Ethical oversight: ESG in M&A

April 2020  |  COVER STORY  |  MERGERS & ACQUISITIONS

Financier Worldwide Magazine

April 2020 Issue

A close affinity with environmental, social and governance (ESG) issues has rapidly become a core component of the M&A process in recent years. Indeed, ethical oversight can be the difference between a transaction’s success or failure.

Evidencing the rapid uptick in ESG-influenced M&A is the Herbert Smith Freehills report ‘M&A in 2020: the new normal’, which reveals that 83 percent of M&A practitioners believe that ESG will become increasingly critical to M&A decision making in the next 12 to 24 months, while 1250 chief executives rated environmental risks as the biggest threat to business growth.

Also highlighting the value of integrating ESG into the M&A process is a 2017 report by Sustainalytics ‘ESG compatibility: a hidden success factor in M&A transactions’, which found that, within a sample of 231 M&As, ESG compatible deals outperformed ESG incompatible deals by an average of 21 percent on a five-year cumulative return basis. Furthermore, to date, there have been over 1400 signatories to the UN Principles for Responsible Investment – a formal declaration committing firms to incorporate ESG issues into their investment analysis.

Boiled down, ESG issues can encompass: (i) environment – waste management, hazardous materials, pollution, water use, energy use, global warming, emissions to air, resource use, biodiversity and land contamination; (ii) workplace – talent attraction and retention, employee development, employee welfare, equality and diversity, and occupational health and safety; (iii) community – community impact, local economic development, human rights and community investment; (iv) marketplace – responsible marketing, responsible products and sustainability within the supply chain; and (v) governance – governance of sustainability issues, board level responsibility, anti-bribery and corruption, business ethics and conduct, and grievance procedures.

“A firm’s ESG profile can have a significant impact on its operating performance and financing cost, so companies are now placing a much greater emphasis on managing the ESG risks involved in their investment,” says Dr Zhenyi Huang, a research fellow at Cass Business School. “In the context of M&A, the ESG compatibility of acquirers and targets is an increasingly important factor throughout the whole deal process, from the early stage of target selection to the due diligence process, then the integration of the ESG standard of the combined business in the post-deal stage.”

In the view of Melissa Sawyer, a partner at Sullivan & Cromwell, ESG issues, while historically a secondary concern, are becoming an increasingly important consideration for both targets and acquirers. “A company without a clear ESG agenda may be a less attractive partner,” she suggests. “Moreover, if a management team has a limited or superficial strategy for handling ESG matters, a buyer may conclude that the team is not adequately managing the company’s long-term risk profile.

“For example, a buyer may ascribe a discount to a natural resources company that is not investing in environmental best practices today on the theory that it is carrying a significant contingent liability for environmental remediation in the future,” she continues. “In addition, because ESG encompasses human capital issues, inadequate ESG planning may be an indicator of potential risk of labour unrest and inadequate global talent development.”

Despite the lack of a clear ESG agenda at many companies, for Tim Clare, director of transactions and ESG advisory at Anthesis, the high-profile nature of many ESG issues means that the perception of what might be a material risk is broadening among the dealmaking community. “There is only a minority, albeit growing, of firms that are yet sophisticated enough in their ESG systems and frameworks to undertake a broad ESG due diligence assessment on every deal,” he says.

An evolving process, the ways in which M&A practitioners are taking ESG factors into account when considering potential investments is becoming increasingly influential in the drive toward generating growth and delivering stakeholder value.

Challenges

Among the biggest challenges facing dealmakers when integrating ESG into the M&A process is fully understanding and assessing the materiality of relevant ESG factors. Materiality is often specific to the target company, its supply chains, its industry sector, as well as the countries and sub-national regions in which it and its supply chains operate.

“A sense of the importance of ESG issues may not be shared between deal teams,” contends Mr Clare. “That lack of appreciation may also be shared or mirrored by other advisers, such as the corporate finance, banking and legal teams. Currently, there are no standard disclosure requirements, so there may be a lack of disclosure by vendors. In a similar vein, auction processes especially, where the number of questions that can be asked is strictly managed, can see ESG losing out.”

Additional challenges include adhering to a transaction’s timescales, especially if ESG has been commissioned late in the process, as well as keeping to a budget, especially important in a competitive M&A process. “The key action is ensuring that an ESG scoping assessment – as recommended in nearly all the guidance – is undertaken very early in the investment analysis in order to identify what might be material ESG issues,” suggests Mr Clare. “ESG is very broad and often it is not possible to evaluate the issues if the time allowed is too short.”

Also significant is the impact of ESG oversight on a company’s reporting function. “ESG reporting is shown to be largely motivated by relevance to investment performance, stakeholder demand, product strategy and ethical considerations,” notes Dr Huang. “A problem with the use of ESG information is the lack of reporting standards, which is the challenge that regulators and policymakers still need to work on. Meanwhile, the cost of gathering and analysing ESG information presents a challenge for many firms. For stakeholders, a lot of times they may find the ESG information disclosed by firms to be too general; in particular there tends to be a lack of quantifiable information that is useful and comparable over time.”

