Entrepreneurial finance and sustainability: Do institutional investors impact the ESG performance of SMEs?

Institutional investors improve the environmental, social, and governance (ESG) performance of small- and medium-sized enterprises (SMEs). Our difference-in-differences framework shows that the backing from private equity and venture capital funds leads to an increase in SMEs’ externally validated ESG scores compared to their matched non-investor-backed peers. Consistent with “ESG-as-insurance” theory, the ESG performance of SMEs with a higher probability of failure is more likely to benefit from the backing of institutional investors. This positive effect is heterogeneous; while SMEs with high ex-ante ESG performance further improve their ESG performance following institutional investor backing, SMEs with low ex-ante ESG performance are unlikely to implement any improvements. Entrepreneurial finance seems to help sustainable entrepreneurs transform into “sustainability champions,” while neglecting the betterment of non-sustainable SMEs. • We employ a difference-in-differences framework to identify the causal effect of institutional investors on portfolio firms' ESG performance. • Venture capital and private equity funds improve small and medium-sized enterprises' (SMEs)’ ESG performance, consistent with delegated philanthropy theory. • Institutional investors improve ESG performance more in SMEs with a higher risk of failure, consistent with sustainability-as-insurance theory. • The positive effect of institutional investor backing on ESG performance is mainly driven by SMEs with pronounced pre-backing ESG orientation.