In the world of Mergers and Acquisitions (“M&A”), both buyers and sellers are placing greater emphasis on Environmental, Social, and Governance (“ESG”) credentials.
ESG criteria are reporting practices used by businesses and are “a set of standards for a company’s operations that socially conscious investors use to screen potential investments.” Companies poised to sell (“Sellers”) can leverage ESG metrics to determine the value of their business. Similarly, private equity firms, multinational companies, and other buyers (“Buyers”) searching for the right acquisition target (“Target”) can use these same metrics to evaluate Targets and reduce reporting burden. As ESG continues to gain importance in M&A transactions, both Buyers and Sellers (“Dealmakers”) realize that ESG credentials are no longer sources of risk mitigation but rather of value creation.
Sellers can use ESG metrics to determine the valuation of their business. In a podcast hosted by McKinsey, Sara Bernow, who leads McKinsey’s work in sustainable investing and co-leads the institutional investing practice in Europe, stated the “reason [ESG] is relevant in M&A situations is that an increasing body of research shows a positive link between ESG performance and financial performance or value creation.” The ability to define a price that is competitive and backed with what is “market” is crucial for Sellers. Furthermore, assessment of known, potential, and contingent liabilities allows Sellers to identify and mitigate risks prior to entering into a sale transaction. Sellers can be more confident that their valuation will not be reduced due to these risks. In the M&A industry, “a company’s failure to understand and properly address key ESG factors in its business is increasingly viewed as a significant risk to the company’s long-term value.” Buyers may choose to reduce the price of the transaction upon discovering ESG liabilities.
Likewise, Buyers that analyze ESG metrics have a better assessment of their Target’s value. Companies are increasingly tracking ESG measures and risks, and reporting on these findings. In fact, disclosure increased more between 2019 and 2020 than in any previous year. Such reports can flag environmental trends or other legal risks, which might not otherwise appear in a diligence request list. For instance, the ability of a Target to adapt in an environmental crisis. The M&A industry will continue to see ESG risk as a prominent transaction factor, since “as the value of loss and damage from climate change grows, litigation risk is also likely to increase.” ESG reports also inform Buyers on ESG opportunities that the Target possesses, such as resource efficiency and cost savings, access to new markets, and resilience in supply-chain.
Despite the lack of a standardized ESG credential framework, Buyers can compare Targets’ valuation based on ESG criteria. Even if ESG metrics are not measured identically, the disclosure of quantifiable information permits Buyers to find commonalities and compare Targets within and across industries. This provides Buyers with a better understanding of how to compare different Targets. Many organizations, such as the Task Force on Climate-Related Financial Disclosures and the Global Reporting Initiative, have also come out with their own recommended guidelines for best ESG practices. These existing ESG frameworks can be useful baseline measurement tools for Buyers.
National and supranational institutions now require ESG reporting measures for investment companies, public companies, and companies in certain industries. Not only do Targets or Sellers have mandatory reporting, but also Buyers may be required to report on ESG metrics. In such instances, Buyers will also need to report ESG metrics for their business as well as any business that they acquire. This reporting burden is eased when Buyers acquire Targets that already provide ESG measurements, which facilitates compliance with national and supranational requirements.
Both Buyers and Sellers should consider the influence ESG reporting has on M&A deals and the best way to diligence given this impact. There is no blanket approach for ESG diligence. However, effective ESG diligence helps Dealmakers have “a clear understanding of the company’s operations, business plan, along with ESG impacts and risks and how management plans to address or capitalize on those issues.” Structuring diligence requests in a way that maximizes relevance of the information collected can facilitate an effective diligence – i.e., aligning diligence requests with ESG reporting requirements. More exact ESG diligence requests trigger responses from the Target that identify liabilities and risks that may not have otherwise been identified. Developing an ESG policy is a common method to structure the process for ESG due diligence, as a policy creates a streamlined and consistent process for firms.
While ESG has traditionally been overlooked in the M&A world, Dealmakers are realizing its inevitable rise in prominence. Sellers who engage in ESG diligence improve their business valuation and competitive market pricing, while Buyers are able to better evaluate their Targets and reduce reporting burden. Both Buyers and Sellers benefit from creating value from ESG metrics rather than perceiving ESG as solely risk based.