ESG factors in M&A

September 2024  |  COVER STORY | MERGERS & ACQUISITIONS

Financier Worldwide Magazine

September 2024 Issue

At the behest of regulators and stakeholders, companies are dedicating significant resources to environmental, social and governance (ESG). Though there is some consternation and pushback, it has become a significant force, driving investments and engagements across jurisdictions.

According to Custom Market Insights, the size of the global ESG investing market is expected to record a compound annual growth rate of 9.4 percent from 2023 to 2032. In 2022, the market size was projected to reach $17.2 trillion; by 2032 it is anticipated to reach $46.5 trillion.

It is also becoming a driving force in M&A activity. ESG targets offer larger corporates an opportunity to reposition their offerings and futureproof certain revenue streams. Subsectors exhibiting high or potential ESG-related growth are attracting attention. Areas such as sustainable food innovation, waste recycling and electric vehicle infrastructure, among others, are propelling activity.

As a result, ESG is increasingly integrated into investment considerations. Benefits can be gained in areas such as risk mitigation, regulatory compliance, competitive returns, innovation and enhanced reputation.

Target assessment

Acquirers often find it challenging to assess ESG factors during M&A transactions and then plan for remedial steps or to capture ESG opportunities post-closing. To that end, ESG due diligence is becoming more important, as it leads to a better understanding of risk and value.

“Some buyers are increasingly looking to identify whether new business acquisitions have the potential to undermine their existing business by introducing new ESG risks,” points out Andrew Lumsden, a partner at Corrs Chambers Westgarth. “Some buyers use ESG due diligence as a tool to protect their reputation or existing ESG portfolios that require certain ESG thresholds to be met in any new deal.

“Other buyers see ESG as an opportunity for value add and value creation and, in these cases, ESG due diligence is much more than a box-ticking exercise,” he continues. “As a result, we are increasingly seeing both private equity (PE) funds and strategic acquirers looking for due diligence to include an ESG focus.”

PE firms have stolen a march on their corporate rivals in terms of making ESG considerations part of the dealmaking process. According to Deloitte, they are three times more likely to conduct formal ESG due diligence.

Deloitte’s data suggests that though half of PE investors and 43 percent of corporates already conduct some form of ESG evaluation during pre-deal M&A due diligence, PE investors are more advanced in this area – 27 percent report that ESG is a “consistent, formalised component of our due diligence process”, compared to less than 10 percent of corporates. Another 23 percent of PE investors and 33 percent of corporates report that they plan to incorporate ESG into due diligence in the future.

For Jacques Kröner, a partner at Houthoff, environmental, social and governance topics, taken individually, have been important to M&A transactions for some time. “These topics have, however, become more important from a sustainability perspective, in the sense that they are more often reviewed from that perspective,” he suggests. “Besides this, considering that in the context of ESG the number of laws and regulations has grown considerably – including reporting obligations, due diligence obligations, child labour prohibition, deforestation prevention and so on – the compliance aspects of M&A due diligence and target evaluation have become increasingly important.”

For the best results, it is essential to make ESG subject matter experts part of the deal team. These individuals should have a deep understanding of the interrelationships between myriad ESG-related risks, and how these manifest in the target’s specific industry. “Legal advisers and their clients are both going through a learning curve when it comes to integrating ESG into M&A and ensuring that ESG value and risk considerations are effectively addressed,” says Mr Kröner.

Creating and preserving value

This increased focus is indicative of ESG’s role as a value driver, creating beneficial outcomes and synergies. But the value of ESG does, of course, vary from organisation to organisation.

In the view of Mr Lumsden, companies should value ESG with reference to the reputational, financial and legal ramifications. An ESG misstep may result in consequential losses, including damage to a buyer’s reputation, which is not usually covered by seller indemnities in sale documentation. “To effectively address this, ESG issues need to be fully understood pre-signing,” he says. “In some cases, there may be ESG issues that need to be remedied or certified as conditions precedent to ensure the matters are effectively addressed before completion.

“In other cases, ESG issues arising at the time of purchase may create opportunities for value creation as the buyer works with the new acquisition to build and strengthen ESG performance and create ESG value,” he adds.

For Mr Kröner, regulators want ESG performance to affect deal valuation. In other words, better ESG performance should lead to a better valuation. “As an example, we are seeing financing parties supporting ‘green’ investments through more favourable terms for financing. We expect this to grow quickly and become more relevant.

“Good ESG performance should not necessarily suggest a deal carries less risk, making it more attractive,” he warns. “The market is not yet fully ESG focused, and non-sustainable assets and activities are still considered good investments with good returns, although possibly only in the short term. As such, sustainable initiatives could be considered riskier, requiring a long-term vision, which would have an affect on deal valuation.”

Ultimately, strength in ESG can reduce a company’s direct and indirect losses. “There may be loss as a result of adverse government or regulatory action, such as a greenwashing claim, or loss of customer base as a result of customers boycotting a company because of its poor ESG practices,” suggests Mr Lumsden.

“To capture all ESG risks and value opportunities, dealmakers should ensure that their ESG due diligence goes beyond compliance and quantitative metrics, to include a qualitative review of systems and processes that address underlying ESG risk management,” he continues. “A number of recent examples in the Australian listed market have demonstrated the sizeable impact that poor ESG management can have on a business. Damage to a company’s reputation has the potential to place the C-suite and board’s tenure at risk – and of course reduce value and liquidity.”

Strategy alignment

Long-term thinking is needed to align and integrate ESG and M&A strategies. Companies should start by developing an ESG strategy with firm goals, and evaluate how M&A can help to achieve them.

