Embracing ESG to Pioneer Change in the Middle East Venture Capital Industry

Introduction

Environmental, social, and governance (ESG) considerations have gained significant importance in recent years across various industries, including venture capital (VC). Beyond being an acronym that has been trending over the last few years, ESG has emerged as an essential item for leadership teams across the board.

Closer to home, VC firms in the Middle East are starting to adopt ESG practices as swiftly as their counterparts in other parts of the world. As a local VC ourselves, we would like to share our perspective on the significance of ESG in the VC industry, and the surrounding business and societal environment. We will discuss how it can impact both the companies receiving funding and the investors providing it, as well as its broader implications for the ecosystem. Additionally, we will explore the current state of the VC industry in the Middle East region and provide insights on how VC firms can develop an effective ESG strategy.

What is ESG?

Let’s begin by explaining what ESG means. In its entirety, the acronym refers to non-financial factors, specifically the impact on the environment, consideration of society, and fair leadership and decision-making processes. To break it down further, each letter in this abbreviation represents the following:

1. Environmental: Environmental considerations refer to a company’s impact on the natural world and its efforts to reduce greenhouse gas emissions and minimize its environmental footprint.
2. Social: Social considerations refer to a company’s impact on society, including its treatment of employees and its involvement in the local community.
3. Governance: Governance considerations refer to a company’s leadership and decision-making processes, including its transparency, accountability, and ethical practices.

Why Does ESG Matter in Venture Capital?

There are multiple compelling reasons why ESG holds significant importance in the field of venture capital. With its capacity to generate positive societal impact, enhance financial performance, attract conscious investors and top talent, differentiate firms, and bolster reputation, ESG has emerged as an integral and indispensable element of responsible and sustainable investing within the venture capital industry. The primary motives to embrace ESG can be summarized as follows:

1. Values that promote a positive influence on society: Generally speaking, the betterment of society matters to VC firms, and fostering a culture of innovation is often a top objective for them. By integrating ESG considerations into their investment decisions, VC firms can proactively contribute to and influence sustainable and socially responsible business practices that will ultimately benefit society as a whole.
2. Financial performance: In addition to helping VC firms ensure that their values are met, there is growing evidence that companies with strong ESG practices tend to outperform their peers financially. This is because ESG considerations can help companies reduce risks, improve efficiency, and increase innovation. For example, a company that invests in energy-efficient technologies may experience lower energy costs and a reduced carbon footprint, which can lead to improved financial performance. Numerous studies have shown that companies with robust ESG profiles tend to outperform their peers over the long term. A 2020 study by the Harvard Business Review found that companies with high ESG scores had a 5% higher return on equity and a 10% lower cost of capital than companies with low ESG scores. Another study conducted in 2020 by the Global Impact Investing Network found that ESG-focused investments generated a 12.2% annualized return over a 10-year period, compared to 9.6% for non-ESG investments.
3. Differentiation among peers: The third significant benefit of adopting ESG practices that VC firms stand to gain, in addition to value-driven operations and investments, is the ability to stand out and differentiate themselves in a crowded market.
4. Attracting conscious investors: With the increasing awareness of sustainability and corporate responsibility, having a strong ESG focus can make a VC firm more appealing to potential investors who are looking for ways to align their investments with their own values. In some cases, investors are even demanding ESG practices from VC firms. In fact, a 2021 survey by Morgan Stanley found that 70% of investors believe that ESG factors are important to their investment decisions.
5. Attracting conscious talent: Companies with strong ESG profiles are often more attractive to top talent. This is because employees, particularly younger generations, are increasingly seeking work that aligns with their values and purpose. A VC firm with a strong ESG strategy may be more appealing to talented employees who prioritize sustainability and corporate responsibility in their career choices, which can, in turn, further drive the innovation flywheel.
6. Enhanced reputation and trust: Companies with strong ESG profiles are often viewed as more trustworthy and responsible. This can lead to an enhanced reputation and trust among stakeholders, including customers, investors, and the general public. This is particularly important in the venture capital industry, where reputation and trust are critical to success.

That’s to say, ESG matters in venture capital due to its ability to promote positive societal influence, improve financial performance, differentiate firms in a crowded market, attract conscious investors and talent, and enhance reputation and trust among stakeholders.

ESG vs. Impact Investing

Impact investing and ESG are both investment strategies that consider environmental, social, and governance factors. However, there are some key differences between the two.

Impact investing refers to investments made with the intention of generating both financial return and positive social and environmental impact. It is a type of investment that seeks to generate a positive social or environmental impact alongside a financial return. Impact investors typically invest in companies or projects that work to address specific social or environmental challenges, such as climate change, poverty, or inequality. According to a report by the Global Impact Investing Network, the impact investing market reached $715 billion in assets under management in 2020 and is expected to continue growing in the coming years.

In contrast, ESG investing is a broader term that encompasses any investment strategy that takes ESG factors into account. ESG investors may choose to invest in companies with strong ESG practices or avoid investing in companies with poor ESG practices. They may also use ESG criteria to screen out certain industries or sectors, such as fossil fuels or tobacco.

