ESG Challenges among Venture Capitalists and Entrepreneurs

Oct. 18, 2023

Many companies and investors profess to prioritize environmental, social, and governance (ESG) issues, but empirical evidence reveals psychological biases in the process of matching investors and entrepreneurs on ESG projects. In this process, profit-driven investors risk overlooking or undervaluing opportunities.

In order to gauge the actual behaviors of US-based venture capitalists and entrepreneurs, Ye Zhang, an Eva and Mats Qviberg Research Fellow at Swedish House of Finance, has generated experimental evidence that serve to complement findings from more theoretical models. 

Running experiments is not new and has its origins in the economics field from the 1950s.  As a result of technological progress, researchers have recently been able to develop new experimental designs, that allow them to move beyond the simple tableau of matching ESG-related goals with outcomes that are primarily based on public statements like press-releases or annual reports. They are now able to dig deeper to assess how specific decisions have been made. 

Profitability of ESG impact ventures still underestimated 

Zhang’s experimental studies conducted with real venture capitalists in the United States indicate that these investors tend to view impact ventures as less financially rewarding. Specifically, profit-oriented venture capitalists are less inclined to support start-ups that aim to promote ESG values. While findings indicate an absence of any inherent taste-based biases against impact ventures per se, the analysis suggests that these effects primarily stem from concerns surrounding the financial profitability of impact-focused investments.  

Additionally, the potential challenges associated with effectively measuring and reporting these investments' social or environmental impact may further contribute to the perception of reduced profitability. However, conditional on being funded, impact ventures associate with improved performance over time. 

Penalty on female investors

Zhang’s research on US start-ups also reveals that when a venture capital fund claims to prioritize environmental sustainability, the start-ups themselves are more hesitant to collaborate with them.

In particular, findings indicate that female venture capitalists who emphasize environmental sustainability suffer from diminished attractiveness toward potential start-ups. By contrast, male venture capitalists gain from prioritizing social impact, and escape punishment for focusing on environmental sustainability. This "double-soft" penalty imposed on female investors is noteworthy, making them disproportionately disadvantaged.

Steps to improving decision-making in the private market

Apart from illuminating these effects and their underlying mechanisms, the studies highlight that business opportunities are sometimes lost for the wrong reasons. By using experimental tools, researchers can gain new insights into the underlying psychological mechanisms that drive decision-making processes in finance.

Additionally, improving rating technologies, such as AI and big data, can help to correct miscalibrated beliefs and facilitate the decision-making process of investors and firms. Zhang mentions the Motherbrain tool, developed by Swedish investors, as an example of a broader trend where investors around the world are starting to use new software to detect potentially promising start-ups, – complementing traditional methods and reducing the risk of human biases.