Estimating ESG returns and the value of impact investing

73% of European Venture Capital funds apply ESG investment criteria to their investment process, however, only half have policies in place and just a quarter is actually monitoring ESG performance, according to a survey conducted by the European Investment Fund.

My research came to very similar results and it may be concluded that this is due to the fact that a consistent way of reporting and a framework that may be easily applied is provoking. The main challenge is that current frameworks were mainly built for pension or PE funds and do not meet the needs of VCs. However, VC firms must start acting since the Sustainable Finance Disclosure Regulation (SFDR) requires all financial market participants in the EU to disclose ESG issues. Therefore, besides the need of reporting in the near future, the challenging question aside from the implementation is how to measure ESG and value impact investing?

How to measure and report impact?

First of all, most recent studies show a clear correlation between implementing ESG and financial performance. But why do most investors still primarily focus on Customer Acquisition Cost or Customer Lifetime Value and not on ESG ratios when it comes to their investment decision? Measurement is essential. It helps VCs to make better decisions and to communicate their values. If you are only talking about IRR, MoIC, DPI, TVPI etc., make sure to have a look at impact measurements too.

SROI (Social Return on Investment) for example is an investment technique designed to integrate ESG factors into the investment decision and provides a framework to calculate an investment’s present social value of impact compared to the value of inputs. It combines cost-benefit analysis, stakeholder engagement and financial proxies. The most important point you need to take into consideration when applying a SROI Ratio is that it should not be used to justify a capital investment, but rather to analyse the value creation through your capital allocation.

The SROI is only one example. In the last years, many different methodologies and frameworks were developed, such as the United Nations Sustainable Development Goals (UN SDGs), the Global Reporting Initiative (GRI), or the Impact Management Project (IMP) Framework. My last blog post already covered the first two. The focus here will be on the latter.

The Impact Management Project (IMP) Framework has the goal to build a global consensus around on how to measure, assess and improve impacts on sustainability issues. The framework focuses on 5 dimensions:

1. What?

Think about the outcomes you, as an investor, are aiming for. It is the intervention of what outcomes of people and the planet experience and how important those outcomes are to those experiencing them. For example, you as an investor want to create a positive outcome by investing in Fintech to revolutionise the way people get access to financial services in traditionally underserved areas.

2. Who?

The second important question is who experiences the outcomes and how underserved were they previously? Imagine you invest in a start-up that benefits an already well-served population, who gets to choose from a large pool of alternatives. The impact with this investment is definitely less than when you invest in a start-up that gives an underserved population access to something they got excluded from in the past.

3. How much?

How much of these outcomes occur? Meaning, how many stakeholders experience the outcome, what degree of change will they experience, and how long will they experience the outcome for? Make sure to break the problem down into scale, depth and duration and focus on all parts!

4. Contribution

What contribution are you making as an investor to the outcomes relative to what is likely to occur otherwise.

5. Risk

As we all know, it is essential to measure a projects risk. Risk is essential in the start-up and VC world, however, not at all costs. You need to make sure to understand possible negative externalities, too.

The value of this framework lies in the deep understanding of how the solutions you want to invest in are designed to have a positive impact. The combination of SDGs and the IMP may be very helpful for VC firms to start measuring and communicating ESG in the right way. Another helpful way is to add a sustainability clause to your term sheet in order to measure ESG along the entire investment process and monitoring.