ESG essentials in M&A

September 2022  |  COVER STORY | MERGERS & ACQUISITIONS

Financier Worldwide Magazine

September 2022 Issue

Driven initially by investor and consumer demand, and now by regulatory developments across multiple jurisdictions, today companies cannot afford to ignore environmental, social and governance (ESG) issues. When it comes to M&A, potential acquirers are increasingly seeking to identify ESG-related risks and opportunities in target companies, and pursuing deals according to their own ESG principles and expectations.

There is a definite buzz surrounding ESG, making it a key point of discussion among investment and M&A professionals. According to a recent Bain & Company global survey of 281 M&A executives, 65 percent of respondents expect their own company’s focus on ESG to increase over the next three years. More than half of those respondents believe leading on ESG justifies higher deal valuations, or expect this to be the case in the future.

Companies are finding that ESG can have many positive impacts. It can add to top-line growth, reduce costs, optimise investment and capital expenditures, minimise regulatory and legal interventions, and boost employee loyalty. It has evolved from a niche concern into an overarching framework that some companies have made a central strategic pillar of their operations.

Companies are pivoting their business strategies to embrace ESG, to curtail related risks, establish stakeholder trust and to grow sustainably. In August 2019, the US Business Roundtable released a statement strongly affirming business’ commitment to a broad range of stakeholders, including customers, employees, suppliers, communities, and, of course, shareholders.

ESG has become a key factor in the way customers, stakeholders and society at large evaluate companies, and the same is increasingly true for potential acquirers. In a world where ESG concerns are becoming more urgent than ever, business leaders are keeping these connections in mind, and how they pertain to dealmaking. According to Deloitte’s M&A 2022 Trends Survey, more than 70 percent of responding organisations reported that they incorporate ESG metrics into target valuations and have re-evaluated their portfolio through an ESG lens.

As such, buyers need to appropriately assess and value the ESG performance of their targets. “The importance of ESG issues in M&A has been driven by significant shifts in investor and consumer awareness, industry outlooks and the development of regulatory frameworks, which has resulted in businesses adapting their core strategies and utilising M&A as a means to meet enhanced ESG expectations,” says Lena Hodge, a partner at Brown Rudnick.

“Consequently, ESG considerations are now playing a key role at every step of the M&A process, from target selection through to completion and post-completion matters,” she continues. “This means that time must be taken to accommodate enhanced ESG due diligence, address ESG-specific deal terms and monitor forthcoming regulatory developments, particularly in respect of enhanced reporting obligations for businesses.”

In addition, lenders are increasingly incorporating ESG disclosure obligations as conditions of their loan agreements, which is a further imperative for appropriate diligence, management and monitoring of ESG risks in M&A transactions.

Sustainable investing

There is a strong push from investors to build greener and more socially beneficial portfolios – a major trend toward sustainable, responsible investing. A recent Morgan Stanley survey that found over 90 percent of millennial investors were interested in sustainable investing. The importance of ESG investing will continue to grow as this demographic group comprises an ever-larger segment of the total pool of investors.

After assets under management in ESG-geared funds crossed the $1 trillion threshold in 2020, the following six months saw an unprecedented $103bn worth of corporate and fund ESG activity, as businesses jettisoned problematic units and launched bold sustainability acquisitions.

Several notable ESG-focused transactions and investments have been made in recent years. One example is the $2.3bn acquisition of Spanish solar and wind developer Eolia Renovables by French utility giant Engie and lender Credit Agricole, which was announced in November 2021. Crédit Agricole Assurances, meanwhile, aims to double its investments in renewable energy to enable an installed capacity of 11 GW.

Elsewhere, Inspire Energy Capital was acquired by Shell New Energies US, a Shell subsidiary, in September 2021, as part of Shell’s strategy to build and scale renewable and lower-carbon businesses with a target to become a net-zero emissions energy business by 2050.

The private equity (PE) industry is also focusing more on ESG, acknowledging its role as a source of value. According to PwC’s Global Private Equity Responsible Investment Survey 2021, 56 percent of respondent firms said that ESG features in board meetings more than once a year, while 15 percent said it was discussed at all board meetings. These figures were up from the 2019 survey, in which only 35 percent said ESG featured in more than one meeting a year, and just 6 percent said it was a topic at every meeting.

PE firms, particularly in Europe, are targeting the renewables space due to the high returns on offer. In November 2021, Swedish PE firm EQT acquired Solarpack for $1.5bn, while Swiss PE firm Partners Group acquired Lithuania-based green energy firm Gren Group for $951.8m in July 2021.

ESG in target evaluation

As ESG becomes more central to company operations, the M&A market is showing greater demand for enhanced ESG due diligence. This focuses on aspects such as the culture, values and social responsibilities of the target company. It allows acquirers to ascertain key ESG-related risks that may affect future reputation, and even valuation.

Issues affecting ESG risk may include regulatory compliance, corporate governance, data protection and privacy, environmental permits and pollution, employment law, and diversity. According to Ms Hodge, there has been a significant increase in ESG due diligence around climate change, data privacy, human rights and corporate governance, for example.

“ESG-linked deal terms, including ESG warranties and indemnities, are becoming increasingly utilised in M&A transactions,” points out Ms Hodge. “We expect such terms to become standardised in transaction documentation as ESG considerations become a customary feature of the M&A process.

Acquirers will want to determine whether the target has an ESG strategy. What ESG procedures, policies and processes does it have in place? What ESG metrics does it create and track? Does it have a track record on ESG, either negative or positive? By analysing a target’s current ESG posture, compatibility, and potential risks and opportunities, an acquirer can avoid unpleasant surprises post-close.

