Venture capital has become an essential intermediary in the financial markets, providing funding to companies with difficulty raising money. These companies tend to be smaller and younger, plagued by high levels of uncertainty and large gaps between what entrepreneurs and investors know.
Investor focus on environmental, social, and governance data has grown significantly in recent years as market participants have become more interested in how much profit companies make and how they get it.
Sustainability and sustainable investing are investment techniques that incorporate ESG criteria into decision-making to achieve better financial returns with minimal risk.
Potential Impact of ESG Criteria on Investments#
Companies that effectively manage their environmental and social impacts and have robust governance practices are generally considered to be better positioned for long-term success.
By incorporating ESG criteria into investment decisions, investors can potentially mitigate risks associated with poor environmental practices, social controversies, or weak governance structures. Also, companies with strong ESG performance may demonstrate better financial performance over the long run.
There is a growing demand from investors, especially institutional investors and younger generations, for investments that align with their values and have a positive impact on society and the environment. Incorporating ESG criteria into investment decisions allows asset managers to meet this demand and attract capital from investors prioritizing sustainable and responsible investments.
Investors may be willing to pay a premium for companies with strong ESG performance, while companies with poor ESG practices may face a discount in their valuation.
Furthermore, poor ESG performance can lead to reputational damage for companies, affecting their relationships with customers, employees, suppliers, and other stakeholders. Incorporating ESG criteria into investment decisions helps investors avoid companies with significant reputational risks.
By integrating ESG criteria into investment decisions, investors can contribute to the long-term sustainability of companies and the broader economy. Addressing environmental challenges, promoting social equity, and fostering good governance practices can help create a more sustainable and inclusive future.
Responsible Investment#
According to Eurosif, (2008, p.6), the concepts of sustainable and responsible investment are currently very debatable issues and this concept is gradually growing in the financial world. The term “social”, “ethical”, “responsible”, “socially responsible” and “sustainable” are used in research very commonly and overlapping, but these words have the same meaning.
Responsible investment, also known as sustainable investment or socially responsible investment (SRI), refers to an approach where investment decisions are made not only based on financial returns but also on environmental, social, and governance (ESG) factors.
The goal of responsible investment is to generate long-term sustainable value while considering the impact of investments on society and the environment.
The RI has been considering ESG criteria in the investment decision-making process. The investors growing attention to ESG criteria consideration across traditional investment, investors are now considering SRI as a mainstream of their investment.
Positive Impacts of ESG Integration on VC Portfolio Companies#
- Safety from Government Regulation: With the effective embedment of ESG factors into the operational framework and policies guiding a business entity’s activities, the firm can successfully operate free from governmental sanctions, red tape, and restrictions. This is notably beneficial to venture funds because the destination of most investments in recent times are technology products and companies. With advancement in technology, comes increased regulatory oversight and government frameworks which the firms would have to operate within. Thus, ESG principles embedded in a firm would ensure that sudden changes that would hurt the business and its associated risks are mitigated.
- Beneficial Reputation: In many businesses and economic sectors globally, there are increased complaints of talent dearth. This is because of elevated levels of attrition and a lack of persons with the adequate skills needed for the roles. Social factors like trends in equality, diversity, data privacy, remote working options, and labor rights have influenced employee satisfaction and loyalty. Since these matters are of interest to the working population, the companies’ disposition to these social issues would then be determinant in the level of satisfaction and willingness to stay.
- Enhanced Financial Performance: Giving attention to the integration of ESG in a company’s operating model does not compromise high returns. Instead, it helps to achieve the opposite. A McKinsey report states that ESG has been found to facilitate topline growth in businesses, reduce operating costs, and minimize regulatory and legal interventions such as sanctions and fines. In addition to the above, it also optimizes investment and capital expenditures while increasing employee productivity
Bottom line#
Multiplying and maximizing an investor’s capital is one of the main goals of venture capital investment. Therefore, to get the most out of it, ESG integration must be made a key consideration before making such investments.
Depending on the sector and industry, a company will have its ESG profile and focus areas that vary depending on the value chain. I concluded that establishing a resilient test to ensure long-term value creation has value in ensuring a satisfactory return on investment.