Let’s cut to the chase: ESG is here to stay. In a COVID-emerging world, we ignore it at our own risk.
From raging wildfires to catalyzing incidents of social injustice and the so-called Great Resignation, one aspect of our “new normal” is heightened corporate accountability, coupled with an increased need for risk mitigation, in the form of ESG compliance.
In contrast to public markets, private equity (PE) and venture capital (VC) markets have a direct responsibility for the companies or start-ups they invest in, often holding board seats in these companies. This direct-stakes approach to raising capital, along with responsibility to their own boards members who typically have considerable wealth at risk, means PE and VC firms will be held to a far higher standard of accountability as the mainstreaming of ESG continues.
European nations have so far led the call to this mainstreaming. The UK has mandated climate-related disclosures as of April 2022, and the EU enacted the Sustainable Finance Disclosure Regulation (SFDR) in March 2021 to combat greenwashing by providing rules on what can and cannot be categorized a “green” financial product. Currently, the EU is in the process of finalizing its “green investment taxonomy” to define which investments can legally be labelled green. PE and VC players on this side of the pond have the opportunity to remain ahead of the game before North America catches up, as it is already beginning to do. Canada has just announced plans to set up a framework for mandatory climate-related disclosures, and the newly formed International Sustainability Standards Board (ISSB) will be taking up an office in Montreal.
VC firms, in particular, can be especially well-suited to remain ahead of the regulatory curve. By investing in start-ups and disruptive technologies, they have the opportunity to integrate ESG into their portfolios from the get-go during the early stages of a company’s life cycle. By weaving ESG into the very culture and fabric of start-ups, which by their nature are incubators of innovation, VCs are in a unique position to shape the post-COVID economy.
Given political, social and, critically, climate volatility characteristic of our still young 21st century, genuine ESG credentials will become critical in strengthening a portfolio’s ability to weather a storm, encourage longevity and minimize risk of all kinds. Thus, for institutional investors, ESG performance will play a not insignificant factor in price negotiations and valuations. In fact, in a recent KMPG survey of private equity general partners worldwide, 54% had reduced a bid after carrying out ESG due diligence, while 34% increased one. Firms that ignore ESG will suffer down the line in their fundraising efforts or if limited partners inquire about their ESG credentials. Reputationally, millennial consumers (along with Gen Z, who will come into their own in the next two decades or so) have repeatedly reported themselves as willing to boycott companies on poor ESG grounds. It can all go downhill with a meme.
While the ESG pressure has been slowly building on public markets over time, the PE and VC spheres are still relatively new to the game. As such, a dearth of market tools or advisory services exist to cater to the needs of investors who will now face additional scrutiny and pressure to collaborate with ESG forward companies.
ESGTree advises that PE and VC firms begin with a baseline collection of solid, reliable and verifiable data before crafting strategies and policies. In our experience, firms often dive into sustainability reporting in the absence of both proper data and an ESG strategy on which it should be based (and low emissions industries should nevertheless collect robust environmental data as well). Data is the edifice upon which real ESG rests. Much has been written about the dismal – but evolving – state of ESG scoring and ratings by ESG ratings agencies. A company can receive wildly differing ESG scores based on the provider. The data that ratings are based on is self-reported, opaque and sketchy, and in the absence of any meaningful benchmarking analysis, these scores lack meaning. In the words of a Tufts University professor, “garbage in, garbage out.” Hardly a stable foundation on which to enact policy.
Based on this data, a company can extract meaningful ESG metrics to see where it stands. Benchmarking these metrics against global standards such as those published by the Sustainability Accountability Standards Board (SASB) can provide a barometer on whether a portfolio is performing well, averagely or poorly on ESG. The United Nations Principles of Responsible Investment (UNPRI) has also issued a number of frameworks and toolkits related to private capital markets and ESG.
So far, ESG is largely viewed as a hurdle, albeit one to the tune of trillions. For the PE and VC industries, it can be a shining opportunity to position themselves and shape the future.