Strategies

There are strategies in the M&A toolkit that investors and dealmakers can deploy to factor relevant and material ESG issues into their decision making and ultimately scope and execute a transaction.

“Due diligence remains the primary avenue for acquirers to assess the ESG health of a business and the associated risks and opportunities of an investment,” says Tyler Drayton, an associate at Sullivan & Cromwell. “However, evaluating ESG issues during diligence can be challenging, as the cultural elements that acquirers are seeking to assess are often elusive and undocumented. That said, the tenor of casual and unstructured interactions with management and employees during a deal process can still provide a strong indication of a company’s corporate culture and priorities.

“Companies should also remain cognisant of the risks and opportunities associated with integrating two companies with disparate approaches to managing ESG issues,” he continues. “On the one hand, the acquisition of a company with a nascent ESG programme could expose the acquirer to potentially unknown ESG risks or erode the long-term financial performance of the combined business. On the other hand, the acquisition of a company with a vigorous sustainability programme can act as a springboard for an acquirer to incubate those same strategies into its own business.”

According to Stephen Pike, a partner at Gowling WLG, a target’s ESG posture could be a key factor in whether to abandon or proceed with a transaction. “Negative screening, for example, could involve declining to pursue an acquisition because the target’s business activities or the poor management of ESG factors would pose a risk profile that would be unacceptable to the buyer. On the other hand, positive screening in target selection might seek a target that outperforms its competitors on relevant and material ESG factors, such as carbon footprint, water use and reuse, fully recyclable packaging and workforce diversity.”

Furthermore, these strategies allow companies to incorporate ESG due diligence in areas such as climate change and greenhouse gas emissions in the environmental dimension, followed by human rights and labour standards in the social dimension. “Investing in firms with a good ESG performance can help with the post-deal financial returns as well,” observes Dr Huang. “Also, many institutional investors are now actively avoiding assets with poor ESG standard, especially in the ‘sin industries’, such as tobacco, arms, gambling and alcohol businesses.”

ESG and deal value

While it is beyond doubt that M&A transactions benefit significantly from the effective integration of ESG factors, it should be noted that there is no hard data that definitively links ESG oversight and value creation.

“The question as to the value of ESG is routinely asked but the data is not really there yet to directly link specific ESG actions to overall value,” says Mr Clare. “Dealmakers will talk about specific bottom line cost savings, risk avoidance and focus in on hard-to-value improvements, which cannot always be connected to the bottom line, and then, ultimately, value. But it is widely accepted that well-run businesses from an ESG perspective are in high demand and transact more smoothly.”

In an attempt to definitively link ESG oversight and deal value, academic researchers have investigated the impact of acquirer and target ESG compatibility using large samples of completed M&A transactions. “It has been shown that a fit of ESG between the firms involved in a deal to a significant extent reflects the similarity in their corporate culture,” says Dr Huang. “Those firms tend to face lower frictions in their deal negotiation and integration stage. As such, they are more likely to close a deal with success, and to create higher synergy values which result in superior long-run operating performance. Thus, from the mega data of empirical studies, researchers find that the compatibility of firms’ ESG contributes positively to deal success.”

Future ESG value

Across the M&A spectrum, investors and dealmakers are increasingly factoring ESG considerations into their investment decisions, with ESG essentially a proxy for a company’s long-term health and financial performance. Testifying to this uptick is BlackRock, which recently announced that all of its active investment teams consider ESG factors a core component of their investment process.

“The driver of this increased focus on ESG factors is the accelerating momentum of corporate governance moving beyond a shareholder primacy focus to a stakeholder and ‘corporate purpose’ focus,” suggests Mr Pike. “ESG factors will therefore take up more of the board’s attention and have a stronger impact on the long-term performance and value of a corporation.”

That being so, companies are proactively addressing ESG issues as part of their business model. “We anticipate that demands for companies to increase their focus on ESG issues will continue to intensify in their frequency and volume,” says Ms Sawyer. “How companies respond to these calls will ultimately contribute to their perceived value and risk in the context of M&A transactions.

“Over the next five years, we expect to see a rationalisation of approaches to ESG-related disclosures,” she continues. “The market will converge on a set of disclosure standards, which may well vary by industry and jurisdiction. With more consistent disclosure practices will come more useful data.” In other words, in future, it will become that much easier to measure which ESG practices correlate with better performance.

“With that kind of data in hand, it will in turn be easier for investors to direct investments to companies that outperform from both ESG and other perspectives,” adds Mr Drayton. “Once investors are able to target investments in this manner, we expect to see more companies optimising their approach to ESG in a cycle that will continue to refine itself and be extended to new sectors and types of businesses over time.”

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BY

Fraser Tennant