Wafra: Taking a holistic approach to ESG diligence in venture capital

Wafra Inc. manages approximately US$32bn in AUM^[1] including in private equity, infrastructure and venture capital. We generally take a hands-on ESG approach and view investments as partnerships in which we aim to educate, engage and empower our portfolio companies and managers to adopt best-in-class ESG practices and build long-term sustainable businesses.

Why we focus on ESG incorporation

Venture capital managers play a crucial gatekeeping role in deciding which new companies will receive funding and which will not. As such, they help determine the new technologies that will shape our lives tomorrow and, with that, the future of key societal, political and economic structures.

This gives rise to:

a) an important responsibility on the part of venture capital managers to identify ESG-related risks within their investment process; and

b) an opportunity to capitalise on sustainability-related opportunities.

However, although ESG incorporation is becoming more prevalent across most asset classes, the venture capital industry has been slower to adapt.

In particular, we find that GPs often struggle with prioritising responsible investing alongside growth and understanding how ESG factors are material for start-ups. Therefore, our Sustainable Investment Group offers to provide venture capital managers with practical guidance on how to identify material ESG issues and how to build an investment-focused integration framework.

By investing in some of the largest venture capital funds, we are uniquely positioned to encourage and support the adoption of strong, long-term ESG practices among GPs. Our targeted approach to identifying financially material ESG risks and value creation opportunities helps us to identify forward-thinking venture capital managers with scalable, innovative strategies.

How we focus on ESG incorporation

Fundamentally, we view ESG risks as investment risks and conduct in-depth diligence on financially material ESG factors prior to investing.

We were an early adopter of the materiality framework developed by the Sustainable Accounting Standards Board (SASB). SASB’s metrics inform our diligence framework and are overlaid with deal-, GP- and industry-specific information to create a holistic approach.

This is founded on the belief that robust ESG diligence should not only focus on GPs’ business strategy and practices, but also include a thorough vetting of the way they select, manage and help grow their underlying investments.

We take a two-pronged approach to ESG diligence whereby material factors are assessed at the level of the GP (Tier 1) and their underlying fund investments (Tier 2).

Tier 1 focuses on cross-sector and governance considerations such as cybersecurity and litigation while Tier 2 homes in on the sector-specific ESG integration practices that we expect of each GP.

To be sensitive to many venture capital managers’ resource constraints, we aim to limit our ESG diligence to a specific set of questions that we consider most material.

We use an ESG scoring system to take a rigorous, quantitative approach to due diligence. Under this methodology, each ESG factor is assigned an objective score ranging from 1 (material ESG risk) to 5 (best-in-class practice). We include these diligence findings in our investment committee materials.

By assessing a GP’s performance relative to what we deem industry best practice, we can identify areas of improvement. Importantly, our scoring rubrics vary depending on the size of the manager, the number of funds and the time frame, intensity and likelihood of a risk or opportunity affecting the financial performance.

We measure and monitor a venture capital manager’s ESG performance relative to their peers of similar size and strategy using our quantitative scoring system. It is then easy to identify engagement opportunities to support venture capital managers in augmenting their approach to ESG integration.

Example

Venture capital managers commonly say that ESG integration can be a broad, complex topic and that such factors are not always material to their asset class. Hence, our ESG diligence focuses only on issues that may directly impact their financial or operating performance, showcasing a practical, efficient approach to ESG integration. Given that venture capital managers’ influence over their investees can be limited and failure rates among start-ups tend to be high, we find this is particularly useful.

In 2021, Wafra contemplated investing in a venture capital firm targeting the consumer and enterprise technology sectors. At the firm level (Tier 1), our ESG diligence focused on governance and social factors such as management expertise, cybersecurity, diversity and business continuity. We have identified specific practices in each of these areas that we evaluate for each GP. In this case, the manager demonstrated generally robust performance, with most firm-level scores ranging between 4 (good ESG practice) and 5 (best-in-class ESG practice).

Our ESG diligence emphasises our collaborative, partnership-based approach to investing, particularly at the investment level (Tier 2). Specifically, diligence focused on the GP’s approach to ESG integration throughout the investment process and on their process for analysing material factors. For example, we asked them how they assess investees’ practices for reducing energy usage, promoting DEI and using consumer data.

While the GP in question did not yet have a formalised ESG approach in place, they were developing a framework for responsible innovation that applies ESG and impact concepts to venture investing. They highlighted that our sector-specific questions provided helpful insights into which issues to focus their investee diligence on.

This helped to inform the manager’s efforts to develop their own set of sector-specific ESG diligence questions, thereby helping to drive their investments in long-term sustainable companies.

Given many venture capital managers’ resource constraints, we recognise incremental progress and allow them to focus on select material ESG initiatives at a time. For the GP in question, we highlighted SASB as a resource to help focus their ESG diligence efforts and may provide further guidance on integration best practices as they continue to evolve.

We find that venture capital managers typically fall into one of two categories: they have either yet to understand the investment-related benefits of ESG integration or they are actively looking to engage.

More recently, we have noticed an increase in managers proactively asking for our guidance, which suggests that GPs’ appreciation for the importance of ESG incorporation is growing.

We believe that successfully advancing more in-depth ESG integration in venture investing depends on constructing a targeted, practical and materiality-based diligence approach that addresses all levels of an investment, to enable GPs to build companies that are well-positioned to navigate the challenges and opportunities of the future.