In his recent book “Impact”, Ronald Cohen predicts that the pie of financial assets will be cut into two kinds of investments going forward: 10% of financial assets will be committed to impact and the remaining 90% consider ESG principles in their investment decisions. ESG (environment, social, governance) principles and impact investing have indeed been gaining importance in the financial community at large, and more recently also in the venture capital (VC) sector. A recent survey of the European Investment Fund found that 70% of VCs use ESG in the investment decision-making process. Similarly, according to Principles for Responsible Investment and VentureESG, it is predominantly the initiative of the funds themselves driving ESG into the industry accelerated by increasing regulatory pressure, particularly in Europe.
However, pinning down what exactly it means to “adhere to ESG principles” or to “do impact investing” has so far been mostly undefined for venture capital investors. Venture capitalists themselves as well as journalistic commentators talk about sustainable investing, ethical investing, responsible finance, and indeed ESG and impact, often interchangeably. Specifically, for VC, there is a general lack of a universally accepted definition, standard, or methodology for ESG. Therefore, the purpose of this blog is to provide a comprehensive comparison between Impact investing and ESG and show how it relates to venture capital, eventually giving a starting point to advance the conversation and practice of ESG.
What is impact investing?
Impact investments are investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return. Impact investments can be made in both emerging and developed markets, and target a range of returns from below market to market rate, depending on investors' strategic goals.
The growing impact investment market provides capital to address the world’s most pressing challenges in sectors such as sustainable agriculture, renewable energy, conservation, microfinance, and affordable and accessible basic services including housing, healthcare, and education.
On April 3, 2019, the GIIN published the Core Characteristics of Impact Investing, which complement this definition and aim to provide even further clarity about how to approach impact investing. The practice of impact investing is further defined by the following elements.
INTENTIONALITY An investor’s intention to have a positive social or environmental impact through investments is essential to impact investing.
INVESTMENT WITH RETURN EXPECTATIONS Impact investments are expected to generate a financial return on capital or, at minimum, a return of capital.
RANGE OF RETURN EXPECTATIONS AND ASSET CLASSES Impact investments target financial returns that range from below market (sometimes called concessionary) to risk-adjusted market rate, and can be made across asset classes, including but not limited to cash equivalents, fixed income, venture capital, and private equity.
IMPACT MEASUREMENT A hallmark of impact investing is the commitment of the investor to measure and report the social and environmental performance and progress of underlying investments, ensuring transparency and accountability while informing the practice of impact investing and building the field.
What is ESG in Venture Capital?
ESG is short for environment (E), social (S) and governance (G), and entails a set of principles guiding a firm’s or a fund’s management, processes, and practices. Generally, ESG can be defined as “how corporations and investors integrate environmental, social and governance concerns into their business models”. Historically, the term ESG as well as the widespread and formalized use of ESG measurements in investment decisions started in the early 2000s. It was first developed in a 2004 report by 20 financial institutions in response to a call from the Secretary-General of the United Nations. The Fortune 100 Best Companies to Work for and the United Nations Global Compact marked important steps in the process towards using non-financial indicators in profit-oriented investment as a common practice.
While reporting is crucial for benchmarking and tracking a fund's or company’s progress on ESG issues over time, it bears the risk of losing the value-based origin of ESG. To avoid this pitfall, a definition of ESG must balance being detailed enough to be meaningful and applicable, and yet broad enough to leave room for initiative of fund employees and evolution over the coming years. According to Antler, ESG is broken down into 3 typical definitions:
Environment: how a company acts as a steward of the natural environment including water, air, deforestation, biodiversity, pollution, waste management, and carbon emissions
Social: How a company manages stakeholders including employees, customers, suppliers, communities and government relations
Governance: The policies and practices in place to address issues such as corporate purpose, diversity and inclusion
ESG versus impact investing in Venture Capital
Many investors and commentators alike are confused by the overlap between ESG and impact. As previously stated, Impact investing refers to investments made with the intention to generate positive measurable, social and environmental impact alongside financial return. Impact here has to be intentional, measurable and manageable. As a result, impact investing is an investment strategy (often related to a thematic investment focus, e.g. on green or clean tech) rather than a set of practice-focused principles. It is based on the assumption that investors can achieve financial returns while also addressing societal and environmental challenges, the so-called double- or triple-bottom-line approach. Impact Investing is related to ESG insofar as it goes beyond it and builds on it. For example, impact investing will use ESG assessments as a “positive screening” tool, allowing investors to actively target start-ups that perform especially well on ESG criteria and actively seek the opportunity of positive nonpecuniary value creation. ESG, however, to refer again to Cohen’s prediction, will become relevant for all investors, while pure impact investing is set to remain a specific (niche) investment strategy and asset class.
Generally, both communities overlap and share a similar mind-set and philosophy to think beyond shareholders and about stakeholder needs, producing ‘better’ business and positive change in the economy. While there is an imperative for impact investors to also adhere to ESG principles (to avoid environmentally harmful businesses or funds who pay their employees and suppliers badly, for instance), we see many opportunities for investors and companies adhering to ESG principles to – in reverse – also think more about (positive) impact in the future. After all, both ESG and impact investing are young for VC and startups, but crucial for the VC-backed economy to contribute to addressing the most pressing challenges of our times better.
VentureESG – Whitepaper
The Antler Quarterly – ESG, Impact and Venture Capital
Global Impact Investing Network – What you need to know about impact investing