“I still don’t believe that ‘doing ESG’ can be done without financial sacrifices.”
A senior investor in a fund made this comment at the end of a training we recently conducted in Europe. It made us feel frustrated: What did we just spend four hours explaining? And it also made us feel worried: How is this a question of belief?
Let us step back for a moment: Our team at Reframe Venture is five years into our work with venture and growth investors to help GPs and LPs integrate responsible investing across their value chains. We have very strong qualitative evidence already that there are several business cases for doing this:
- More responsible companies are more financially successful, finding procurement and hiring easier while avoiding devastating incidents. (This is the “bottom-up” business case.)
- ESG credentials are increasingly expected and scrutinized on exit, whether through M&A, follow-on or IPO.
- LPs globally are asking more and becoming more sophisticated on ESG requirements in their private-market investments. That’s not just in Europe; we’re seeing continued and increasing action in the US, Canada, and APAC.
Data from our “more mature” cousins in private equity supports this evidence. EDCI data has shown very clear links between certain sustainability practices — worker engagement, for instance — and financial outcomes. The most recent work by the PRI, together with Bain and NYU, supports this argument on the post-investment value creation side.
Yes, we need to be hyper-focused, not only on regulatory compliance (which itself doesn’t drive value but is simply part of the cost of doing business), but also on material issues. This has been clear for years — from the public markets research of Harvard’s Georg Serafeim and others to much of Alex Edmans’ later work (e.g. on Rational Sustainability). Risk identification and focused value creation are what actually drive financial outcomes.
This is not a question of belief and conviction (unlike many other decisions in VC), but simply one of doing the right work.
You need to seed before you can harvest
We have been working with hundreds of private-market investors, mainly VCs and their LPs, on how to do this work. We see three barriers to responsible investing being done well in our ecosystems.
1. LPs need to coordinate, specify and harmonize what data they ask for
LPs need to have asset-class-specific approaches (PE is not VC) that are proportional and ideally coordinated with peers to keep the box checking to a minimum. Start with reporting and do it in a harmonized way. (We laid some groundwork here with Invest Europe and the largest VC LPs on the continent).
2. Investors need to pull their weight
Heads of ESG or responsible investing can’t do their job of helping identify and work on material issues when investors — who often own the relationship with companies and are regarded as more influential — don’t push explicitly in the same direction. Sustainability is a big commitment and investors have a key role to play.
Responsible investing has to be owned by investment teams, not just ESG heads. Start with education and training, and make it as easy as possible for investment teams to engage without changing their processes. ESG doesn’t need to be an add-on; it just helps investors ask better questions during due diligence and on boards. LPs can play a key role in pushing investment teams in this direction.
3. Everyone needs to allocate budgets
Change doesn’t come without change management and investment; none of the above will “just happen.” You need to actively manage this process and bring expertise into your funds. That will cost some money. The firms who have been making the most progress on this front have started to allocate significant budgets to their responsible investment and ESG functions over recent years for tools, trainings and peer learning. Again, LPs have a key role to play here: Make clear that you expect the expertise in your GP teams to grow and they will finally put a budget line in.
This latter issue is especially prevalent among earlier-stage investors; they are not used to spending on sustainability (or on external input in general). Every week we hear from people who are tasked with “doing the responsible investing” work they don’t have budget for. But how do you expect to reap benefits without any investment?
There is a strong business case for responsible investing across private markets. But in order to see this case pan out, earlier stage investors still need to invest resources in it.
Johannes Lenhard is the CEO of Reframe Venture and affiliated lecturer at the University of Cambridge. Oliver Nixon is the research lead at Reframe Venture.
Guest posts on ImpactAlpha represent the opinions of their authors and do not necessarily reflect the views of ImpactAlpha.
