The Ethics of VC — why have VCs not engaged in ESG experiments yet? (#7)
In November, I laid out why I believe that the incentive structures for investors (and the startups they invest in) to care more about their impact, about ESG guidelines — in short: about being good or ethical — are changing. Increased pressure from the public and consumers, from LPs and from regulator is pushing investors into that direction. Bad press, scandals, the so-called techlash — all of this seems to be contributing to an environment were first of all being bad is costly (see the Uber debacle) and being good starts to make financial sense as consumer appetite shifts. What I haven’t answered yet, and what I am still struggling with myself is the question: why has nobody in the VC world started to really care? Why are supposedly much less progressive asset managers and buy-out funds — from KKR to BlackRock to JPMorgan Chase — beginning to at least announce that they care, but there isn’t a single traditional venture fund that has shifted perspective on the topic?
Today, I want to put the question in the context of the wider VC incentive model, something I have been researching for the last two years, as well as offer three possible answers. First of all, I will talk about the influence of ‘fiduciary duty’ on investment decisions; in a second step, I will address three hypotheses in turn: LPs actually have much less influence on (top-tier) VCs than on for instance PEs; VCs don’t have to overcompensate as much as other investors in terms of doing good; and lastly, quite a few VCs are in fact doing ESG/impact/for-good investing but don’t call it by its (new) name.
The VC incentive model — and how ‘good’ doesn’t seem to fit in there (yet?)
How does venture capital actually work? Unlike in the very beginning of the industry in the late 1800s and early 1900s when ventures were financed mostly by family money (see Nicholas’ excellent history of US VC on this), today’s venture money is mostly not family money. The majority of the VC money comes from public pension funds, private equity, fund of funds, foundations, government agencies and endowments (together making up ~80% of VC funding). Importantly, VC general partner are not investing their own money but really are asset managers for other institutions. They are hence — as so many of them explained to me in our interviews — bound by fiduciary duty to their limited partners or shareholders. “We are first and foremost responsible to make (big) returns for our limited partners. That is the bottom line,” as one partner in a UK fund told me. “We are a financial investor and we are responsible to pay the money back [to the LPs]”. Additionally, most funds have a set and limited life time of ten years. That means not only will they have to pay back investors (ideally a multiple of their invested capital) but this also has to happen within a specific period. This puts a very restricted timeline in front of the VC which arguably doesn’t allow for as many experiments as the assumed ‘risky nature’ of venture investing suggests.
On an even broader scale, this view is supported by a very simple observation. While VCs are happy to take risks and bets and conduct ‘contrarian experiments’, they only really do so in two specific industries: biotech and IT (and very, very little in agriculture, housing, media, retail, automotive and anything to do with the environment). The most common argument why ‘impact’ is not part of what VCs do is that returns are not (yet) on par with standard VC returns (or in fact S&P 500 returns, as this Cambridge Associates report from 2019 shows). While since a big push at the latest since 2015 (and the first GIIN/CA report) to argue that ‘impact returns’ are almost comparable to venture returns, this gap hasn’t quite closed yet. Another factor the industry might still remember: first endeavours into ‘green growth’ territory in the mid-2000s ended rather badly for industry heavyweight Kleiner Perkins. Perhaps others don’t want to risk it, stringently following a much wider industry trait of herding (see Wharton here for more context on herding during the first clean-tech boom).
So the argument for VCs is easy: Cobbler, stick to your last — if anything, for the sake of your LPs. The general VC incentive and organisational model with the fiduciary duty at its core and the avoidance of industry risks could be one major reason for VCs not to jump into ESG/impact/green tech investments. In the end, the life of a venture fund beyond ‘fund #I’ depends on securing returns. ‘Good investments’ haven’t proven viable enough yet — so, paradoxically, they so far seem to simply be too risky — as a new asset class, a new industry — for VCs.
But beyond this fundamental analysis of the basic workings of VCs and how there might be a mismatch with taking ‘good’ bets, there are three other hypothesis I want to offer as possible explanations why VCs are so far not attracted to impact investing: first, there is no (LP) pressure to do so; second, they don’t have to show they are ‘good’; third, they are doing it anyway but don’t call it ‘impact’.
- LPs can’t actually influence VCs as much as they can other managers — that’s because of the power-law.
