16 January 2020

Why ESG is core to long-term success in venture capital

Venture capital (VC) is a relatively new asset class but is already having a transformative impact on large sections of the global economy. Successful VC-backed companies have the potential to create large numbers of jobs and deliver impactful services. This is particularly true in emerging markets where the technology-enabled firms targeted by VC investors can leapfrog market constraints to enable large-scale access to essential products and services, including to under-served groups, and create a path into the formal economy.

While the attention given to environmental, social and governance (ESG) issues has never been greater, VC has trailed behind other asset classes in the adoption of ESG practices. The slower pace of thinking may be because investors believe ESG is less relevant for VC. Tech companies do not directly emit many greenhouse gases or pollute many rivers after all.

However, ESG considerations can be critical to the long-term success of venture-backed companies. You only need to look at the impact of WeWork’s governance problems, or the reputational damage suffered by ride-sharing and takeaway-delivery apps over the rights of workers in the gig economy, to see that ESG issues can be material.

VC generally targets disruptive business models. But disruptive companies that have not developed a responsible approach to ESG issues can lose out when regulations eventually catch up . Tech firms are also often at the forefront of emerging ESG concerns. For instance, the ethical use of personal data will be a major human rights issue of the 2020s. Similarly, there are concerns that artificial intelligence can inadvertently perpetuate discrimination.

Surely experienced VC investors will identify these ESG risks in their normal due diligence? In some cases, yes. But, without systematically integrating ESG into investment decision-making, important risks can be missed. A systematic approach is particularly valuable for VC investors because they have smaller teams and bigger portfolios than their private equity peers.

It does not take much for a social media crisis to destroy the reputation of a promising start-up, which often rely on brand strength and goodwill to carry them through the early funding rounds. The adoption of corporate governance structures, anti-harassment policies and grievance mechanisms can help mitigate risks and provide a healthy framework for inexperienced founders.

Once operating at scale, it can be difficult for companies to change course, particularly when it comes to relationships with workers and consumers. By incorporating ESG thinking early-on, VC investors can set the foundations for rapid growth and ensure long-term sustainability. There is a fine balance between allowing early-stage companies room for manoeuvre and adding value by formalising processes. Therefore, ESG action plans should follow a staged approach that address material ESG risks and opportunities at a given point in a company’s development. Investors should use new funding rounds to assess progress and determine if additional requirements are appropriate.

Likewise, an ESG lens can offer real opportunities. Good human resources policies can help to attract and retain top talent. A clear ESG commitment can also appeal to increasingly discerning consumers, especially millennials. Similarly, aligning with good practice can enable a company to more efficiently scale across multiple jurisdictions.

Demonstrable ESG performance can support exits too. Likewise, VC funds that can show a robust approach to ESG management and impact will have increased traction with a growing number of limited partners.

We’re pleased to publish ‘Responsible venture capitalwith FMO, the Dutch development bank, to help investors and other stakeholders navigate these emerging issues.

CDC has invested in Africa for over 70 years. In our experience, Africa-focused fund managers have led the way on ESG management; outstripping their peers in developed markets. With a new generation of VC funds launching in Africa, we believe many of them will lead the way as well.

Our report does not provide all the answers to the array of complex ESG issues, but we hope it provides a framework for VC investors to consider and manage their ESG impact.

Read CDC and FMO’s good practice note Responsible venture capital: Integrating environmental and social approaches in early-stage investing

CDC is becoming British International Investment