Ermitage Blog: The pursue for ESG 2.0 through sustainable value creation

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ESG provides numerous value creation opportunities for VCs from ESG-based investment selection to industry-wide collaboration. Though these opportunities are limitedly known and understood today, their importance will grow in the future, as VCs need to accomplish a more sophisticated ESG level, ESG 2.0.

 

As was described in my last blog, VCs have developed a rather refined ESG approach, which allows them to capitalize on the business potential and various opportunities of ESG. Today, they are turning vacuous ESG commitments and promises into concrete actions and thereby, employing ESG for sustainable value creation. The prior ambiguity and vagueness around ESG issues has been replaced with those concrete, deliberate actions that create value for venture capitalists, their investors and portfolio companies. It is, however, worth noticing that this value creation thinking of ESG has been established only recently. Consequently, out of the numerous value creation opportunities that ESG provides in venture capital, only a fraction is recognized and understood for the time being, and even less is currently in use.

Based on my master’s thesis research on the topic, one value creation method that is widely stressed and utilized among VCs is ESG-based investment selection. This does not mean excluding some controversial and ESG-incompliant targets but rather refers to deliberately investing in companies and sectors with an ESG-related purpose or mission. The fundamental behind these investments is that ESG targets are associated with a greater business potential than before. In addition to providing good returns for VCs and their limited partners, they contribute to the wider good of society.

Such targets include circular economy, new sustainable ingredients and materials, as well as Industry 4.0 (the digital transformation of manufacturing processes) to name a few. A Finnish start-up called Infinited Fiber is a great example of such target, as it creates new, premium fiber from waste and hence, reduces the world’s dependence on virgin raw materials and promotes circular economy. Another Finnish start-up called ColloidTek is also a great example of an ESG target, or Industry 4.0 target to be more specific. It uses advanced technology and data to provide a real-time, comprehensive view of industrial liquid processes, which enables to optimize the productivity, efficiency, and quality of those processes.

VCs can create value not only by seeking new, sustainable targets, but also by influencing companies already part of their portfolio through a board seat and persistent board work. The purpose is to implant ESG priorities into these companies during their formative years and shift their attitudes and practices towards a more ESG-positive direction. Concrete actions used to influence portfolio companies’ ESG efforts include ensuring the existence of all relevant ESG policies (HR policies, employment contracts, code of conduct, etc.), organizing ESG-related webinars and trainings to management and employees, as well as drawing from a broad portfolio of investments and introducing best ESG practices.

In fact, this might be the greatest value creation opportunity that ESG provides for venture capitalists. It can have a huge impact not only on the influenced portfolio companies, but also on the business world and its ESG attitudes more broadly. Moreover, driving their portfolio companies’ ESG efforts brings added value for VCs themselves, most notably at exit. That is, companies that are more advanced in their ESG practices and have a well thought-out and articulated ESG approach will likely have a higher exit value, especially if the exit occurs through an IPO.

The value creation potential of ESG is not limited to VCs’ investment activities, though such handprint thinking is dominant among venture capitalists these days. The fact that VCs are better aware of ESG issues, and ESG is a frequent part of their conversations already adds value itself. By better understanding ESG and its different aspects, venture capitalists can take advantage of its numerous opportunities, as well as prepare for and resolve ESG-related problems more easily. Furthermore, VCs with a better grasp of ESG tend to have more favourable attitudes and mindsets towards it. Influencing and conforming those attitudes is crucial, since the ESG development of the entire VC industry ultimately depends on them. To quote one of the interviewees of my master’s thesis research: “the alignment of mindsets is more impactful than prioritizing ESG in each discussion”.

VCs can also create value with ESG not only by improving their own understanding and actions, but also by working together as a community. Although ESG is increasingly a source of competitive advantage, and venture capitalists do not want to disclose every detail of their ESG approaches, they also benefit from an active and transparent collaboration with each other. This collaboration helps in agreeing on common ESG standards, harmonizing ESG practices, as well as diminishing green washing activities and other wrongdoings. Most importantly, it enables sharing ESG-related practices and policies among VCs, which, in turn, brings much-needed ESG benchmarks for the entire industry. A more ESG-progressive VC industry drives all venture capitalists forward, especially those that are lagging behind in their ESG efforts.

