On ESG, what can US venture capital learn from Europe?

US venture capital funds and investors are trailing Europe, which is ahead of the game on ESG regulation and adoption. Stephanie Baxter reports on what can be learned from the bloc.

ESG business

Environmental, social and governance investing is arguably the biggest trend in the financial sector as concerns mount over the pressing issues of climate change and sustainability. While worldwide these issues are increasingly important to investors, Europe stands ahead of other regions, such as the US, in terms of implementation and regulation.

European governments and corporations have aligned over the past few years to address the climate emergency and other environmental and social challenges.

This year, the EU has become the first regulator globally to attempt to codify ESG disclosure rules through the Sustainable Finance Disclosure Regulation.

Even before SFDR, venture capital general partners and limited partners in Europe had been making progress on incorporating ESG into their investment decision-making processes. Meanwhile, investors have been increasingly asking European VC funds more questions on how they take ESG factors into consideration.

Rob Genieser, partner at London-based ETF Partners, says with the increased focus on ESG in Europe, the region presents unique opportunities for entrepreneurs and venture capitalists to simultaneously generate returns and have an impact.

ESG
Rob Genieser, ETF Partners

“Europe is pushing beyond just insisting on stringent ESG policies by moving forward with major initiatives, like the European Green Deal, to deliver sustainable, economic prosperity,” he says. “The sustainable movement in Europe represents a major opportunity for venture capitalists, as companies seize new opportunities for growth and traditional industries are reinvented. Sustainable investing in Europe equates to fundamental change.”

SFDR, which came into force on March 10, is a gamechanger, requiring European financial firms – including qualifying VC firms – to consider how sustainability risks are incorporated into their investment decision-making processes.

“As ESG considerations continue to become increasingly important for both consumers and investors, LPs may prioritize investing in funds that can demonstrate a strong commitment to these”

Mike Stokes
Deloitte Ventures

It is likely to have a huge impact on VC allocations and the way LPs invest. Manuel Silva Martinez, partner and head of investments at Mouro Capital, expects SFDR to favor money flowing into VC, and says the asset class seems particularly well suited to be an early adopter of SFDR. Mike Stokes, London-based investment manager at Deloitte Ventures, adds that the regulation provides an opportunity for increased transparency over investor decision-making and diligence processes.

“As ESG considerations continue to become increasingly important for both consumers and investors, LPs may prioritize investing in funds that can demonstrate a strong commitment to these,” Stokes says.

“Fund managers will need to consider the potential impact the regulation will have on their ability to raise additional capital in the future, as well as any operational changes required in response to these regulatory developments.”

He adds that, overall, the introduction of new regulation such as SFDR will be an effective way to encourage more investors to focus on analysis of sustainability risks and, more generally, the development of more sustainable investment portfolios.

European VC approaches

In VC and private equity, there has always been quite a big focus on the governance element of ESG, says Bevan Duncan, managing director in Gresham House Ventures’ strategic equity division.

“When we invest, to support the development of effective governance we require an independent non-executive chair to join the board on investment,” he says. “We have specialist in-house resource focused solely on finding high-quality non-executives and executives to help businesses to grow.”

ESG Venture
Bevan Duncan, Gresham House

Gresham House is still developing its ESG approach and is “making good progress, but there is clearly still more that we can do,” Duncan adds.

Over the past 12-18 months, Gresham House has developed, with the help of an independent consultancy, an in-depth ESG assessment tool based on the UN’s Sustainable Development Goals. These 17 sustainability themes are becoming increasingly popular among investors seeking to map their investments to real-world outcomes.

Duncan explains how it works: “This tool is embedded into our investment process, so as soon as a deal comes [in], and it’s in one of our core investment themes, an initial ESG assessment is conducted. If there are risks that we think are going to be significant, or that we cannot mitigate, then we will not progress the opportunity. For deals we take forward, the assessment of ESG factors gets more and more in-depth as we get to know the business better and, where appropriate, we commission due diligence on specific ESG factors.”

Part of the initial engagement with the businesses Gresham invests in involves bringing issues such as sustainability and carbon footprint on to the investee company’s radar.
“A key part of our investment process now is having those conversations early and making sure that we have identified key risks but also that we have alignment with a team that will want to work with us to address those risks,” Duncan says.

He points out that ESG is not just an add-on to the investment process but “quite a philosophically changing approach.”

“Where we can run into danger is if you try to force a square peg into a round hole by redefining the company as having an ESG impact”

Chris Wiles
Foresight Williams Technology EIS Fund

Gresham House is also developing a practical set of toolkits or modules alongside a network of people that it can introduce to companies to give them support on ESG.

“Most VC-backed firms want to have a more positive impact, but the question is how can they do that?” Duncan explains. “Our job is to articulate why ESG is important to us as investors but also why it is important to the business and the value creation story.

