ESG and the Future of VC
Increased awareness of ESG investing is further stimulating discussions about the interconnectedness of sustainability and the financial system.
By Christopher Canzano
Investors have become keen to put their money toward “good” in recent years. ESG stands for Environmental, Social, and Governance. ESG investing is a form of sustainable investing that considers these factors in the analysis of an investment’s return and overall impact. Investments that consider environmental, social, and governance factors are gaining more attention. According to a report from the Forum for Sustainable and Responsible Investing, assets under management using sustainable investing strategies in the US reached $17.1 trillion in 2020.
Increased awareness of ESG investing is further stimulating discussions about the interconnectedness of sustainability and the financial system. There is no standard for ESG principles required in company annual reporting. There are a number of groups which are attempting to standardize reporting so that a uniform ESG investment label can be applied. The Sustainability Accounting Standards Board (SASB), the Global Reporting Initiative (GRI), and the Task Force on Climate-related Financial Disclosures (TCFD) are working to create such investing standards which accurately define ESG factors. Similarly, the CFA Institute is leading the financial industry by performing research, coordinating experts to facilitate discussions, and creating the needed standards to apply to ESG investing.
In the spirit of ESG investing, Harvard, under the leadership of N.P. ‘Narv” Narvekar, CEO of Harvard Management Company (HMC), became the first university to make a net-zero endowment pledge. As a result of Harvard’s lead for a net-zero portfolio, others have joined the accelerated efforts and established standards that accurately reflect the real-world emissions of investments. HMC became the first endowment office to announce that its own operations will be net-zero, beginning in FY22. Headquartered in Boston, HMC is an independent investment office formed by Harvard University in 1974. It invests the University’s endowed funds and related financial assets that support scholarships, teaching, research, museums, and more. Annual distributions from the endowment represent more than one-third of the University’s operating budget.
ESG investments provide comparable returns to traditional investments. A 2019 white paper produced by the Morgan Stanley Institute for Sustainable Investing compared the performance of sustainable funds with traditional funds. It was found that the total returns of sustainable mutual and exchange-traded funds were similar to those of traditional funds when reviewing data from 2004 through 2018. Though the perception that ESG investments are more expensive to an investor or underperform persists, other studies have shown that ESG assets can outperform conventional ones. The same Morgan Stanley white paper found that sustainable funds consistently showed a lower downside risk than traditional funds, regardless of asset class, during turbulent markets. In recent down markets as have occurred in 2008 and 2015, traditional funds had significantly higher potential for loss. ESG funds have even managed to perform well during the height of the pandemic in 2020. Investment research company Morningstar analyzed 26 sustainable index funds during the pandemic. Research revealed that 24 of these 26 ESG funds outperformed comparable traditional funds in the first quarter of 2020.
Venture capital firms have been slow to completely embrace ESG investing. There are many factors for the slow adoption. First, the mechanics of a successful VC firm is dependent on the start-ups they invest in. Some sectors that currently are in-vogue and performing well may not necessarily hit all marks if considering a target market that employs only ESG principles. As with any investor, VC partners seek high returns that allow themselves as well as the associates within the firm to earn a living. In addition, VC partners seek a return on investment for their limited partners. The limited partners include pensions, family offices, endowments, insurance companies, foundations, and high net worth individuals. Currently, there is little influence that these limited partners have on directing a VC firm to comply with ESG investment initiatives. The percentage of highly successful VC firms are small. Those limited partners who have access to the most successful VC firms may feel “lucky” to be part of the investment fund and thus are less likely to voice influence and desire for ESG investment direction if returns are exceptional. Similarly, VC firms may seek to invest in “good” industries rather than in “good” people or concepts. For example, energy and cleantech, biotech/immunology, AI, blockchain and cryptocurrency, healthcare, e-commerce, and fintech are hot trends in VC capital. If none of these hot sectors (that have the greatest potential for success) meet ESG criteria, do VC firms abandon such start-ups and choose to fund an entrepreneur solely because the business is ESG friendly? There are some who do not feel VC investment decisions should be constrained to an ESG label. Lenore Palladino, an economist at University of Massachusetts Amherst states that investment managers and VC firms may look at the bigger picture of ESG and a framework for corporate sustainable investing but ultimately they have a fiduciary duty to increasing the value of the fund. Palladino comments that “They can’t also care about the status of the planet if that will contradict their ability to make money.” Tariq Fancy, the former chief investment officer for sustainable investing at Black Rock, takes a more jaded view of the entire ecosystem of socially minded and ESG investing. He declares that ESG products are basically useless — that funds can slap an ESG label (and likely a higher fee) on the financial product to keep socially conscious investors content. He is troubled that people think they are aligning their dollars with their values when they are really not. “If you really care about social changes, invest your portfolio as you’ve always done, which is to get the best returns and preserve your savings, and then turn to the government and push political action around solving climate change, because that’s the only level where it can actually be solved,” Fancy said. Such challenges to maintain defined and standardized ESG principles may be similar to the labeling of organic foods prior to USDA Organic Foods Production Act of 1990. Creation of reporting standards and uniform ESG principles will ultimately improve investing transparency.
ESG investing can and should be a part of the VC ecosystem. If developing companies and entrepreneurs with ESG principles are successful, then VC influence will further the ESG platform. If ESG portfolio returns, however, are weak then the primary focus of VC capital into ESG-related business will suffer. It is unlikely that a VC firm can maintain ESG as a sole focus for their investments. ESG values are important and alignment of such core values with VC capital is achievable with disciplined sourcing. Fund performance ultimately drives the flow of VC capital.
