M&A and ESG: The Importance of Environmental, Social, and Corporate Governance on Deals

This artice explores how environmental, social, and corporate governance (ESG) issues are affecting M&A deals, from driving the deal to valuing the target.

M&A and ESG | Firmex

Environmental, social and corporate governance (ESG) issues are growing in importance for both corporate and financial investors. And they’re affecting M&A deals in many ways, from driving the deal to valuing the target.

When surveyed by IHS Markit and Mergermarket in the first quarter of 2019, more than half (53%) of senior executives in private equity, asset management and corporate entities said the role of ESG issues at investment targets would become significantly more important in M&A decision-making over the next 12 to 24 months. While 30% said it would be somewhat more important, not a single respondent said ESG would decline in importance.

In some cases, ESG has even become the primary deal driver. Pressure from institutional investors and the public is causing both financial and corporate investors to enter into M&A deals, says Miles Huq, EY power and utilities strategy and transactions partner, in a recent report by EY. Acquisitions in the renewable energy segment accounted for 45% of the power and utility deals done in the Americas in the first half of 2020 and $3.5 billion of the $8.3 billion of deals done, according to the report. 

ESG Due Diligence in Deals

With the growing importance of ESG in M&A deals, ESG due diligence is becoming mandatory. It involves identifying potential exposure to ESG risk and then evaluating a company’s approach to handling risk exposure or capitalizing on ESG opportunities. It must be determined how ESG issues will affect a company’s risk profile, valuation, potential for smooth integration and possible effects on deal timing.

Many ESG factors, such as labour practices, corruption, regulatory compliance and cybersecurity practices are already being evaluated as part of traditional deal due diligence. But others, such as a company’s impact on biodiversity or approach to human rights risks, are not a traditional part of due diligence and can be difficult to measure.

There are few standardized metrics or reporting standards for ESG issues. The World Economic Forum (WEF), Sustainability Accounting Standards Board (SASB) and International Federation of Accountants (IFAC) are among the organizations working to develop standardized metrics and reporting. Each has resources that can provide guidance on what to look for and suggest metrics that can be used in valuation models.

Sources such as corporate social responsibility (CSR) reports and sustainability reports that some companies are now producing can be helpful, but it may be necessary to use outside consultants or resources for thorough due diligence. Given the complexity and scope of the issues, some firms might wish to have a dedicated ESG due diligence person or team, but all members should be aware of the issues because there’s crossover with other areas.

Similar to other areas of due diligence, ESG due diligence needs to look at the company, the industry and the competition. Start with the macro issues that face the industry. Identify the primary ESG issues and main stakeholders, and assess whether ESG issues will drive trends that are positive or negative for the industry as a whole. These might include greater consumer demand that drives growth or increased regulation that adds to costs.

At the company level, it’s again important to identify the stakeholders, the issues that matter to them and how the company is managing their relationships with these stakeholders. Look at whether the company has an ESG policy or strategy, how it approaches ESG governance and the policies and procedures it has in place for identifying and mitigating ESG risk. Determine whether the company is allocating enough resources to ESG issues and assess its ability to identify and adapt to new issues and regulations.

Also evaluate how the company is addressing ESG issues in relation to its peers. Is its approach to these issues helping or hurting its ability to compete? Are there opportunities to gain competitive advantage through better ESG practices? It may be instructive to look at some of the third-party ESG scores for the company and how they compare with competitors.

ESG Issues Affect Valuations

C-suite leaders and investment professionals said they would “be willing to pay about a 10 percent median premium to acquire a company with a positive record for ESG issues over one with a negative record,” when surveyed by McKinsey in July of 2019.

While ESG is often thought of as largely affecting intangibles such as brand value and reputation, it can also flow through to cash flow and valuation. ESG links to cash flow through top-line growth, costs, regulatory and legal interventions, employee productivity, and optimizing investment and capital expenditures, according to McKinsey.

Examples include boosting growth by attracting more customers with sustainable products; reducing costs by being more energy efficient; earning government subsidies through good regulatory compliance; attracting better talent by having a strong purpose; and optimizing capital by avoiding large write-downs, such as the value of an oil tanker, from long-term environmental issues.

The effect of ESG on companies and M&A continues to evolve and will likely continue to grow in importance. At the same time, metrics and tools for ESG risk assessment and valuation will improve as well. And it’s fast becoming a consideration that is not optional for M&A.

Illustration by Christy Lundy

Douglas Warren

Doug Warren, MA, CFA, writes for the financial industry, drawing on experience he gained working as an institutional portfolio manager, bond salesman, credit analyst and financial advisor.