of the engagement on the issue is coming from their portfolio companies themselves. Company founders are especially interested in environmental impact, but they are also keen to engage on social issues, such as hiring and retaining more women and people of color, the panelists said.

The discussion was conducted under Chatham House rules, meaning Venture Capital Journal can report on what was said but not the identities of the speakers.

“On the founder side, I think we’re seeing a much more heightened focus on both impact and ESG measurement,” said one partner. “People feel like the world has changed and these so-called non-economic variables now have heightened meaning. That is actually awesome to see because we feel like we’ve heightened our awareness at the same time.”

Another partner said: “What we continue to see is an increased trend of adoption where founders are more and more looking for help and are willing to engage [on ESG issues].”

A third partner noted that they have “seen a sharp increase in the level of engagement [with founders on ESG] over the past two or three years.” Entrepreneurs understand that ESG is a competitive differentiator for their companies, so “you will be a more attractive employer, you will be a more attractive investment, you will be better prepared for exit,” the partner said.

Direct impact

The partner shared the details of a program their firm created to help its companies improve diversity and inclusion. Eighteen companies opted in, spending six months developing tools to improve on inclusive hiring and equitable compensation.

“Those were the two areas where they thought they could make meaningful change – not only with diversity and inclusion but with their bottom-line business performance outcome,” the partner said. The firm measured the performance of companies in the program against a control group and found that companies in the program “outperformed on every single one [of the measurements] by significant margins,” the partner added. The firm has now shared the tools from the program with all of its portfolio companies.

While institutional investors continue to express interest in ESG, VCs aren’t entirely clear about the ESG expectations of their LPs. That lack of clarity may simply be because LPs understand that VCs don’t have the leverage to demand that their portfolio companies hit particular ESG milestones.

Still, VCs on the panel said they would appreciate more LP guidance. “To figure out what our LPs are expecting or where they may be strategically headed, I work closely with our investor relations team and try to get insights from them,” said the third partner. “I also follow different publications that report on what our LPs are doing and their strategic direction and I look at what commitments they’re making.

“And I try as much as I can to read between the lines and infer insights from the questionnaires they’re sending. Like, why are they asking this question? Is it a compliance-driven question or is it a strategy-driven question?”

The first partner said that due to the large size of their firm they often get the same ESG questionnaires that its LPs send to large buyout shops. To make sure expectations are aligned, the VC firm proactively reaches out to key LPs to have a “nuanced conversation” that goes beyond the questionnaire to help the LPs understand what it can and can’t do with regard to ESG, the partner said.

What’s clear from the comments on the panel is that, despite what detractors have to say, ESG is growing in importance to venture firms. And the firms that are embracing ESG are finding that it leads to more collaboration with their portfolio companies. Firms that aren’t staying up to speed on the subject may very well find themselves at a competitive disadvantage.