“At a macro level, an M&A strategy needs to incorporate all different types of risk, but ESG risks require a particular focus and a deep understanding of how the transaction will fit and be consistent with the buyer’s overall M&A strategy,” explains Mr Lumsden. “To this end, buyers can find assets that address existing issues in their business. For example, if supply chain vulnerability is a key existing risk, a company may build consideration of ESG issues, such as acquisitions that improve modern slavery risk and environmental risk, into their M&A strategy.

“In this way, acquirers can find assets that supercharge existing ESG initiatives,” he continues. “This could take the form of a straight risk assessment or integration diligence to dovetail the acquisition with their own processes. Conversely, buyers are also looking to identify whether new businesses have the potential to undermine their existing business by introducing new risks. To this end, buyers may screen potential acquisitions for contagion ESG risks.”

According to Mr Kröner, all companies should fully integrate ESG into their strategies, starting with larger companies, which will have a knock-on effect through the value chain to then impact smaller companies. “As such, M&A and ESG strategies should be aligned – or said better, should not be seen as two separate strategies. ESG should be at the core of any strategy,” he says.

“Having a climate transition plan is becoming obligatory under the EU’s Corporate Sustainability Due Diligence Directive, whereby a company is obliged to make its best efforts to achieve net-zero greenhouse gas emissions by 2050, and reduce them by 55 percent by 2030,” he continues. “A transition plan will also be obligatory for investors, so actions will be driven toward achieving the realistic goals set by investors themselves, influencing their choice of targets. Although there is considerable focus on the ‘E’ in ESG, the ‘S’ should not be forgotten in this respect, as the human rights aspects of M&A, for example, should be given the same attention.”

Reporting challenges

ESG reporting provides stakeholders with insights into an organisation’s efforts to operate sustainably, ethically and responsibly. Companies are facing intensifying pressure to ensure they report accurately on ESG performance. “ESG reporting will contain a lot of forward-looking statements on target goals for the future. These reports will be a valuable source of information for due diligence and for comparing targets,” says Mr Kröner.

Environmental reporting encompasses the company’s impact on the planet, including carbon emissions, energy usage and waste management. Social reporting covers how a company manages relationships with employees, suppliers, customers and communities, including areas such as labour practices, diversity and human rights. Governance reporting involves transparency in leadership, executive pay, audits, internal controls and shareholder rights.

To prepare meaningful, compliant reports, companies must gather a vast array of ESG-related data. “Any ESG-related information to be reported to stakeholders will be heavily dependent on the target’s industry and nature, and the ESG due diligence investigations undertaken should reflect this,” suggests Mr Lumsden. “For example, certain sectors heavily reliant on unskilled labour may have modern slavery risks. Organisations exposed to jurisdictions with significant integrity issues may have human rights risks. And certain manufacturing processes or product input may have environmental or climatic risks.

“Target and industry-specific ESG issues should be reported to stakeholders,” he continues. “Boards should be diligent in developing more detailed forward planning, and in their consideration of alternate strategies and restructuring options. This includes boards preparing for activist approaches on future M&A transactions, and staying proactively and meaningfully engaged with stakeholders on ESG issues.”

There are, of course, challenges associated with ESG reporting. These include data collection and quality, resource constraints, transparency, stakeholder alignment, regulatory compliance, and lack of standardisation, among others. By recognising these hurdles, companies can develop a more effective and credible reporting process, which will be vital moving forward.

A threshold item

Organisations can contribute to building a sustainable and prosperous future by prioritising environmental impact, social responsibility, risk mitigation and good governance.

According to Mr Lumsden, investors are increasingly using ESG considerations as one of their investment criteria, and both investors and environmental and human rights activists alike are taking a proactive role to influence the outcomes of M&A transactions. “For ESG-conscious investors, this includes ‘buying’ votes as a means to vote down proposals,” he says. “We anticipate more of these activist actions to come, particularly for commodities businesses.”

But 2024 is a crucial year for elections around the globe – particularly in the US where there is already a growing backlash against the ESG movement. “For a number of years, change has been expected to come from voluntary action because sustainability is the proper thing to do,” says Mr Kröner. “But voluntary actions have not brought the required change, so governmental institutions now use legislation to achieve set goals. The trend is that legislation will increase in the EU. For example, in terms of EU regulation, one of the specific goals of the Corporate Sustainability Reporting Directive is to compel financing parties and investors to invest more in sustainable targets. In this way, the market drives the change to a fully sustainable economy.

“At the same time, however, we have to be aware of a relatively strong anti-ESG movement in the US, which may also gain momentum in the EU,” he adds.

Nevertheless, most experts, including Mr Kröner, expect to see ESG factors accelerate, driven by regulation. From an environmental perspective, there will be a focus on the EU’s climate transition plan, which aims for net zero by 2050. Also important is the complexity of scope 3 for a prospective target, and its obligation to take action to reduce scope 3 emissions. Regarding social factors, human rights and the fair and equal treatment of employees throughout the value chain is likely to gain importance. And on the governance front, acquirers will want to understand the extent to which ESG considerations have become a core element of the strategy adopted by the target’s senior leaders.

“We have seen greater government and regulator intervention with mandatory climate-related disclosure, and increased enforcement actions against greenwashing,” notes Mr Lumsden. “Non-compliance with these requirements, including ESG misrepresentations, and unmet stakeholder expectations may have even greater reputational, financial and legal consequences for companies.

“In the months and years ahead, ESG considerations will continue to be a threshold diligence item for M&A,” he concludes.

© Financier Worldwide

BY

Richard Summerfield