ESG Investing: European VC Funds Lead Community Building

Understanding ESG in Venture Capital

ESG, an acronym for “environment-social-governance,” represents a collection of principles addressing a wide range of considerations. These encompass areas such as diversity initiatives, board composition, labor practices, supply chain management, data ethics, environmental impact, and adherence to legal standards.

Distinguishing itself from impact investing – which prioritizes the (external) consequences of business operations – ESG primarily centers on internal practices and procedures. These practices aim to enhance the sustainability of both a fund and the companies within its investment portfolio.

ESG Adoption in Different Asset Classes

While asset classes like buyout funds and public equities have experienced significant momentum regarding ESG ratings and programs, venture capital has historically been slower to adopt these principles. However, recent developments are changing this landscape.

In recent months, numerous European funds have initiated efforts to address ESG concerns. For example, Balderton unveiled its Sustainable Future Goals with considerable attention at the Slush startup event in December 2020.

Their approach encompasses both internal fund operations and external factors, influencing investment choices and providing support to portfolio companies. Colin Hanna, a principal at the firm and a key figure in this development, explained the origins of this initiative.

The Formation of an ESG Community for VCs

This underlying reasoning also prompted a coalition of approximately 25 venture capital firms to establish a dedicated ESG community. This initiative is spearheaded by GMG Ventures and Houghton Street Venture.

Houghton Street Venture, a new firm linked to the London School of Economics, convened its inaugural meeting in December. Representatives from firms including LocalGlobe, Latitude, Kindred Capital, Balderton, Westly Group, and Blisce were in attendance.

The group’s primary objective is to facilitate the sharing of knowledge from practical experience and address shortcomings in existing ESG frameworks.

The Need for Collaborative Frameworks

Sophia Bendz, a partner at Cherry Ventures based in Berlin, emphasizes the critical need for this collaborative approach:

What is fueling the increased focus on ESG?

I consulted with Susan Winterberg, an ESG specialist who recently completed a two-year research fellowship at Harvard focused on ESG within venture capital, to understand the reasons behind this growing momentum.

The year 2020 proved pivotal in driving change, influenced by both social and economic factors. Issues such as the Black Lives Matter movement, racial equality, the COVID-19 pandemic, healthcare access, and the preservation of democratic principles were widely discussed. These societal shifts, alongside emerging research demonstrating the business benefits of ESG, significantly impacted startup founders and investors.

Hana shared that at Balderton, a confluence of the factors Winterberg highlighted initiated their ESG journey.

Martin Weber, a founding partner at HV Capital and collaborator with the St. Gallen-based ESG initiative ROSE, noted that engagement began with Leaders for Climate Action. Weber confessed: “Our consideration of ESG was previously insufficient, often limited to our immediate scope… sometimes external impetus is necessary, and Leaders for Climate Action provided that catalyst, sparking our initial awareness and dedication.”

For HV Capital, and also for some U.S. funds like the Westly Group, the adoption of ESG principles often began with a specific focus area – either the ‘E’ for environmental concerns, or ‘DEI’ (Diversity, Equity, and Inclusion) as part of the ‘S’ and ‘G’ pillars of ESG.

Recent conversations with Limited Partners (LPs), including moderating a panel at the Allocate conference in the U.K., reveal a growing trend towards “better business practices” among asset owners. Family offices are particularly vocal, but larger institutional investors are also increasing their awareness and involvement.

Michael Cappucci, managing director of Compliance and Sustainable Investing at Harvard Management Company – Harvard’s endowment – believes that “the period for observing whether ESG integration is beneficial has passed” (refer to the UNPRI report for further details).

However, the strongest impetus for this movement appears to be originating from Europe once more. Consequently, the same groups – Houghton Street Ventures and GMG Ventures – advocating for ESG in venture capital are now working to engage more LPs through a dedicated workshop scheduled for February. The pace of progress on the LP side is accelerating.

Remaining Challenges in ESG for Venture Capital

Despite considerable advancements at the fund level, among limited partners (LPs), and in incremental industry-wide initiatives, fundamental components remain undeveloped. I identify five key areas needing attention: a distinct separation of ESG from impact investing, refined terminology, a standardized framework, agreed-upon metrics, and genuine LP dedication.

Understanding the Distinction Between ESG and Impact

A significant number of investors, including LPs, still lack a clear understanding of the difference between impact and ESG. Essentially, ESG focuses on the internal processes within a fund or portfolio company, while impact investing centers on outcomes, often measured against the Sustainable Development Goals (SDGs).

While impact investing may remain a specialized asset class, ESG principles should guide the practices of all investors to some degree.

Developing Precise Language for ESG Discussion

Relatedly, establishing appropriate terminology to articulate the nuances of ESG – as opposed to impact – is crucial for clearer differentiation. As highlighted by Sarah Drinkwater of Omidyar Network, a suitable term to define what ESG represents within venture capital and technology is currently lacking.

Terms like “principled,” “progressive,” or “equitable” could be considered, and framing it as “setting a standard” may also prove beneficial.

The Need for a Unified Standard

ESG and impact frameworks within the venture industry are currently fragmented, drawing influence from various sources and largely developed independently by individual funds. This situation presents a risk of greenwashing, where marketing claims outweigh genuine change.

For meaningful industry transformation, an authoritative organization must take the lead. Current efforts, such as the European Investment Fund’s high-level questionnaire, are insufficient. Perhaps the UN Principles for Responsible Investment (UNPRI) could extend its focus to specific industry guidelines.

Establishing Benchmarkable Metrics

A core element of a standardized approach is a set of widely accepted and measurable metrics. Identifying the most relevant measurements for early-stage and late-stage venture capital portfolio companies is essential.

A London-based fund group is rightly prioritizing this question, but broader adoption and dissemination are needed. LPs can play a vital role by requiring GPs to report on ESG performance annually, fostering a more equitable, responsible, and stakeholder-focused startup ecosystem.

Securing Genuine LP Commitment

Currently, a significant obstacle is the lack of robust LP commitment to ESG. Many GPs report that LPs generally do not inquire about ESG practices during fundraising. Some U.S.-based LPs even perceive ESG as a potential distraction from financial returns.

As a result, ESG remains a “nice-to-have” rather than a “must-have.” Existing questionnaires, like the EIF framework, are often too broad and lack specificity. Increased scrutiny from anchor LPs – such as the EIF and BBB in Europe, or large foundations and university endowments – during due diligence will compel GPs to prioritize ESG compliance.

Given the involvement of public funds, adopting this approach seems a logical and necessary step toward establishing ESG as the standard operating procedure for venture capital.