The impact of ESG on M&A transactions

Overview

In the current landscape, any acquisition will need to take into account not just strategic and financial objectives, but also environmental, social, and governance (ESG) factors. This is true for both potential targets and prospective buyers. While ESG considerations have long played a role in corporate decision-making, their influence is growing due to factors such as social media, activism and a focus on sustainability. As a result, the impact of ESG on M&A transactions is becoming more significant and unavoidable.

The approach to ESG in the context of M&A deals is still being refined by participants. Given the broad range of topics covered by ESG, the shifting priorities and evolving standards around them, and the challenges of assessing the ESG risks and rewards for a specific deal, deal-makers can find it difficult to determine in what way and to what extent ESG considerations should affect a deal decision.

Here we look at five key areas that dealmakers should consider when developing an ESG strategy for M&A:

• Target selection

• Due diligence

• Valuation

• Deal financing

• Integration, corporate governance, and other post-closing considerations.

Target Selection

The consideration of ESG issues when selecting a potential target is not a new concept. Traditionally, dealmakers have taken into account factors such as a target's long-term strategy, risk profile, human capital management, and industry and public reputation under the umbrella of “cultural fit”. But, the current growth in attention paid to ESG issues both by the public and by investors has made these ESG issues more important in the M&A context.

Historically, one of the main drivers of M&A activity has been the filling of existing gaps, both for strategic buyers and sponsors. It is therefore not surprising to see dealmakers applying the same principle to ESG. In this environment, a company that is looking to be acquired and can effectively highlight its ESG strengths can significantly improve its negotiation leverage and potential valuation, particularly vs a buyer that is looking to fix existing ESG liabilities or improve its own ESG performance. In a similar vein, buyers with experience managing portfolio companies’ ESG performance, particularly private equity funds, may want to acquire a poor ESG performer at a depressed price, then use their expertise to amplify the transaction upside.

With respect to selecting an M&A target, it will be essential to anticipate ESG concerns in the deal process and consider how to effectively address these concerns in messaging to stakeholders like employees, regulators or the media, who are also going to closely scrutinize the ESG effects of a proposed deal.

Due Diligence

Today, ESG due diligence is a common part of the M&A process, with ESG assessments becoming increasingly detailed over time. A thorough investigation of a target's ESG profile is important not only in anticipating the reputational implications, but can also help a prospective buyer more accurately assess the extent of post-closing integration issues. These can include the feasibility of, or the amount of resources needed to, solve ESG risks.

Recent data suggests that the results of ESG due diligence can often affect decisions, with many company executives stating that they have walked away from an investment or M&A target due to negative findings on ESG issues at the target.

M&A dealmakers have long recognized the importance of conducting due diligence on certain ESG topics that can materially impact a target's capital and operating expenditures, operational capability (including in connection with workforce and regulatory compliance issues), future growth trajectory, and brand image. These topics include environmental impact and oversight, employee-related and business continuity risks, supply chain risks and policies (such as human rights and labor standards policies and compliance), consumer protection, product safety, and data privacy.

Though these issues are already a significant part of the areas covered by a standard M&A due diligence checklist, current events are adding to the scope and detail of standard requests on these issues. Covid-19, for example, has highlighted the potential risks associated with relying on non-diversified offshore sourcing of materials in the face of widespread disruption to international travel and manufacturing.

Several key factors make it difficult to gain a complete and accurate picture of a potential target's ESG profile through a traditional due diligence process. First, given the amorphous nature of ESG, which spans issues that range from operating model, regulatory compliance, and supplier management to climate change, sexual harassment, and community impact, many components of a target's ESG profile are intrinsically hard to analyze.

Often, gathering dependable data presents a significant hurdle in evaluating ESG at portfolio investments or prospective targets. In many cases, this problem is exacerbated by the target company's lack of responsiveness to the investor's or the prospective buyer's ESG concerns, and an unwillingness on the part of target management to devote adequate attention and resources to the exploration of ESG issues.

Management may be able to increase a company's attractiveness as a potential target by highlighting a track record of proactive investor engagement on ESG, and may be able to alleviate a prospective buyer's concerns during due diligence by making the appropriate team members available to respond thoughtfully to reasonable inquiries regarding the target's ESG risks and oversight.

