Navigating Uncertainty in Cash Flow Forecasting / Navigating Digital Disruption
Navigating Uncertainty in Cash Flow Forecasting / Navigating Digital Disruption

In Mergers and Acquisitions, ESG Issues Are Becoming a Growing Factor

David Haufler, Managing Director Global M&A Practice Leader
Ryan Reents, Associate Director Transaction Services

To date, companies have often discussed environmental, social, and governance (ESG) factors from a qualitative perspective – reflecting on the company’s stated values, marketing communications and other statements. But today, almost 90% of M&A targets are only being acquired after a thorough review of their ESG quantitative performance, indicating that buyers are becoming increasingly conscious of the growing impacts that ESG can have on their business. Firms are – and should be – asking the question: “How can ESG impact my deal?” Before an organization’s leadership dives into the possibility of an M&A deal, they should stop and consider how ESG would impact the following elements:

  • Due diligence
  • Financing
  • Transaction risk mitigation
  • Shareholder Impacts

Due Diligence

Evaluating the ESG performance of M&A targets is quickly becoming an integral part of the diligence process as it presents both opportunities and risks for the acquiring company. ESG diligence goes further than traditional due diligence by specifically focusing on the culture, acted values and social responsibilities of the target. This analysis can help the buyer firm identify key ESG-related risks that can affect its reputation, the valuation of the target, and the deal structure. Buyers must ask key questions to assess their potential target’s ESG prowess. Does the target have an ESG strategy? What ESG procedures, policies, and processes does it have in place? What ESG metrics does the target create and track? Does the target company have a track record related to ESG, either negative or positive? By focusing on the target’s ESG record during due diligence, buyers can proactively identify and assess a target’s current ESG posture, ESG-related compatibility, and potential risks and opportunities.

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With 88% of investors, including private equity funds, considering ESG factors during the due diligence process, firms must understand the financial impact ESG factors can have on their next deal. Access to and the cost of capital for a firm is being increasingly linked to various ESG ratings and performance factors, especially when institutional and commercial lenders are involved. The Equator Principles is a risk management framework for determining, assessing and managing environmental and social risks in projects and has become a globally accepted standard for evaluating ESG value creation. MSCI, a leader in ESG scoring, found that companies with higher ESG ratings exhibited higher average returns on invested capital and were valued at a greater premium when compared to companies with low ESG ratings. By influencing a firm’s financing, ESG is quickly growing as an essential part of M&A value creation.

Transaction risk mitigation

In evaluating and approving a transaction, leadership teams should understand the ESG risks associated with the transaction, how to mitigate such risks, and how to ensure proper implementation of the mitigation processes. Both regulatory and reputational risks are key areas of focus during an M&A deal due to increased government and industry regulations related to ESG and the growing presence of advocacy groups who draw attention to ESG deficiencies. An example of such risks includes the recent creation of The Climate and ESG Task Force by the Securities and Exchange Commission to “proactively identify ESG-related misconduct” in both environmental and social areas.

While ESG may still seem difficult to quantify, some industry standards have been established: carbon emissions in the oil and gas industry and drug testing and safety in the pharmaceutical industry, for example, and GMAP (Global Map of Environmental and Social Risks in Agro-Commodity Production), which is a tool for evaluating  environmental and social risk in agriculture.

Shareholder impacts

Customers and shareholders increasingly expect their company’s management to focus on sustainability and global environmental goals, act in socially responsible ways, and become more diverse and inclusive in the workplace. Negative ratings or public opinions on issues like environmental harm and human rights violations can have a lasting impact on a company’s reputation and stock price. By focusing on ESG factors, acquiring firms can ensure target companies meet their own ESG standards and shareholder expectations. This allows firms to create premium valuation of their business, positive returns on invested capital and improved stakeholder feedback.

ESG is not just a qualitative issue; ESG factors have a proven quantitative effect on overall returns, consumer and employee sentiment, and shareholder value. Mitigating ESG risks and maximizing ESG-related value throughout an M&A deal will be a cornerstone of transactions for years to come.

Wayne Taylor and Christopher Buttimer, Senior Consultants with Protiviti’s Business Performance Improvement practice, contributed to this content.

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