ESG and VC: Deferred dialogue

Singapore-based ride-hailing platform Grab’s business model was initially based on altruism. The founders knew that taking a taxi could be dangerous business in Southeast Asia and dedicated themselves to a social solution. Their first engineer only joined on the condition that operations were non-profit. Eight years later, financial performance is clearly a priority. Grab is currently raising a $6.5 billion round – at a valuation of $10 billion – from investors that want to see growth and ultimately profit. 

Origin stories colored by impact or environmental, social, and governance (ESG) ambitions are not uncommon in VC because problem-solving for businesses and communities is seen as a ticket to both bankability and responsibility. Most VC firms are quick to point out that impact and ESG-related outcomes are natural byproducts of a for-profit investment approach and that many of their most successful portfolio companies bear this out.

LPs are active proponents of this concept in PE but have proven slow to adopt it in VC. To some extent, this is due to concerns around adding a potentially stifling filter or administrative layer to a business building process already challenged by scant resources and minimal investor control. It is also partially attributable to a lingering disconnect between best-practice ESG and enhanced start-up portfolio performance.

“It’s coming and it’s coming in spades but if you talk to the top-tier VC firms, they know they don’t have to worry about it,” says a US-based fund-of-funds manager active in venture. “Most LPs care but not to the point where they’re going avoid sponsoring VCs that give them the best long-term multiples they can get. But at the same time, once Harvard says, ‘we’ll only do finds that think about this stuff,’ then it will start to become a normal thing.”

This is being compounded by what appears to be a general lack of awareness among many institutional investors with appetite for ESG and impact that small digital companies are relevant actors in their broader responsible investment agendas.

Khailee Ng, a managing partner at 500 Startups, an early investor in Grab, saw this first hand as part of a UN panel on sustainable development in 2017. The assembled investors said they were having difficulty finding impact companies to support, prompting Ng to point out that VC portfolios happened to fit all the necessary criteria, especially in developing markets. This precipitated a joint UN-500 Startups accelerator program last year in Indonesia.

“There is a world of investors looking for ESG lens and impact companies saying they can’t find profitable deal flow. We happen to have invested in many of those types of companies as highly profitable endeavors, as we are purely a returns-focused investor,” says Ng. “However, those companies may not immediately measure themselves through an ESG or impact lens. Hence, it is up to seed investors like us to tell start-ups that these kinds of investors are looking for them, and that it’s in their best interest to measure themselves with the ESG and impact lens so they attract that kind of capital too.”

Emerging advocates 

It remains to be seen how long and thorough this education process will be – for all stakeholders – but a higher profile role for the UN could be an accelerant. The TPG Capital-founded Rise Fund, for example, has fashioned itself largely as a VC champion of the UN’s sustainable development goals (SDG) and attracted LPs like Washington State Investment Board, New Jersey State Investment Council, and San Francisco Employees’ Retirement System.

Meanwhile, the UN’s Principles for Responsible Investment (UNPRI) network has grown to some 2,300 institutional signatories that are expected to gravitate toward technology as they splinter off into new entities. One of the most recent of these groups is the air pollution-focused Net-Zero Asset Owner Alliance, which represents $4.7 billion in assets under management and a host of brand-name pension funds and insurance companies.

Tracy Barba, 500 Startups’ global investor relations director and head of ESG, is tracking this progress, mostly in the form of discussions and tentative experimentation. Barba joined the firm in January primarily to handle marketing duties but brought a 10-year background in impact investment services with her. That has facilitated the establishment of a formal impact and ESG policy that will see portfolio companies reporting on metrics such as SDG performance. 

500 Startups’ fifth global fund, which is expected to be the firm’s largest to date after reaching a first close of $66 million last month, will be the first vehicle to implement the strategy. The VC has declined to disclose the anchor LPs but has historically attracted pensions, publicly listed corporates and sovereign wealth funds.

Fund V will screen for typical ESG red flags such as child labor and gambling, but will also quiz start-ups on data privacy and diversity inclusion. The plan is to require all portfolio companies to track ESG-related data, while some, especially those that go on to receive follow-up investment, may need to report quarterly and annually on a set of individually tailored, PE-style ESG metrics. The idea is to help professionalize start-ups that already happen to be impact or ESG-oriented while also making it easier for interested LPs to recognize the qualities they seek in a portfolio. 