A prospective buyer may need to conduct a deep dive of news, social media, sustainability reports, ESG scorecards, and other public disclosures, both from the target and other constituents. A growing number of standard-makers, such as GRI, SASB, TCFD and ISSB, have developed frameworks aimed at quantifying ESG risks and increasing the comparability of ESG performance across different industries.

Regardless of a potential target's adherence to a specific ESG disclosure framework, it could be beneficial for a prospective buyer to take into account the primary ESG concerns underscored by these standard-setters in relation to the target's industry while formulating its due diligence process. Keeping an eye on alterations in these standard-setters' frameworks and their public pronouncements could also serve as an effective method to trace the evolution of high-priority ESG issues, which frequently change swiftly in response to unfolding events.

Valuation

Understanding the pro forma ESG impact of a proposed deal is important, but quantifying the impact of ESG can be challenging. Nowadays, M&A dealmakers almost everywhere agree that valuation is affected by ESG performance. A prospective buyer's positive assessment of ESG factors may increase valuation substantially while a negative assessment can sometimes lower valuation significantly, if the prospective buyer is not deterred from a deal altogether.

Nonetheless, the same elements that complicate ESG due diligence also present obstacles when incorporating the impact of ESG on deal valuations. Given that the integration of ESG into financial assessments is still in its early stages, it can be particularly challenging to calculate the potential upside of a transaction attributable to ESG factors. Often, the effort to quantify ESG factors turns into a vote on the trustworthiness of the management's long-term strategic blueprint and predictions.

If a prospective buyer can make a convincing argument that there are serious and long-term ESG issues plaguing a target company, the target's shareholders may support the prospective buyer's offer even if management believes the offer undervalues the company. In such circumstances, investors may lose faith in company management's ability to deliver on long-term value, and may be more likely to support the bidder, especially if the bidder has a plausible long-term strategic plan and a reputation for ESG-related expertise.

Deal Financing

Financing availability might hinge on ESG considerations. Loans tied to sustainability are gaining traction, with lenders mandating borrowers to track, disclose, and achieve specific agreed-upon ESG performance indicators. Prominent rating agencies have also started to factor ESG elements into their rating reports.

Several private funds are currently focusing on ESG-friendly investments to meet their investment guidelines, implying that more private capital might be accessible to fund deals with ESG-enhancing characteristics. Conversely, potential buyers might encounter increased financing costs and lower capital access if they consistently underperform based on the ESG factors evaluated by rating agencies, or if they are involved in certain industries with high ESG risks.

Integration, Corporate Governance, and Other Post-Closing Considerations

In addition to liability exposure and valuation impact, ESG factors can, and often do, affect the extent to which a buyer will realize projected synergies and smoothly navigate post-closing business operations. ESG risk elements pinpointed during due diligence will, in many instances, remain important post-closing, and new ESG risk factors might also emerge. Therefore, where possible, it is important for the buyer and target to work together closely through the integration process to design corporate governance, risk oversight, and compliance structures that are tailored to the combined company's ESG risk profile.

ESG considerations can also impact the post-closing corporate governance structure. For example, a buyer may want to consider whether it makes sense to establish a separate board committee to oversee ESG risks and opportunities, or whether it would be more effective to integrate ESG oversight into the mandate of an existing committee, such as the audit committee or the risk committee.

Furthermore, a buyer might think of whether it's better to set up a distinct management-level ESG committee or task force to manage the company's ESG endeavors and to report to the board or the relevant board committee on ESG matters. A buyer may also want to consider whether it makes sense to hire or designate a senior executive with ESG expertise to oversee the company's ESG initiatives.

Conclusion

ESG factors are growing to be increasingly important in M&A. As the ESG landscape continues to evolve, it is important for dealmakers to stay informed about the latest trends and developments in ESG and to consider how these trends and developments may impact their M&A strategies. By doing so, dealmakers can better position themselves to navigate the challenges and opportunities presented by ESG in the M&A context.

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At Alehar, we're deeply passionate about M&A and fundraising, equipping us with the expertise and extensive network needed to carry out transactions efficiently and represent the interests of our clients effectively. Our expertise is particularly valuable for transactions ranging from USD 3m to 200m, as we guide companies through every step of their M&A and fundraising journey (including both equity and debt transactions)