ESG considerations in M&A transactions
November 2021 | TALKINGPOINT | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
November 2021 Issue
FW discusses ESG considerations in M&A transactions with George Casey, Doreen Lilienfeld and Paul Strecker at Shearman & Sterling LLP.
FW: Could you outline how and why environmental, social and governance (ESG) issues are becoming more important in M&A transactions?
Casey: Environmental, social and governance (ESG) issues have become a key agenda item for shareholders and boards. Given this, not surprisingly, boards and management are paying significantly more attention to ESG considerations in M&A transactions. As each company is developing its own ESG strategy and culture in which ESG is a core component, management and boards are very conscious of whether a target’s ESG strategy and culture will be compatible with their own. Also, stakeholders, including large institutional shareholders, are requiring greater transparency and accountability from companies on ESG factors, and this unprecedented level of engagement is creating both risk and opportunities that are financially material to companies. Mitigating ESG risk and maximising ESG-related synergies in M&A transactions have become important considerations for M&A practitioners.
FW: Value and risk are typically two significant drivers in an M&A transaction. How should companies view the value of ESG? Is there any emerging evidence to suggest that the ESG performance of a target company may affect deal valuation?
Strecker: ESG can be a key value component for many companies. Implementing a comprehensive, companywide ESG strategy takes time. It requires active stakeholder engagement, significant resources and a commitment at every level of the organisation. But the payoff can be significant. A well-executed ESG strategy can drive value in a variety of ways, including opening new avenues of capital from ESG-focused investors, promoting positive stakeholder engagement, including with customers and suppliers, and improved hiring and retention of employees. Ultimately, this can drive positive change in the culture of a company and in some cases, give the company a redefined purpose. From an acquisition perspective, these value components can create synergies for a buyer that will certainly enhance deal value.
“Fundamentally, the constituencies within the buyer that oversee and implement its ESG strategy need to be part of the M&A process.”
FW: How would you define the risk of ESG to a buyer?
Lilienfeld: Buyers have long evaluated acquisition targets as to ESG metrics on a qualitative basis – examining their mission statements and public communications. Now the due diligence process has become more quantitative as buyers become increasingly aware that underperformance on ESG metrics can affect the long-term performance of their targets, presenting significant execution risk for a deal. Buyers have increased focus on measures of culture like employee engagement scores, the diversity of the workforce, C-suite and board, and the target’s activities in the communities in which it operates. While regulatory risk has always been in focus during due diligence, reputational risk has increasingly come to the fore as a means to determine how emerging trends in ESG will impact a target’s future earning potential.
FW: In your experience, are buyers and sellers making more of an effort to factor ESG considerations into their M&A strategies? How does a company align M&A and ESG strategies?
Casey: Successful companies develop M&A strategy focused on business objectives. As a company develops an ESG strategy as part of broader objectives, it would likely focus on ESG considerations for its M&A strategy. For example, for an industrial company that would like to transition to new technologies that will help to reduce CO2 emissions or develop ‘cleaner’ processes, it will likely look to acquire businesses in this area. Similarly, a company may decide to sell certain business lines because they are no longer aligned with its strategy. Companies should start with developing an ESG strategy and see how M&A can help achieve ESG goals. As a separate issue, a buyer should generally assess key ESG risks and opportunities in the target’s business in a transaction. This assessment should be evaluated against the buyer’s ESG policies to ensure alignment with its own ESG strategy, including the buyer’s applicable disclosure regime.
“Reputational risk has increasingly come to the fore as a means to determine how emerging trends in ESG will impact a target’s future earning potential.”
FW: What specific steps should be taken to appropriately integrate ESG considerations into the M&A process? What strategies can be deployed to ensure that significant ESG value and risk considerations are being effectively addressed?