An acquirer will want to know whether a target’s ESG strategy and culture will be compatible with its own. Today, stakeholders require greater transparency and accountability from companies on ESG factors, which creates both risks and opportunities for organisations. Acquirers should focus on the big picture of whether the target business has good processes in place to mitigate ESG-related risks and is able to capitalise on ESG opportunities. Due diligence can also reveal weak areas, and whether the buyer can help the target improve its ESG metrics in the long run.

Acquirers are increasingly likely to prioritise target companies that place ESG at the centre of their decision making. Indeed, buyers are demonstrating a willingness to pay a premium for companies with a positive ESG record. To assess this, buyers need to review the target’s ESG data and ensure that any publicly available information is integrated into the process. There are obvious benefits to elevating ESG due diligence from a ‘tick box’ exercise into a holistic process, identifying outperformance on relevant metrics against peers and highlighting areas of value accretion.

A review of the target’s internal policies should also provide an insight into the company’s culture. If the organisation does not permit dissent or value the feedback of employees at all levels, this may indicate a risk of hidden issues. The structure of the management team, the target’s whistleblower programme and whether it has formal processes for providing feedback to management should also be examined.

By the same token, issues such as sexual harassment should be examined. The MeToo movement has put a spotlight on whether companies are doing enough to tackle retrograde attitudes and potentially criminal behaviour. Due diligence should be undertaken to understand a target’s policies and procedures on sexual harassment, and the nature of any reports or claims. This area is becoming more prevalent as a representation in purchase agreements.

Employee diversity should be closely scrutinised, too. Acquirers need to understand the value the target places on diversity and inclusion by examining the composition of management positions, and any formal initiatives the company promotes to improve on this front.

“We expect the buzz surrounding ESG factors in M&A and investment decisions to continue to evolve in the months and years ahead, and soon reach the stage where most, if not all, M&A deals shall consistently need to be reviewed and analysed to assess ESG implications,” says Ms Hodge.

Sustainability standards

There is no standardised way in which to perform ESG due diligence. Unlike some other forms of due diligence which benefit from multiple reporting frameworks, there is no unified structure for ESG matters, which can make it challenging for acquirers to evaluate a target company’s performance in this area.

That said, efforts are underway to introduce uniform sustainability reporting standards, which would provide certainty and reduce ambiguity around ESG processes, targets and expectations.

Following the COP26 meeting in November 2021, both public and private sector players set out to implement plans to cut CO2 emissions, in an effort to limit global temperatures from rising more than 1.5 degrees Celsius above pre-industrial levels.

With this goal in mind, the establishment of the International Sustainability Standards Board (ISSB) was announced. The ISSB aims to “deliver a comprehensive global baseline of sustainability-related disclosure standards that provide investors and other capital market participants with information about companies’ sustainability-related risks and opportunities to help them make informed decisions”.

The ISSB intends to develop the International Financial Reporting Standards (IFRS) Sustainability Disclosure Standards, providing global standard disclosures on sustainable ESG matters, in the same vein as existing IFRS accounting standards for financial metric disclosures. The ISSB’s primary focus will be on climate disclosures, and it has committed to publishing the first Sustainability Disclosure Standards in 2022.

Currently, the prevalent ESG reporting frameworks are those issued by the Global Reporting Initiative, Integrated Reporting, the Principles for Responsible Investment, the Task Force on Climate-related Financial Disclosures, and the Sustainability Accounting Standards Board.

Some governments, including those in the EU, Australia, New Zealand, the UK, France and the US, have already developed their own version of mandatory and voluntary climate-related disclosures for certain organisations. Some financial institutions are already mandated to increase their investment in sustainable products and disclose their level of sustainable investments, for example. Additionally, rating agencies such as S&P Global have developed methodologies to track ESG performance and help investors understand and compare company disclosures.

In the US, the government has announced that it is increasing its scrutiny of companies’ ESG initiatives. In March 2021, the Securities and Exchange Commission (SEC) created a Climate and ESG Task Force within its enforcement division. The task force will initially focus on identifying material gaps or misstatements in issuers’ disclosure of climate risks under existing rules. It will also analyse disclosure and compliance issues relating to investment advisers’ and funds’ ESG strategies.

Given these developments, it is unsurprising that ESG is playing a larger role in transactions. Current and forthcoming changes mean that ESG reporting obligations, both voluntary and mandatory, should remain front of mind.

Value

ESG performance is being incorporated into company valuations and risk assessments, and acquirers are factoring this in when evaluating potential transactions. “The increased focus on ESG considerations by businesses has naturally resulted in heightened demand for ESG-accretive M&A opportunities and enhanced deal valuations,” notes Nick Davies, an associate at Brown Rudnick. “Furthermore, the increase in quality and availability of ESG disclosures by M&A targets has also served to help facilitate the deal valuation stage of M&A transactions, with more ESG information being readily available early on in the transaction process.

“Alongside the increasing demand for ESG accretive M&A opportunities, businesses should also be wary of taking the necessary steps to mitigate against any potentially negative ESG exposures which could inhibit deal value for M&A transactions,” he adds.

Going forward, companies should expect to demonstrate their ESG credentials. If a potential acquirer concludes that the seller’s ESG strategy is deficient, it may determine that the business is inherently less valuable, or presents a long-term risk. A company’s ESG outlook is an increasingly important component when assessing strategic fit and financial profile.

Whatever the motivation for a deal, acquirers will require quality data on ESG issues, particularly as related opportunities and risks evolve in the coming years. As such, we can expect to see rising demand for due diligence in this area.

© Financier Worldwide

BY

Richard Summerfield