Not all ESG-related value creation methods are as widescale and include the entire VC community, as the ESG collaboration presented above, but the mere exploitation of more advanced ESG metrics and models brings added value for venture capitalists. Thanks to these models, ESG data that is often vague and ambiguous can be addressed with more sophisticated and measured actions, which, in turn, enables a more systematized ESG reporting to investors. Moreover, since ESG information is increasingly transparent and ESG is more strongly reflected in company value, the importance of these models highlighted, as they can authenticate that value.

VCs seem to especially value AI-based tools and models, such as Upright, Normative and World favor. The Upright model, for instance, provides an automated way to quantify companies’ net impact on the surrounding world. Using comprehensive data, the model evaluates their actions in respect of four dimensions (society, knowledge, health and environment), which are further divided into multiple categories. Companies are given net impact scores in each category, and the scores are made proportional to firm size. “Compared to similar-sized companies, you are 5x better than the average company in this category” is what the Upright model ultimately tells a company. In addition to AI-based models, predictive and forward-looking measures, science-based targets to name one, are also of mounting interest, as they allow VCs to make the most out of emerging ESG opportunities, as well as prepare for future ESG-related challenges.

It cannot be stressed enough that the value creation thinking of ESG is only in its infancy, and the methods described above are merely those that were highlighted in my master’s thesis research. ESG withholds a lot of uncharted potential and opportunities that are insufficiently understood and utilized for now. Nonetheless, despite missing the full solution, the VC industry is undergoing a clear transition in terms of ESG. Where ESG used to be a mere “nice-to-do”, it is now becoming a “must-have” for venture capitalists. Today, ESG can even be described as a prerequisite for VCs to do business and get funded. It is already steering and will continue to steer investors, capital, talent, and other resources in the VC industry. As a result, those resources will be increasingly allocated to ESG-oriented venture capitalists who promote wider good with their investments.

It is difficult to predict what awaits venture capital in terms of ESG in the future. No more than five years ago, very few VCs had come across with ESG, whereas now, it is one of the central topics in their agendas. Furthermore, it seems that ESG has reached a “tipping point” in venture capital meaning that it is highly unlikely to go away anymore, as a large enough share of VCs has adopted it. For a long time, ESG development was hindered by the fact that ESG was seen as a philanthropic matter that had no clear connection with financial returns or performance. Today, however, the business case for it is indisputable, and financial incentives are expressly the reason why ESG has spread so quickly and widely among venture capitalists. ESG data and models, in turn, enable the authentication and capitalization of this financial potential, which is why data-based ESG approaches will likely become more important going forward.

In fact, one of the interviewees of my master’s thesis research even speculated whether ESG potential could equal financial potential in the future meaning that all ESG issues were critical in respect of returns. This will probably not be the case, as it would require major changes in society and its mindsets. Nonetheless, data-driven ESG should gain momentum and bring ever more concreteness and purposefulness to VCs’ ESG considerations and activities. Additionally, ESG approaches are likely to narrow down in terms of focus. Up to this point, ESG-related discussion has been all over the place addressing issues from climate change to diversity to corporate governance. In the future, as ESG and its opportunities are better known and understood in venture capital, one could imagine that VCs’ ESG approaches will also focus down on the most relevant themes and issues.

Overall, ESG seems to be becoming somewhat “mainstream” in the VC industry. Venture capitalists are already expected of some sort of a stance on ESG issues by their investors, government officials and other stakeholders, but in the future, these requirements will be even higher obliging VCs to adopt a more sophisticated ESG level, a so-called ESG 2.0. It is in the entire industry’s interest that ESG is no longer emphasized separately but it is rather taken automatically into consideration in VCs’ operations and decisions. This will likely not be achieved in the near future, but instead, ESG will remain a “hot topic”, like it has been during the last few years. Moreover, as ESG increases in importance, the differences in VCs’ ESG level will multiply leading to clear “winners” and “losers”. To succeed in this intensifying competition, VCs must proactively develop their ESG efforts, adopt best practices and engage in concrete, value-creating activities.

Read Part 1

Read Part 2

 

Kristian Perttunen

ESG analyst

Date
December 13, 2021