How ESG Due Diligence Drives Venture Capital Value

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Does focusing on environmental, social, and governance (ESG) mean you have to sacrifice financial performance or shareholder returns? Recent studies suggest the opposite – that ESG and sustainability priorities benefit valuations over the long-term, particularly when integrated into the company’s core strategy.

ESG falls under the broader triple-bottom line sustainability umbrella wherein investors, analysts, and business leaders evaluate the impact of the industry- and sector-specific sustainability issues on a company’s risk profile and performance. For decades, leading investment funds like TPG, KKR, and BlackRock have incorporated ESG considerations into their evaluation process, with positive results that point to long-term value creation as a result of measuring and monitoring their sustainability-related risks and opportunities.

In years past, sustainability reporting frameworks were scattered, divergent, and confusing, making consistent and efficient measurement and reporting challenging for most companies because they weren’t sure where to start their baselining and benchmarking efforts.

This has changed in recent years as a few key guiding frameworks have begun to develop harmonized standards for how companies are evaluated on key ESG issues such as climate, diversity, equity, and inclusion (DEI), data security, and corporate governance. Among the most commonly referenced frameworks include the Principles of Responsible Investment (PRI), the ESG Data Convergence Initiative (EDCI), and the International Sustainability Standards Board (ISSB).

Controversy Around ESG Practices

ESG has also sparked controversy, with detractors complaining that it is redundant, measurement is subjective and difficult to benchmark, it requires sacrificing returns, and it creates an overall distraction from a company’s most important issues. Despite this pushback, ESG and sustainability considerations are trickling down to the middle market. General partners who don’t pay attention to this megatrend are at risk on multiple levels, especially as it relates to accessing limited partner capital and the risk of reduced terminal values.

According to Ryan Williams, PhD, former Chief Sustainability Officer at Coatue Management and Sustainability Operating Partner at NextWorld Evergreen, and current strategist with VITAL, “Anti-ESG backlash is simply the politicization of ESG that was initiated in several state legislatures as a response to what they perceive as ‘woke capitalism,’” he says. “Effective ESG integration, on the other hand, is a value creation strategy that creates outcomes for key stakeholders—customers, employees, and investors, that drive financial performance.”

Michael Whelchel, Co-Founder and Managing Partner at Big Path Capital, an investment banking advisory firm working with leading mission-driven companies and private equity funds agrees about the value creation impacts inherent in integrating sustainability principles.

“Companies that integrate sustainability principles into how they develop and deliver their product or service activate value creation on two different levels,” he says. “First, they reduce business risk and cost, thereby creating a more resilient business model. Second, they increase upside for their business by being in step with customer interest and better identifying areas of innovation.”

A Growing ESG Demand for GPs

Several recent studies reaffirm the assertion that good ESG practices support long-term value creation and can help lead to optimal results for GPs.

A 2023 Pitchbook Sustainable Investment Survey interviewed hundreds of private market GPs and LPs about their opinions on impact investing and ESG frameworks, and determined that “investing for profit and investing for purpose…need not be mutually exclusive.” Proponents for ESG integration cited the following considerations:

  • Access to a Growing Investor Base – 92% of respondents noted rising institutional and retail demand for ESG investments, and that it’s becoming more difficult to attract business or capital without a sharper focus on ESG. This is supported by 75% of surveyed LPs who feel that at least some amount of thinking around sustainability is important when considering a potential investment.
  • Enhancing Long-Term Value – 91% of respondents believe ESG integration contributes to enhancing the long-term value of their investments.
  • Meeting Stakeholder Expectations – 86% of GPs surveyed recognize that ESG alignment is critical for meeting the expectations of various stakeholders, including customers, employees, and communities. Responding to these expectations can enhance brand reputation, customer loyalty, and talent retention.
  • Mitigating Risk – 79% of surveyed GPs cited ESG factors as integral to their risk assessment processes.
  • Regulatory Compliance and Market Access – Over 70% of respondents believe regulatory compliance and adherence to ESG standards are key drivers in their investment decisions. Europe has traditionally led on mandatory ESG disclosures, but there is growing pressure in the United States for ESG regulations, and some states like California have already enacted laws focused on climate disclosures and anti-greenwashing.
  • Fostering Innovation – 64% of GPs see ESG considerations as a catalyst for fostering innovation within their portfolios.

A 2023 analysis by McKinsey & Company of over 2,200 public companies came to a similar conclusion that “financially successful companies that integrate environmental, social, and corporate governance (ESG) priorities into their growth strategies outperform their peers—provided they also outperform on the fundamentals.”

Their research highlighted companies they dub “triple outperformers,” which evaluate total shareholder returns (TSR), financial performance, and ESG ratings. The analysis shows how growth and profitability are positively impacted when a company also demonstrates leadership on ESG issues, by up to 7 percentage points above the study’s baseline.

The Value of ESG Due Diligence for Portfolio Companies

A 2022 KPMG study on Managing ESG Due Diligence in EMA Deals surveyed 150-plus dealmakers across Europe, the Middle East, and Asia about the importance of conducting ESG due diligence.

While the study clearly acknowledges that ESG enhances value (80% of dealmakers said they consider ESG in M&A and that material concerns could be a dealbreaker), it also highlights some common difficulties related to performing ESG due diligence accurately and consistently. These include undefined scope, poor data availability, lack of written policies, and difficulty quantifying metrics and targets.

This data illuminates the growing recognition of ESG considerations among dealmakers and underscores the opportunity to approach ESG as a platform for venture capital and private equity. The platform approach is a compelling opportunity for portfolio engagement to leverage shared learnings, create tools, and identify best practices to maximize value creation potential. Furthermore, because most small and medium sized funds focus on a subset of business models within an industry, there are inherent synergies across most portfolios such that GPs can build out a small but effective suite of material metrics to monitor across the portfolio. 

“ESG considerations have increasingly become a strategic negotiation tactic for private equity firms where the absence of an ESG program can be identified as unknown risk that may influence the valuation,” says VITAL’s Williams. “Companies that disclose ESG topics in due diligence often have a stronger negotiating position and may attract a broader range of buyers when they are able to provide ESG metrics.”

There is also growing recognition that the fiduciary responsibilities for board members are expanding to include ESG issues. If your board is not currently conducting comprehensive sustainability or ESG due diligence assessments, you may be lagging in effectively managing risks, meeting stakeholder expectations, and capitalizing on long-term opportunities. Momentum is continuing to shift toward more urgency, transparency, and disclosure on sustainability issues. Terminal values are being affected, regulations are on the horizon, and access to LP capital is increasingly at stake.

ESG risks do influence valuation and mitigation is frequently critical to a company’s exit strategy and investor returns. And while a lot of work remains in terms of data standardization and consistent comparison, progress is being made by groups like the ESG Data Convergence Project to support the investor due diligence process.

Getting Started with ESG Due Diligence

It is critical for GPs to engage in due diligence and performance monitoring now, and not as a pre-exit exercise, because doing so will position them for success, help mitigate risk, enhance the value of their investments, address stakeholder expectations, and create sustainable value for the long-term.

GPs looking for a place to start should perform an ESG Due Diligence assessment to help them better understand company- and industry-specific sustainability risks and opportunities for their portfolio companies, and begin to understand how to integrate these considerations into their core strategies. Contact us to learn more.