Strecker: Fundamentally, the constituencies within the buyer that oversee and implement its ESG strategy need to be part of the M&A process. The board should have ultimate oversight on ESG matters, and part of its evaluation of the transaction will be to assess the target’s pro forma impact on the buyer from an ESG perspective. ESG diligence should be an integral part of the M&A due diligence exercise. Understanding those aspects of the target’s business that create material ESG risk, for example its supply chain, is key. Reviewing the target’s performance against its ESG disclosure, key performance indicators and industry-specific metrics is also important. It may be appropriate to retain external consultants who are better equipped to directly assess how the target is performing with each of its stakeholders on issues like carbon emissions, sustainability, diversity and inclusion, and health and safety. These findings will be key to understanding what deal protections are required in the acquisition agreement and the financial impact of any integration costs and synergies post-closing.
FW: What ESG-related information should be gathered and prepared for the purposes of reporting on M&A transactions to stakeholders? What areas and issues are most prevalent?
Lilienfeld: Shareholders expect management to focus on sustainability and broad environmental goals, and to report results on statistics like emissions in measurable increments. In addition, to achieve best in class governance practices measured against institutional investors’ bespoke governance scorecards, shareholders are looking for tangible progress on diversity and inclusion metrics. Shareholders will expect that a target will align with a buyer’s articulated strategies in the ESG arena and further those goals. Shareholders are also increasingly evaluating how ESG metrics are factoring into executive compensation, rewarding executives for performance on ESG measures as well as on financial performance criteria.
“As ESG concerns continue to underpin corporate decision making, the value of leading on ESG issues will increase, as will the demand for those acquisition targets that are forward thinking.”
FW: How do you expect the buzz surrounding ESG factors in M&A and investment decisions to evolve in the months and years ahead?
Casey: Shareholder scrutiny on ESG will continue and is likely to intensify, particularly for publicly traded companies. The 2021 proxy season saw a continued and significant increase in shareholder support for ESG topics, particularly on climate change, sustainability and diversity. The role of activist shareholders working with large institutional investors to promote change within corporations on ESG issues is also a major recent development. This increasing accountability means that M&A should be considered through the lens of whether a transaction will be consistent with the buyer’s disclosed ESG strategy and whether it will promote the buyer’s stated ESG goals. Another important developing area is materiality. As the Securities and Exchange Commission, the European Union and other regulators continue to develop ESG-focused disclosure requirements, a key question will be whether a unified standard of materiality will emerge. In Europe, the concept of ‘dynamic materiality’ has gained traction. Dynamic materiality relates to an issue that is material from an ESG perspective today – for example it has important social value – but only becomes financially material to a company over time. This concept is at odds with the ‘reasonable investor’ definition used in the US, which speaks to what a reasonable investor would consider material at a particular point in time. How M&A practitioners think about the materiality of ESG issues in the context of an M&A transaction will be an important consideration in the months and years ahead. In M&A transactions, evaluations of ESG risks are evolving from a check the box exercise of ‘dos’ and ‘do nots’ to a process of identifying outperformance on relevant metrics against peers and highlighting areas of value accretion. As ESG concerns continue to underpin corporate decision making, the value of leading on ESG issues will increase, as will the demand for those acquisition targets that are forward thinking.
George Casey has broad experience in advising boards on corporate governance and ESG and in representing major companies in US domestic and cross-border M&A transactions, ranging from public company acquisitions to complex carve-out sales, strategic investments and joint venture transactions. He has been recognised as one of the leading M&A practitioners and is an adjunct professor at the University of Pennsylvania Law School and a regular guest lecturer at the Université de Paris Sorbonne. He can be contacted on +1 (212) 848 8787 or by email: george.casey@shearman.com.
Doreen E. Lilienfeld focuses on a wide variety of compensation-related matters, including the design and implementation of retention and compensation plans, disclosure and regulatory compliance, and employment negotiations with senior executives. She has advised both US and non-US issuers on corporate governance and regulatory requirements relating to compensation and benefits matters and high-profile individuals in their employment and severance negotiations. She can be contacted on +1 (212) 848 7171 or by email: dlilienfeld@shearman.com.
Paul Strecker has over 20 years’ experience in cross-border M&A transactions, including public and private company acquisitions, leveraged buyouts, minority investments, strategic alliances, joint ventures and asset sales across a wide range of industries. He also has extensive experience advising private equity clients, pension funds, sovereign wealth funds and other financial investors on transactions globally. He can be contacted on +44 (0)20 7655 5047 or by email: pstrecker@shearman.com.
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