I spoke to several big LPs in the US last year, all with sizable venture allocations. They all said they cared about ESG and impact (I wrote a piece specifically about their influence on increased diversity). But their influence on the top-tier fund in this respect is actually relatively small. As a representative from a big foundation in the US told me: “There are a lot of private conversations you are having with these individuals every six months — but it’s hard.” What I really understood the LPs were saying to me, however, is that they can’t threaten Sequoia, Greylock, A16Z and Co. They don’t want to risk being thrown out. The rationale behind that is simple: fund returns in venture capital are heavily skewed (see McKenzie/Janeway or also Nicholas’ recent comparison of VC returns to the whaling industry). VC returns follow a power law distribution, which means that the top decile of funds significantly outperforms the average; in other words: only the top 10% of funds really produce above average (e.g. above S&P500) returns over time. Moreover, there is persistence over time, i.e. there is a high likelihood that top-tier funds generate above average returns continuously.
What am I getting at here? High return VCs are actually rarer — and in some sense more foreseeable — than good returns in other asset classes (like buyout/PE) so that once you have an allocation as an LP you hold on to it. The pressure that LPs might be putting on buyout firms — that are overall more competitive and interchangeable — to for instance adhere to ESG guidelines would hence be much riskier in the venture world. So without this pressure on GPs which is seen as one of the major forces in other parts of the investment community to adopt impact/ESG more, there is one less incentive for VCs to change.
2. VCs don’t have to overcompensate as much to show that they’re doing good
Private equity firms as well as hedge funds were called locusts, barbarians and the ‘worst of capitalism’ both before and after the 2008 crisis; their practice of buying cheap, cutting into pieces and selling high is often frowned upon as value extraction. Many of their deals increase the overall level of debt, bankruptcy and job loss. Some even claim that PE threaten ‘companies, communities and countries’ with these deals. Even the PE companies and hedge funds themselves are concerned with their ‘bad rep’.
It is hence not exactly surprising that the trade bodies of these investors have massive incentives for charm offensives on both sides of the Atlantic. ESG is one major factor in this, supposedly off-setting the otherwise debt-fuelled short-term profit making of these investors. Carlyle, Bain, KKR and a number of hedge funds all published extensive ESG strategies, in some cases even started dedicated ESG or impact funds. Again, the pressure here came at least partly from LPs (particularly pension funds) and the loan investors PEs so badly depend on. But really, I argue, the push can be cladded as a massive public relations initiative (that might just stay a ‘façade’, just as CSR more generally as Alison Taylor recently reported).
The reputation VCs had over the last decades — until the inceasing techlash also swept some of them under the carpet since perhaps 2015 — been positive (as job-creators, innovators, disruptors) and neutral at worst. Somehow, it has so far mostly been the tech-founders — Uber’s Travis Kalanick more than anyone else and most recently WeWork’s Adam Neumann — that were called out for being jerks. Venture investors are usually in the background. Beyond several accusations, lawsuits and oustings as part of the #MeToo movements, recently followed by more and more of a probe into the lack of (gender) diversity, venture capital has a good reputation. They don’t really need white or green-washing. They don’t have CSR departments and they don’t need to show they are ‘doing good’.
3. VCs are doing it anyway — just don’t shout about it.
Going beyond just the lack of a reputation issue and hence incentives, lots of VC partners I spoke to, particularly in Silicon Valley, were rather surprised by any question about their ethics and concern about ‘doing good’. It was part of their self-understanding — in their words — that they also thought about the impact they had on society at large, not just their wallets. Lots of VCs, particularly the ones with sizable investments in areas that lend themselves to be understood as impact — med tech, bio tech and reg tech for instance — don’t see the need to even consider a specific impact fund or ESG guidelines: ‘Everything we do is impact.’ And indeed both in the US and in EU, verticals that are more likely to be ‘impactful’ such as health and bio-tech are among the top 5 sectors for VC investment.
Relatedly, there is also a tendency to not label this kind of impactful investing ethical, ESG or impact investing at all. Obvious Ventures, a fund that only started in 2014 but is run by industry veterans such as the former Twitter and Medium CEO Ev Williams is a good example. They started Obvious in order to do something differently: solving humanities biggest problems while at the same time investing in the most valuable companies of our time (according to their Credo). They call that ‘world positive investing’ which they do under the umbrella of a B-Corp. In interviews I conducted with people inside the fund, they refuted the label ‘impact investor’; in fact, they went as far as inventing their own term: world positive investing.
