ESG Investing: Hope v. Reality
As is true in the implementation of many principled goals, especially from the financial community, there seem to be some problems between words and actions, as is the case with ESG. ESG stands for environmentalism, sustainability, and governance. This means:
· Environmental: Are we doing what is good for the environment?
· Sustainable: Is what we are doing good for the long run?
· Governance: Is what we are doing good for everyone?
DOES REALITY LIVE UP TO THE HYPE?
Bloomberg BusinessWeek (5/9/2022, page 22) notes that there are a few snakes in the garden:
· Some arms dealers, who don’t get with ESG principles, manage to fit if arms are only a small part of their sales. So being a “little pregnant” seems acceptable.
· ESG ratings are developed by index creators and the process is opaque. Even though the “G” stands for fair governance, a conflict of interest seems acceptable for the ones making the rules.
· ESG seems to be measured based on the impact of a scarce resource on the company, not on consumers and the community. A company that uses a lot of scarce resources is acceptable if the company controls enough of the scarce resources. Hoarding seems acceptable if the artificial scarcity and higher prices hurt society – but not the company.
IS VC CONSISTENT WITH ESG?
Environmental: The most successful VCs invest in high-growth industries, which are mainly emerging industries.
The problem: Are all emerging industries environmentally friendly? Can ESG-VCs succeed without subsidies if they invest in environmentally friendly industries?
Socially conscious or elitist: The most successful VCs focus on financial returns, not social ones. High financial returns are often obtained by ventures started and led by entrepreneurs educated in the right skills, or by experienced entrepreneurs with great track records. Entrepreneurs who do not fit these exalted requirements are often replaced by experienced executives.
The problem: Can low-income-community members without a pedigreed institution in their background get VC from top VC funds? Can we teach unicorn skills to everyone to takeoff without VC?
Governance is not a key VC priority. Poor governance principles have not kept VCs from investing in ventures. Mark Zuckerberg controls more than 50% of Facebook’s voting rights but owns less than 30% of the company. The founders of Snap are said to control more than 90% of its voting stock even though they own far less. Both ventures got VC funding. Verkada sells security tools, but there are questions about the company. According to TechCrunch, “boy, did investors have to look away from a lot of alleged terribleness.” But that has not stopped VCs from funding Verkada. So, does governance really matter to VCs?
The problem: If it takes a single-minded focus on returns, and not governance, to get to the top 4% of VC funds, can restricted ESG-VCs join the top 4% of VC funds? And if they don’t get to the top 4%, will these funds get non-subsidized funding from the pension funds?
PUTTING ESG-VC FUNDS IN THE TOP 4%
VC is elitist because the institutions that fund them want high returns. The top 4% of VC funds, who get most of the institutional funding, are said to earn 95% of VC returns in the U.S. They earn high returns because they invest in the few homeruns that offer high returns without worrying about ESG, which seems to be an afterthought and mainly for PR reasons. Without these homeruns, VCs do not reach the top.
Can ESG-VC funds earn high returns and reach the top?
Having financed, interviewed, and studied unicorn-entrepreneurs (UEs), and having worked with the hardest form of ESG-VC, i.e., with community development corporations (CDCs) that focus on low-income communities and with the U.S. Department of Health & Human Services that funded them, here are a few suggestions for ESG-VC to seek a place in the Top 4% of VCs.
#1. Blend unicorn-entrepreneurship (UE) and VC for more unicorns everywhere. To earn high returns, ESG-VC funds will need to actively create unicorns rather than passively waiting for them to show up. The top 20 VCs are in Silicon Valley because that’s where the unicorns are. The unicorns are there because the UEs, who start unicorns, are there. VCs don’t do much before Aha – they don’t start unicorns. They enter after Aha, i.e., after potential is evident. To build unicorns elsewhere, ESG-VCs need to develop unicorns. To do so they need to train all entrepreneurs to bridge the VC gaps with unicorn strategies.
#2. Expand VC availability from pedigree to skills. Do not reject anyone – they might be the next Steve Jobs. About 10 VCs rejected Steve Jobs, one of the greatest entrepreneurs of all time. Offer training, not capital. No one can identify unicorn-potential by looking into an entrepreneurs’ eyes or listening to a pitch. ESG-VC can train everybody to build a unicorn with the skills and strategies used by the 94% of unicorn-entrepreneurs who took off without VC.
#3. Design better exits. VCs have to expeditiously exit from their ventures due to the 10-year life of the typical VC fund. To exit at high valuations, VCs need strategic sales or an exuberant stock market. Not many qualify for IPOs, especially when the stock market is not in a froth. In a strategic sale, the returns may be lower, and the acquiring corporation may relocate the venture. ESG-VC needs more equitable exits, especially for low-income areas.
#4. Use smarter financial instruments. Go back to the future for more equitable exits. VC started with subordinated convertible loans with detachable warrants that offered liquidity and returns. This instrument can be adapted to better compete with the preferred stock financial instrument used by institutional VCs in the 21st century.
#5. Make highly profitable ESG-VC less reliant on home runs. By combining UE and a smart financial instrument, ESG-VC can build more unicorns while simultaneously being less dependent on unicorns for their exits. This can open ESG-VC to all who prove their skills.
MY TAKE: Entrepreneurs can build unicorns with ESG (the real kind rather than the tortured definition used by financial institutions), in all communities by using unicorn skills and strategies. 18% of UEs delayed VC and 76% avoided it. By helping entrepreneurs takeoff without VC, ESG-VC can start more unicorns, finance them, and live up to the ‘S’ and ‘G’ goals of ESG. That would be a good start.
