Terms like “small” and “local” have become shorthand for “ethical” – a way for consumers and businesses to signal virtue. Meanwhile, having large investors or a multinational footprint carries the stigma that profit will always come before corporate responsibility. Contrary to this common perception, small and local can also mean unaccountable and under-regulated, while having large investors and footprint can increase accountability and transparency.
Venture capital and private equity play a role in bringing these smaller enterprises under oversight. By accepting investment, smaller firms may find they have new disclosure requirements to substantiate their ethical claims. As someone who helps alternative assets managers collect this data, I believe the aggregate impact of bringing these companies onto the radar matters.
In recent months this idea that ESG matters has been confirmed by unlikely sources. A slew of U.S. states instructed their state agencies to divest from or stop doing business with several major financial institutions in what was described by the New York Times as a political backlash against ESG focus. It reveals that both supporters and detractors of ESG policies believe those policies make a difference.
Push and pull
As a result of ESG policies and regulation, we are seeing a level of detailed disclosure across all private equity fund types that we have only previously encountered in the data of impact investors. As just one example, it’s now common for regular buy-out private equity funds to ask portfolio companies to report kilowatt-hour (kWh) of power consumed from renewable sources. My team and I have worked with data of privately held assets for almost 10 years and can tell you that level of granular detail is new for most funds.
Some of this is driven by LP requests for asset-level KPIs, and some of it is because these businesses now fall under regulation that impacts the fund.
Even the recent ESG Disclosure Proposal by the SEC, which is unlikely to put pressure on small businesses, will form a model and expectation for disclosure, as well as spawn new benchmarks for public assets. LPs will ask the private markets for the transparency they get from the public markets.
On the other side of the pond, SFDR affects all EU financial market participants (including alternative assets funds, pension providers, and insurance companies) and has metrics such as carbon footprint which uses emissions from the individual asset level, instantly bringing those assets into the reporting space.
Geography offers little shelter from the reach of this EU regulation. As S&P Global reported last year, even in the US-based financial services companies they reviewed, half of these companies had subsidiaries in Europe, bringing more than $3T in value under SFDR. Due to the inclusion of venture capital, many small and even pre-revenue companies will collect and report more data. Even with deal sizes trending up in this space, the average is still under $10M, so relatively small.
Is this increased disclosure burden on smaller companies a good thing? There are obvious benefits for investors with ethical commitments and regulators seeking to manage environmental or social impacts, but there are practical operational uses on the business side as well. In many cases, ESG metrics are material for the bottom line, too.
It’s no accident that the manufacturing sector focused on waste reduction long before being pressured to do so for environmental reasons. Practically all reductions in wasted raw goods result in higher profits.
Small adjustments to conserve resources yield significant cost-savings. Servers that use less power are less expensive for cloud-based companies to host on. Hiring and retaining diverse staff results in a richer mix of new ideas and better dialogue with clients. Monitoring KPI shows the connection between ESG metrics and both enterprise health and profit.
There are limits, of course. Not every improvement is going to provide ROI to a growing enterprise. Companies may have to hire new talent to calculate these metrics. Focus on ESG improvements could genuinely detract from investment in the core business. There’s no cosmic guarantee of ‘impact alpha.’
But these trade-offs are not new. These are the choices of running even a minimally responsible business. It’s the rare business leader who boasts of supply chain slave labor or waste disposal violations, and the rare investor who wants to take on that type of risk.
A thoughtful approach
As my team sees clients handling newly granular reporting pressures, a few best practices emerge.
Include responsible investing in all stages of the investment lifecycle. Collect relevant ESG metrics during due diligence as part of broader data collection exercises. Store this data in a consistent way, then bring it into the asset onboarding process. The hundred-day plan is a great place to capture and manage ESG risk factors alongside other operational improvements. Portfolio monitoring of financial metrics can easily be expanded to include more KPIs, or you might find ESG data hiding in metrics you already have.
Use ESG reporting as an indicator of operational excellence. Tracking emissions as well as a handful of other ESG metrics is becoming easier and more commonplace and ultimately has become a proxy for judging the operational intelligence of an organization. This can be an opportunity to evaluate the management team’s handle on leading indicators and whether the technology being used for accounting and reporting is robust enough.
Focus on impact. Rather than chasing a flashy out-of-context number or a score, put together the movement and trajectory behind that number and a meaningful story will emerge. This is also the way to tease out ‘impact alpha’ as part of the value creation story.
To some degree, every company in the modern marketplace acknowledges that transparency around sustainability has fundamental operational and ethical value in the long term. In many ways, ESG is simply codifying and extending accepted practices across enterprises of all sizes.
Investors are bringing more accountability to small businesses, and with a thoughtful approach that focuses on relevant and useful metrics, they can also provide invaluable support and guidance toward excellence.
Danielle Pepin is the head of product for portfolio monitoring and valuation at Dynamo Software.
This article was first featured in Impact Alpha on October 27, 2022.