In general, impact investing is a more focused and targeted approach compared to ESG investing. Impact investors are typically seeking to make a specific social or environmental impact, while ESG investors may be more focused on reducing risk or improving long-term returns.

The Opportunity to Improve ESG Adoption across MENA

Over the last decade, the MENA VC industry has experienced remarkable growth. The total amount of funding increased from $0.15 billion in 2010 to $3.94 billion in 2022, according to MAGNiTT. This growth can be attributed to increased entrepreneurship, supportive government initiatives, and a flourishing startup ecosystem. However, a report by Wamda and MAGNiTT highlights persistent challenges in the practice of ESG. The report presents the following facts:

• Gender gap: Female-founded startups in the Middle East receive only 1% of all venture capital funding. The average funding round for a female-founded startup in the Middle East is $1 million, compared to $2.5 million for a male-founded startup. Only 10% of venture capital investors in the Middle East are women.
• Lack of diversity: People of color receive only 1% of all venture capital funding in the Middle East. The average funding round for a startup founded by a person of color in the Middle East is $1 million, compared to $2.5 million for a startup founded by a white person.

In fact, despite 64% of VC firms in the Middle East having adopted a formal ESG strategy, this falls below the global average of 76% (according to Preqin). Therefore, the need for robust ESG practices is profound.

These challenges present unique opportunities for Middle East VC firms to lead by example, bridge gaps, and foster sustainable and inclusive investment practices. We, at DFDF, strive to pave this path.

How can VC firms develop an ESG Strategy?

Developing an ESG strategy is an important step for VC firms that want to attract top talent, differentiate themselves in the market, and drive positive change in the world. Here’s how venture capitalists can go about developing an ESG strategy:

1. Identify your ESG priorities: Start by identifying the ESG issues that are most important to your firm and your portfolio companies. This will help you focus your efforts and ensure that your strategy is aligned with your values and priorities.
2. Set ESG targets and goals: Once you have identified your priorities, consider setting targets and goals related to these issues. For example, you may set a goal to invest in a certain number of companies that are focused on reducing greenhouse gas emissions.
3. Engage with portfolio companies on ESG: Engage with your portfolio companies to understand their ESG efforts and challenges, and provide support as needed. This can include providing resources and expertise or connecting companies with external partners.
4. Monitor and report on ESG progress: Regularly monitor and report on your ESG efforts and progress, both internally and externally. This will help you track your progress, identify areas for improvement, and demonstrate your commitment to ESG issues.
5. Develop ESG policies and procedures: Develop ESG policies and procedures to guide your organization’s decision-making. This could include policies on environmental stewardship, social responsibility, and corporate governance.
6. Provide training on ESG: Provide training on ESG to your employees. This could include training on ESG concepts, ESG reporting, and ESG best practices.
7. Support ESG initiatives: Support ESG initiatives by donating to ESG organizations, volunteering time, or participating in ESG campaigns. This demonstrates your commitment to making a positive impact.

By following these steps, VC firms can develop a robust ESG strategy that aligns with their values and drives meaningful change in the industry and society as a whole.

How can Investors Incorporate ESG Into Their Investment Decisions?

Once a VC firm has established its ESG strategy, it is important to ensure that the strategy is reflected in its investments, extending beyond the firm’s own fund or firm-wide operations. Here are a few steps to consider:

1. ESG screens: Investors can utilize ESG screens to filter out companies that do not meet their ESG criteria. For instance, an investor might choose to exclude companies with poor environmental records or weak corporate governance practices.
2. Active ownership: Investors can actively engage in ownership to promote ESG practices within the companies they invest in. This can involve collaborating with company management to address ESG issues or voting against management proposals that do not align with ESG values.
3. Read company reports: Companies are increasingly disclosing information about their ESG practices in their annual reports and other filings. Investors can leverage this information to evaluate companies and make well-informed investment decisions.
4. Attend shareholder meetings: Investors can participate in shareholder meetings to gain insights into company ESG practices, pose questions to management, and encourage the adoption of ESG practices.

By incorporating these steps into their investment decision-making process, investors can effectively integrate ESG considerations, align their investments with their values, and contribute to sustainable and responsible business practices.

How We Aim to Build a More Conscious VC Ecosystem

In summary, developing an ESG strategy is essential in venture capital. By prioritizing ESG in the investment process and within their own internal operations, VC firms can drive positive change and contribute to a more sustainable and equitable future for all.

Closer to home, the Middle East VC industry is currently at a pivotal moment where embracing ESG principles is not only vital but also presents significant opportunities for growth and impact. At DFDF, we are deeply committed to advancing this movement and encourage readers to reach out to us to learn more about the transformative power of ESG in Middle East venture capital.

For conscious investors and founders seeking ESG-focused funds, we would be delighted to engage in a conversation with you about how we can assist you in investing in a fund that aligns with your values.