“Given that start-ups have the challenges of scaling up, raising money, hiring people and winning customers, we want to make a company’s transition to being more responsible as frictionless as possible.”

ESG Venture
Chris Wiles, Foresight

Other VC firms are more wary of marketing themselves as ESG funds. For example, the Foresight Williams Technology EIS Fund invests in UK-based deep technology businesses that have some net benefit to society, but it does not market itself as an ESG fund.
Chris Wiles, senior investment manager in Foresight’s London office, says: “Where we can run into danger is if you try to force a square peg into a round hole by redefining the company as having an ESG impact.”

Wiles says that for early-stage companies that are still in the formative stages of trying to develop their technology, and then trying to commercialize it and get it off the ground, throwing other hurdles, such as ESG reporting, is putting too much weight on a start-up’s shoulders. It’s asking for trouble, he says.

“The way we like to think about it is what companies are doing and how they do it,” Wiles says. “There are a lot of companies in our portfolio that either directly or indirectly have fantastic benefits.”

Decarbonizing venture

There is increasingly widespread agreement that LPs and GPs can play a role in channeling capital towards solutions that will drive the move to a resilient, low-carbon economy.

As Siobhan Gardiner, climate change and environment lead at Deloitte Ventures, says: “Within the context of the venture capital industry, we have observed a growth in funding solutions and demand for… technology developed to address climate change.”
Along with this, Gardiner says the firm has seen a clear shift in the regulatory, political and economic landscape towards an urgency for sustainability.

It offers a “scope for market growth and for start-ups to play a prominent role in shaping the future and supporting organizations and communities to achieve their sustainability goals,” she says.

ESG Venture
Manuel Silva Martinez, Mouro Capital

Gresham House’s Duncan believes the VC sector’s future could involve investing in businesses that are “driving the ESG change and accelerating the move to a more sustainable world.”

Mouro Capital’s Silva Martinez says that even the sub-sectors of private equity or VC that invest in industries with higher capital expenditure (such as automotive, spacetech, or potentially foodtech) are built on newer technologies and contemporary principles, and
they are often crossing over with ESG criteria.

“The adoption of ESG practices for the capital markets industry and for the private equity/venture capital industry is likely to follow the same boundary-less approach, and it just takes one place in the world to ignite the topic for the rest of the world to follow suit”

Manuel Silva Martinez
Mouro Capital

There is also an array of industries that are primarily targeted by private equity and VC that are squarely aligned with ESG, such as cleantech or energytech, he adds.
For example, Foresight’s technology fund includes three key areas in its portfolio. The first is focused on resource efficiency, doing more with less and improving economic output with fewer input resources.

Wiles says: “We have a couple in the remote collaboration space and additive manufacturing and 3D printing, which are helping to produce more goods, less waste and more energy efficiently.”

The fund also invests in companies supporting the decarbonization of the energy system. One such company develops sub-surface robotics for surveying the structures of wind farms to help reduce their operating costs and improve their life expectancy.
The third key area in Foresight’s fund is companies that monitor gas grid networks to reduce leakage and increase uptime performance.

Brace for more ESG

As capital markets are probably the most integrated part of the global financial services ecosystem, what happens in one part of the world tends to quickly transfer over to other parts of the globe, says Silva Martinez: “Similarly, if covid-19 has shown something, it is how liquid and movable private equity money is, both at early stages but also at later growth stages as companies approach liquidity

“The adoption of ESG practices for the capital markets industry and for the private equity/venture capital industry is likely to follow the same boundary-less approach, and it just takes one place in the world to ignite the topic for the rest of the world to follow suit.”
Regulation similar to the EU’s SFDR “is coming” to the VC sector in the US, Silva Martinez adds, as well as to other countries outside Europe. However, there may be differences in how standards are set.

In Europe, the VC industry has allowed the public sector to take a first shot at setting up best practices and reporting requirements.

“Most VC-backed firms want to have a more positive impact, but the question is how can they do that? Our job is to articulate why ESG is important to us as investors but also why it is important to the business and the value creation story”

Bevan Duncan
Gresham House Ventures

The US has a tradition of the private sector taking the lead and regulators coming to the table later, Silva Martinez explains.

“In this case, I feel the impact in the US is somewhat going to be hybrid: there have been some private initiatives in the US to foster ESG adoption that have yielded good practices but not consolidated into clear standards,” he says.

“It is likely that the second wave, somewhat inspired by what happens in Europe, will be the crystallization of such standards, and the convergence of the private practices into those standards.”

All in all, Silva Martinez believes SFDR in Europe and other similarly-minded regulatory developments concerning ESG will favor VC and the wider innovation and technology investment ecosystem.

He says: “In today’s very competitive VC environment, to the extent ESG values are of importance to portfolio companies or targets VCs want to invest in (as the current trend shows), VCs will incorporate those principles early on in their thought process as a way to be more attractive to prospects and stay competitive in the marketplace.”