ESG Investment Strategy

ESG investment is not a buzz word but a well-recognized global investment trend. ESG is about taking into account E (Environmental), S (Social) and G (Governance) issues, risks and opportunities while making a final investment decision. HSBC Sustainable Financing and Investing Survey shows that 94% of companies plan to disinvest unsustainable businesses in the next five years. This demonstrates a huge shift in investment strategy, and if investors demand ESG-aligned targets, the market, including VC funds should definitely think through (rethink) their business and operating models. 

ESG as a part of the whole investment circle. Why early stage matters?

EU operating VC funds should encourage their portfolio companies to integrate ESG into their strategy, business model and operations. Here is why:

• SFRD (Sustainable Finance Disclosure Regulation) provides a 2-level obligation (firm and product) for sustainability (ESG) disclosures. SFRD applies to financial advisors and financial market participants, including banks, asset managers, pension fund providers, insurers, and qualifying venture capital. So even if a VC fund does not fall (yet) within SFRD, the next round might bring in a SFRD-covered investor, or a VC fund might plan to exit to such an investor or simply portfolio companies might need venture-debt financing, thus startup’s next financing round might come under ESG scrutiny.
• CSRD (Corporate Sustainability Reporting Directive, which comes into force from 2023 and from 2026 with respect to SMEs) provides for broad ESG reporting obligations for all large companies* (it doesn’t matter if they’re listed or not) and all listed companies apart from listed micro-enterprises (up to 10 employees). Consequently, if exiting to a strategic investor, for which ESG reporting is mandatory, portfolio company will be verified in terms of ESG risks and metrics compliance. Additionally, portfolio companies often consider an IPO, and listed companies (no matter their size) will need to be ESG-aligned. Finally, portfolio companies often target blue-chips and clients, and, again, such corporations are obliged to conduct ESG due diligence through supply chains before starting cooperation.

Better valuations for ESG-aligned portfolio companies 

Much has been said about ESG-aligned companies outperforming the competition and providing better returns. There’s also another angle supporting the fact that ESG-noncompliant/agnostic portfolio companies should not dismiss ESG trends by just saying “in the worst-case scenario, we obtain a lower valuation and don’t become unicorns”. According to Morningstar Research, ESG issues pose long-term and (rather) low probability risk, but if materialized, the damage is material. Thus, a lack of ESG integration increases uncertainty and lowers the valuation ( at the same time diminishing the investibility of a company). 

On another note, the war in Ukraine has demonstrated that low probability risks cannot be downplayed as ESG investors criticised for their failure to assess risks regarding Russia are now counting their losses over Russia (just as an example, BlackRock funds lost $17bn on Russian exposure).

 How to approach an ESG investment strategy for portfolio companies?

The ESG investment strategy of many VC funds and PE funds often involves a tick-the-box process which is most likely to result in gigabytes of documents and questionnaires, rather than something facilitating a long-term sustainable portfolio. Let’s go through some of the approaches to discuss their advantages and disadvantages:  

Exclusion lists

Funds often declare that they do not invest in certain non-sustainable sectors, e.g. coal, alcohol, gambling and pornography. While it’s no bad thing to make such commitments, such a declaration does not in itself constitute an ESG investment strategy. If your fund does not invest, someone else will, and your lack of support does not make the business more sustainable.

ESG due diligence questionnaires, policies and procedures 

ESG due diligence questionnaires are sent to portfolio companies at the beginning of an investment process and are updated annually. Portfolio companies are asked about policies, procedures and complaints which refer to E, S or G issues, just to mention a few:

• E: environmental policy, waste management policy
• S: employee handbook, record of employee complaints, litigation, government action, settlements, and arbitration related to discrimination, harassment, and equal opportunity employment, policies and procedures related to ethics and compliance (e.g. Code of Conduct, related party transactions, reporting, auditing, political contributions, conflicts of interest, employee training etc.), employee census (incl. name, status, department, position, location, salary, gender, race/ethnicity, etc.) and organization chart, severance policy, remuneration policy, annual leave/vacation policy, sick leave policy
• G: anti-bribery and corruption policies and procedures, details on any sustainability initiatives, internal policies, procedures, and guidance documents regarding data privacy and security

While such inquiries should be conducted prior and post-investment, the policies and procedures are not core to, or the goal of ESG. Policies and procedures serve as tools in order to:

• set, monitor and deliver ESG KPIs;
• manage external and internal ESG risk; and
• facilitate external and internal communication to improve a company’s ability to respond to ESG challenges and opportunities quickly and adequately.

First and foremost, VC funds and their portfolio companies need to:

• jointly decide on key ESG risks and opportunities for the portfolio companies,
• set sustainability goals and actions to achieve them, and
• establish policies and procedures that would be secondary to the materiality analysis and ESG goals.

VC funds also have to keep in mind that ESG-agnostic firms might have fantastic policies and procedures in theory, but no real positive sustainable impact.

Representation, warranties and contractual (investment agreement) ESG obligations

Some VC funds are of the belief that they support ESG by obtaining extensive ESG Reps & Warranties in an investment agreement through which they undertake to comply with ESG requirements (sometimes with contractual penalties).