“There are a lot of organizations trying to figure it out, but I’m not sure about the amount of capital moving towards it,” says Barba. “It’s more common now for us to get DDQs [due diligence questionnaires] with ESG components from LPs because they are UNPRI signatories. They are required to report on their responsible investing activities so they’re asking their GPs to report on it as well, which is a step in the right direction. But I’ve only just started seeing that in venture capital." 

TPG and 500 Startups notwithstanding, Silicon Valley has offered little global leadership in this trend. This has opened a distinct opportunity for developing VC ecosystems, including those in Asia, to close the gap in terms of professionalism and credibility. Development finance institutions (DFI) targeting Asia are expected to play a significant role in this process, with CDC Group and FMO issuing a report in January stressing the importance of increased GP-LP engagement on impact and ESG themes in VC in particular.

Regionally based players may be better positioned to realize this goal, however, with Starquest Capital, a renminbi-denominated fund-of-funds focused offering a case in point. Starquest was established in mid-2018 with Sequoia Capital China, JD.com and a Chinese state-owned investor providing RMB10 billion ($1.4 billion) for a debut fund. The firm, which invests across early to growth-stage VC with a strong ESG overlay, joined UNPRI later the same year. 

“People say ESG is only for mature, big organizations, and they don’t have the resources. But for us, everything starts from ESG and motivation,” says Frankie Fang, a co-founder and managing partner at Starquest. “Why are you starting this company? What problem are you solving? Who’s going to benefit? These are crucial questions entrepreneurs should ask themselves. So, I think it’s even more important for early-stage GPs.”

Fang, who previously led the China ESG strategy rollout for LGT Capital Partners, has helped Starquest establish itself as a domestic leader in bringing the concept to VC. The plan is to rally a local network of investors, regulatory bodies, and universities to bring improved rigor to a market of some 25,000 GPs with low levels of institutionalization and sophistication.

Light touch

When China’s more established VC firms implement ESG, the others are expected to follow. Starquest’s portfolio GPs include Gaorong Capital, Source Code Capital, and Sequoia China. Starquest claims to have developed a quantitative, points-based method for assessing ESG performance of both GPs and their portfolio companies. But the questionnaires require a light approach. 

“We don’t want to overwhelm them with 100 pages of guidelines. We give very simple, easy to understand practices so they can focus on their daily operations,” Fang adds. “We have to roll it out in this way because otherwise people will lose focus. They need to understand these things over time by themselves. They have to make mistakes and eventually realize why it’s important by themselves.”

One GP doing this without much LP handholding is Singapore-based Openspace Ventures. Indeed, Jaclyn Seow, vice president of ESG and impact at the firm, describes it the other way around. She notes that LPs are coming to her team to better understand the association between ESG and returns for investors that are not strictly impact-oriented. 

Seow says that based on her conversations with DFIs, global VCs, and ESG and impact networks, Southeast Asia is at the beginning of an uptrend in integration of the strategy that will gain ground over the next few years. This outlook is further supported by immediate macro realities.

“The ongoing COVID-19 crisis in particular has brought the S in ESG to the forefront, shining a spotlight on the ways in which companies treat their employees, customers, and suppliers in difficult times,” Seow says. “Companies that have taken the effort to map their supply chains are also seeing the benefits of establishing transparent, resilient networks. We think the relative resilience of companies with strong ESG positions could drive more attention from LPs going forward.”   

The last frontier in all this is ethics. Little of the early traction in responsible VC touches on this point, and it is not expected to be a hot topic for years to come. Even as controversies around the ownership of identity data or the misuse of artificial intelligence (AI) bubble up with alarming regularity, dialogue on the subject has yet to become a part of regular GP-LP engagement.

This is true even for specialist firms. AI-dedicated Pi Ventures counts DFIs such as CDC and the IFC as LPs, but these investors have not yet questioned the Indian VC on policy for sensitive AI applications such as surveillance. There is every expectation these questions will come to the industry in the future, but for now, the focus is on spotlighting the benefits of tech, not preempting the damage it can cause.

“What I’m hearing from LPs is more about how AI companies can lead to ESG outcomes. Just like any other innovation, AI also has its downsides, and we need to be cognizant of that without taking a restrictive view,” says Manish Singhal, a founding partner at Pi. “Any restriction inhibits innovation, which is completely the reverse of what you want to do as a VC.”

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• Topics
• GPs
• LPs
• Venture
• Investments
• Asia
• USA
• ESG
• development finance institution
• Impact investment
• 500 Startups
• Starquest Capital
• Openspace Ventures