Responsible investing is still important to institutional asset owners. Here's why

Despite the negative headlines surrounding responsible investing – and frameworks such as ESG and DEI – the picture is much more nuanced, even in big tech.

When you talk to the people who fund the venture capital and startup ecosystem – the limited partners (LPs) – the picture is very clear. Over the last six months, we interviewed 26 of the largest institutional asset owners and managers as part of a survey. Not one of these LPs, who are managing over $1.5 trillion in assets, plan to do less on responsible investing than they were two years ago and most are planning to double down, despite the politicized backlash. This is because it makes good business sense to think broadly about risk and value creation opportunities, particularly when investing in early stage companies.

Some of the big tech collapses in the last 10 years have made it clear how risks are often overlooked; some non-financial but financially material risk factors should be impossible to ignore. The latest implosion of scale-ups such as FTX, WeWork or Africa’s biggest FinTech Flutterwave have shown the power of governance failures.

Diversity, equity and inclusion (DEI), when done well, comes with both reduced human resource costs, e.g. due to increased retention, and a better company culture that tackles sexual harassment issues. Both are directly aligned with the bottom line – as Apple and Costco’s shareholder defence recently highlighted. Conversely, Target customers boycotted the retailer in response to their DEI cutbacks. Human rights and environmental considerations are linked to the financial impact of both regulatory non-compliance and potentially impacted reputation, as customers ask more questions on supply chains and sustainability.

These are all business case arguments that institutional asset owners and managers agree with. Their biggest goal: reframe responsible investing and environmental, social and governance (ESG) so that it actually works.

LPs see ESG frameworks not as a one-size-fits-all box to be ticked, when making an investment decision, but an analysis of broad ESG risks – useful starting points to deep dive into the specific factors with potential to influence returns.

Building on the expertise of the last year’s ESG experiments in venture capital (VC), LPs are becoming more sophisticated on how to support their VCs in this endeavour. They are increasingly demanding specific responsible investing practices (including a policy, a fitting investment framework and demonstrated integration across the VCs’ processes). LPs also view their role as partners in developing more sophisticated responsible investing approaches with their VC fund managers. The LP stewardship includes substantial support rather than just monitoring compliance. This also comes with flipping ESG from a mere risk management into a value-creation framework.

Some of these issue areas – good governance, portfolio diversity tracking, carbon accounting (at least in Europe) – have become so fundamental that many LPs no longer talk about them as ESG; they are viewed instead as core fiduciary responsibilities.

The increasing asset-class-specific sophistication of VCs and LPs combined with the politicized ESG backlash in the US, has overall led to a shift in language. Use of the terms “ESG” and “corporate social responsibility” increasingly trigger cries of wokeism – and we have seen departures from the voluntary industry group Climate Action 100+ and the UN-backed Glasgow Financial Alliance for Net Zero (GFANZ). In the age of highly-politicized vocabulary, “responsibility” is emerging less in the words that are said and more in the actions, processes, and factors involved in decision-making.

In fact, spearheaded by the most sophisticated LPs, we have seen the emergence of best practice methods of integrating broader responsibility concerns into existing VC processes. LPs increasingly ask for more evidence to go beyond box ticking and into the action. They ask for case studies and examples, they speak to various team members about responsible investing/ESG – from junior to partner – and they also get their hands dirty. They share best and worst practices across their funds, and host workshops and trainings on issues as specific as responsible AI or dual use, and as general as responsible investing.

What we have also observed is generally more alignment between LPs. Aligning on reporting is one step, reducing the annual burden of ESG. In parallel to the private equity EDCI, Invest Europe (together with VentureESG and seven of Europe’s biggest state LPs) has led successfully on this effort. This reporting season, the large majority of European startups will report on this template – with the potential to drastically reduce the reporting burden and enable better data comparison going forward.

The next step is working together on the harmonization of the responsible investing process. How can LPs normalize an expanded perspective of risk and opportunity, considering all stakeholders and create a shared vocabulary and understanding of the materiality. This will make it easier to ask questions on responsibility when investing in competitive environments, and improve the quality of the answers – since if the same thing is being asked more frequently, fund managers and founders will be more likely to shift, without confusing the direction of change.

European regulation has played a core, if occasionally clunky, role in developing this unified approach so far. SFDR, whilst often lamented for its lack of materiality, has had two important consequences: ESG and responsible investing are now at the forefront of VC and startup minds across Europe, and a picture of what good sustainability reporting looks like is emerging. It was the LPs who translated mostly unspecific regulatory requirements into asset class specific expectations that actually made a positive difference for how VCs invest and work with their portfolios. More importantly, these effects go beyond the borders of Europe – as American VC managers increasingly raise LP money in Europe, they have to meet the uplifted ESG practices.

The next step to building this shared approach will be creating the right forums for communication and practice sharing amongst LPs. Only in speaking to each other – sharing what works and what doesn’t, what is material when and why, and what can go wrong – can a norm of doing more emerge across the VC ecosystems.