A likely reason for this is the current EU Taxonomy (EU unified reporting standards providing for a classification system of environmentally sustainable economic activities), GRI (Global Reporting Initiative), recommendations of TCFD (Task Force on Climate-related Financial Disclosures of the Financial Stability Board) or SASB (Sustainability Accounting Standard Board) reporting standards still tailored to large companies and high-emission sectors. VC funds do not have clear criteria from regulators as to what should be required from tech portfolio companies, so they tend to shift the burden to the startups themselves, and request catch-all clauses related to ESG regulations compliance. 

However, formal commitments do not mean ESG-alignment. Moreover, a new proposal for a Directive on corporate sustainability due diligence clearly discourages the shifting of the ESG burden to SMEs and states that such an approach would not constitute ESG compliance, providing a duty of care and due diligence. 

A better approach is to truly understand the ESG landscape of your portfolio companies and:

• be honest about the risks and determine where and why the portfolio companies is are falling behind;
• set improvement KPIs;
• then obligate the portfolio companies to come up with procedures and deliver on the KPIs; and
• monitor and support the portfolio companies in their ESG improvement journey.

ESG-aligned business model

ESG should not be treated on the same basis as legal or tax due diligence. A true ESG investment strategy should include ESG metrics as a part of the very first business analysis of a potential investee. 

At the very first screening stage a VC fund should:

1.Verify whether the products and services of portfolio companies contribute to achieving any of the environmental or social goals set by the EU

The EU Taxonomy (already in force) establishes 6 environmental goals:

1. Climate change mitigation
2. Climate change adaptation
3. The sustainable use and protection of water and marine resources
4. The transition to a circular economy
5. Pollution prevention and control
6. The protection and restoration of biodiversity and ecosystems
   
   The Social Taxonomy  still has a way to go and is under discussion with 3 social goals currently on the agenda:
7. Decent work (including value-chain workers)
8. Adequate living standards and well-being for end-users
9. Inclusive and sustainable communities and societies

So, your portfolio companies might:

• directly engage in activities contributing to achieving these goals
• or engage in enabling activities (helping other companies achieve these goals directly or helping large corporates undergo a sustainable restructuring).

EU regulations introduce new compliance obligations but on the other hand, create new business opportunities. 

2. Conduct a materiality study 

Businesses must explain their ESG impact according to the double materiality rule: (i) how their operations effect the environment and society; and (ii) how their business operation is affected by environmental and social risks and opportunities. This means that a VC fund needs to verify the strategy and business model of a portfolio company through an ESG lens by assessing:

• the pitch deck, business model, financial projects, rollout strategy, operations and target client base  screened through the double materiality perspective, also in the long run, with an account of what ESG challenges and opportunities a portfolio company might face when growing
• the interests, rights and concerns of all stakeholders (employees, customers, regulators, local communities, suppliers, etc.)

The existing ESG standards cover larger companies and often focus on traditional industry (manufacturing, oil & gas, agriculture) and VC funds might find it hard to determine which standards to apply to screen their portfolio companies for ESG risks. So, investors might approach this lack of dedicated standard two-fold:

• dig into the underlying revenue drivers and the core foundations of the business model: does it take advantage of any regulatory loopholes, does it (ab)use personal data, does it strive to play on disadvantaged groups, are the products or services addictive (i.e. towards children), does the business (even indirectly) strengthen inequalities, does the company make profit because the regulators/state authorities are slow to execute law which would otherwise restrict the form of profit. 
  For example, Aviva, M&G and Aberdeen Standard walked away from their investment in Deliveroo due to the allegation that riders were misclassified as self-employed and therefore denied employment protection.
• follow the new standard and laws applied to the tech industry, especially in terms of AI, data and privacy protection - this could include, for example, the EU’s proposal on AI, its new strategy applied towards search engines or Biden’s administration take on the responsible development of digital assets.

A double materiality study of a business model will allow VC funds to spot ESG risks and opportunities, and either result in the VC funds dropping their potential investment or coming up with KPIs to minimize risk, or a tweaking of the business model to achieve more sustainable outcomes. 

Last but not least, even the most ESG-aligned portfolio company does not guarantee a superb return unless it has a viable business model at its heart - an ESG analysis should not substitute or replace a traditional financial review but complement it. 

Summing up, ESG investment is becoming more and more impactful. According to Morgan Stanley, ESG investment already amounts to $22.8 trillion and it will continue to soar.  We strongly encourage VC funds to start working on their iESG investment strategy now, as even if VC funds do not need to undertake ESG reporting, fund managers might. Consequently, a VC fund will almost certainly look to make an exit to an ESG (strategic or PE fund) investor, which will start its assessment with an ESG due diligence before they even start asking for tax, legal and financial documents. In 3-5 years ESG investment will be in full swing and VC funds must act now to help your portfolio company grow into an environmentally and socially sustainable scaleup. Failure to do so may result in difficulty in exiting in the future. 

* choose 2 out of 3: revenues > 40m euro; assets > 20m euro; 250 employees 

Related Posts:

Your Startup Needs To Be ESG-aligned To Be Investible (by Aleksandra Polak, Partner, B2RLaw)

ESOP For Startups: What is ESOP and how does it benefit startup? (by Marcin Laczynski, Partner, Next Road Ventures)

How ESG Will Affect VC Funds And Startups? (by Ewa Chronowska, Partner, Next Road Ventures)