ESG clock is ticking for M&A

Environmental, social and corporate governance (ESG) factors are now dealmakers or deal breakers in M&A. And having a plan for how to uncover and enhance these attributes in a target company is critical.

“We are convinced that detailed ESG analysis and future planning for target companies will be mainstream within the next few years", explains Dealsuite CEO Floyd Plettenberg. "And as a company, we value contributing to ESG and strive to stay innovative on this important subject. We already offer customers the opportunity to filter and score on ESG-metrics."

All markets are adapting to a changing ESG landscape and M&A is no exception. The global pandemic has underscored shortcomings in both society and business practices, forcing an urgent reassessment of companies’ social purpose and environmental footprint, and placing the ESG agenda at the heart of strategic plans.

ESG: from concept to necessity

Sustainable investing and ESG are often used interchangeably but while the world’s first socially responsible index was launched in 1990, ESG was first coined some 14 years later in the United Nations’ ‘Who Cares Wins’ study. A joint initiative with 18 financial institutions from nine countries, the study sought to develop guidelines and recommendations on how to better integrate these factors into business. In this way, ESG set out to provide a toolkit for companies to manage sustainability issues in order to compete successfully.

Initial progress was slow and limited ‘buyer’ pressure saw many firms adopt a tickbox approach, doing just enough to maintain their corporate image. The first meaningful developments in the corporate mindset focused on managing risk. Activity attempted to foresee and mitigate the reputational risk and financial consequences of poor ESG choices and numerous high-profile cases reinforced the need for it. Take, for instance, the renowned Exxon (now ExxonMobil) Valdez oil spill in 1989. If the company had invested in a new radar system and better managed the ship’s crew it might have avoided $2 billion in clean-up costs and $1.8 billion in habitat restoration and personal damages. Potentially even more costly, however, was the reputational damage caused. Decades later, the company was still struggling to shake it off.

ESG activity has expanded considerably in the 13 years since PwC published its first report on sustainability efforts at UK companies but it is only in the past few years that a noticeable shift has begun. What started as something to be managed alongside normal business operations is becoming intrinsically linked as non-financial, or intangible, assets – such as brand value and reputation - comprise a growing component of company value.

The sustainability premium

Growing acknowledgement that ESG is a driver of value creation is pushing adoption into the next phase, according to a recent report by PwC. Its 2021 Global Private Equity Responsible Investing Survey found that 66% of respondents ranked value creation among their top three motivations for ESG activity. Large asset managers including BlackRock have openly stressed the importance of comparable ESG data and made it an essential part of all their investment processes.

While businesses can directly enhance their bottom line by, perhaps, focussing their brand awareness on their ESG credentials or reducing their electricity consumption, they can also take advantage of the sustainability premium investors offer for a clear, concise and robust ESG strategy. Fundamentally, investors are prepared to accept lower returns if the companies they are investing in are environmentally savvy and contributing to society.

Additional incentivisation can also come in the form of increased access to debt capital at lower cost. New offerings such as green, social and sustainability bonds afford companies cheaper borrowing rates if the money is exclusively used for eligible environmental and/or social projects. An alternative, sustainability-linked loans, offer margin incentives (or penalties) that are structured against client-specific targets. For instance, the margin on a housing association loan might be favourably adjusted based on the successful delivery of improved energy performance across their estate or through an increase in the number of their tenants in employment.

Mounting pressure from all stakeholders

A groundswell of social and environmental consciousness over the past year has only heightened the need for urgent action. Investors, employees, consumers and regulators alike are demanding that companies be more transparent about their social and environmental impacts and act within a sustainable investment framework. With less than a decade to deliver on the United Nations’ 17 Sustainable Development Goals (SDGs), investors are also looking to the private sector to show meaningful contribution to national efforts.

In an increasingly connected and transparent world, no business of any size can afford to neglect ESG and stakeholders are quick to hold them accountable. Only last month, the UK finance sector was called out for its carbon emissions level in a study commissioned by Greenpeace and the WWF. The campaigners said British citizens would be shocked to learn that their money was being used in ways that ‘damage the environment’.In the same month, a court ruled that Royal Dutch Shell should cut its greenhouse gas emissions much harder and faster than planned, a ruling that could have far-reaching implications for the rest of the global fossil fuel industry.

In the same way, ESG metrics are becoming an essential part of all aspects of the M&A process, from initial selection to post-integration monitoring and reporting. Stakeholders will no longer accept a ‘greenwashing’ tickbox effort – managers will need to demonstrate that they have not only incorporated ESG into their investment methodologies but also that they are gaining financial value from it.

Regulators have also stepped up the pressure. The EU’s Sustainable Finance Disclosure Regulation (SDFR), which came into force on 10th March 2021, requires all financial service providers to assess and disclose ESG considerations publicly. In the same month, the SEC launched a task force dedicated to proactively addressing any gaps or misstatements in ESG and climate change disclosures.

Measuring ESG success

One of the main obstacles to widespread adoption has been measurement. ESG is notoriously hard to define and broad in its scope, from diversity and employment practices to privacy and data security policies. To date, there has been no accepted benchmark for investors to compare the ESG credentials of various companies, and - with a reliance on self-reported information within annual reports or on company websites – a huge variation in inputs.

Some headway has been made with various organisations and initiatives helping businesses understand and disclose their impacts on issues such as climate change and gender diversity including the UN Principles for Responsible Investment (UNPRI), the Global Reporting Initiative (GRI) and the Sustainability Accounting Standards Board (SASB). In April this year, the UNPRI went a step further in removing obstacles for private equity market implementation, publishing a technical guide specifically for limited partners. It sets out guidelines for integrating ESG in private equity by assessing and engaging with general partners at all stages of the investment process, from a pre-investment due diligence questionnaire to a framework for ongoing monitoring and reporting.

Meanwhile, global data providers such as Refinitiv and Morningstar provide insights by measuring decisions taken by company management and assessing their potential impact on future strategic direction and operational efficiency. These ESG metrics validate and analyse hundreds of datapoints for global businesses, based on publicly reported data. The Dealsuite platform offers its own ESG labelling functionality across the mid-market space allowing managers to filter and screen on market opportunities, identify which targets categorise as an ESG investment, and use the intelligent matching algorithm to ensure the right fit.

As well as the standardisation issues, there will also be significant variations in the ESG priorities of individual companies, depending on their industry and the will of their investors. Using a platform like Dealsuite allows you to hone in on those ESG metrics that matter the most to your organisation. As the recognised ESG metrics advance and standardise over time we will continue to update the platform to reference this criteria.

Survival of the fittest

The culmination of these drivers is promoting natural selection, where companies without viable ESG frameworks will soon fall by the wayside. In PWC’s latest study, 72% of respondents said they screen target companies for both ESG risks and opportunities at pre-acquisition stage and more than half have turned down investments on ESG grounds.

As ESG continues to mature, the winners will be those that - armed with the right data – can use it as a core differentiator, embedding ESG principles into targeted due diligence processes, robust value-creation plans and compelling exit strategies.