ESG and its growing importance within the M&A process

The importance of ESG within the M&A space has been growing consistently and rapidly over the years. Recent figures suggest that nowadays about 90% of M&A targets are acquired only after a thorough review of their performance by analysing Environmental, Social and Governance factors.¹

One key driver behind this wide adoption of ESG analysis is that companies increasingly need to be sustainable to acquire or keep their social license to operate. Recent scandals well reported in the media – such as BP’s Deepwater Horizon or Volkswagen’s Dieselgate – have increased people’s awareness of the risks associated with corporate misconducts. Consequently, consumers are increasingly asking for irreproachable social behavior and full transparency from the companies they buy from.

Younger generations are adding to this trend: Surveys have shown that the vast majority of millennials agree that the primary purpose of business should be to improve society rather than generate profits.² Companies are responding to this megatrend by formulating ambitious sustainability plans, for example by becoming a net zero company by fully offsetting their current CO2 emissions (e.g. BP) or even by compensating for all their historical emissions to date (e.g. Microsoft, Google).

Access to capital is also becoming dependent on the performance of a company’s ESG dimensions. On a scale previously unheard of, large investors are now divesting from any company not delivering on expectations with regards to environmental or social dimensions, or with a core business misaligned with the ethical values of the fund’s owners. As early as 2006, Norges Bank Investment Management, today the largest single owner in the world’s stock markets, started to divest from companies active in areas violating their ethical guidelines, from nuclear weapons to anti-personnel landmines and tobacco. Additionally, in 2020, BlackRock unilaterally decided to divest from companies active in tar, sand or coal.

Furthermore, an increasing number of investors are operating under strong codes of conduct from international agreements; institutional investors with over USD 80 trillion of assets under management have signed up to the Principles of Responsible Investment, pledging to incorporate ESG issues into investments and decision-making. Lenders such as the International Finance Corporation (IFC) also now fully incorporate ESG metrics as part of their initial credit review process. Overall, recent studies suggest that better ESG scores translate into c.10% lower cost of capital.³

Conversely, the ESG megatrend is creating new forms of risks for companies because ESG performance is a moving target with ever-growing requirements. Regulations increasingly necessitate companies to disclose their nonfinancial impacts on society. In the EU, it has been a requirement for listed companies to disclose non-financial statements on corporate social responsibility since 2018. Further reform is being pushed towards a standardisation of ESG reporting for large companies, as well as the systematic integration of ESG factors in banking, insurance, and asset management industries too. In such a fast-evolving regulatory context, the risks and uncertainty can be high for companies, forcing them to pre-emptively understand where their nonfinancial impacts come from and how to reduce them.

Another form of risk is reputational risk, often the result of scandals uncovered by NGOs and civil society, pushing firms to operate sustainably even beyond their own boundaries; industry leaders are periodically caught in sustainability scandals that often originate outside of their own operations. Nestlé, a leading food and beverage company, has been under the attack of Greenpeace for purchasing palm oil from suppliers that contributed to the extensive deforestation of the rainforest in Indonesia, destroying precious habitats for endemic species. Nike has been repeatedly accused of bad social practices, most recently in 2018 by the Clean Clothes Campaign following claims of decreasing salaries in Asian factories, with the share of total production costs of shoes that ends up as salary in a worker’s pocket reduced by 30% compared to the early 1990s. Finally, shareholder activism as materialised by threats of divestments is also keeping companies in check.

These global, complex challenges are pushing companies to integrate ESG practices quicker and deeper. But how is M&A contributing to addressing these challenges?

M&A advisors can leverage ESG to help companies and investors generate value and reduce risks. Historically, the primary focus of ESG due diligence was to verify that target companies were not involved in any activity that could end up in litigation or result in reputational damage. As such, the due diligence phase was primarily aimed at reducing risks for potential asset buyers by pre-empting potential misconducts that could jeopardise the long-term viability of the business. ESG due diligence has helped in reducing the information asymmetry between the buyer and the target and going forward ESG due diligence will also need to help identify and mitigate emerging risks such as regulatory or reputational risks.

However, beyond risk reduction, ESG is increasingly used as a lens to directly drive up the value of a target by improving operational performance and generating a substantial premium. Recent evidence suggests that ESG assets very often display higher valuations. In 2019 and 2020, companies under the Ethibel Sustainability Index Europe or the MSCI Global Environment Index have been traded at about 12x EV/EBITDA, compared to about 10x for the Stoxx Europe 600.⁴ This held true even more during the recovery period after the first wave of COVID-19 in April-October 2020; after the April crash, the MSCI Global Environment Index had recovered to an index value of 164 in October 2020 (October 2017 = 100), compared to a value of 95 for the Stoxx Europe 600.⁵

There is in fact mounting evidence that well-performing companies along the ESG criteria are typically performing better financially as well. A study by the Boston Consulting Group has shown that nonfinancial performance as captured by ESG metrics was statistically significant in predicting the valuation multiples of companies, across all industries analysed.⁶ In 2019, the top 100 most sustainable companies in America according to Barron returned on average 34.3%, 2.8 percentage points higher than the average for S&P 500 of 31.5%.⁷ MSCI, a leading ESG scoring provider, has found that over the last five years companies with higher ESG ratings exhibited higher average returns on invested capital compared to companies with lower ESG ratings, and that they were also valued at a premium over their top performing peers with lower ESG ratings.

In practice, financial performance can be galvanised by a strong ESG focus through multiple channels during the operations phase. For example, a strong ESG focus helps find efficiency improvements in areas where doing good for society also helps to do well financially. One key example is CO2 emissions. Companies that dedicate substantial effort to reducing CO2 emissions from their own operations will in parallel reduce their energy use too. By doing good for society and reducing its carbon footprint, the company will also gain financially by reducing its energy bills. An ESG lens can help identify areas where ESG brings clear financial benefits and find innovative ways to generate direct profits for companies.

A strong ESG positioning will also help companies increase revenues. In B2C activities sustainability is typically used to generate pricing premiums or access new customer segments. Unilever, a leading FMCG company known for its strong sustainability leadership as reflected in their Sustainable Living Plan, claimed in 2019 that its purpose-led Sustainable Living Brands were growing 69% faster than the rest of the business, as well as delivering 75% of the company’s growth.⁸

In B2B businesses, adhering to strong environmental norms will in turn help client companies downstream to achieve their own sustainability targets, for example by reducing their CO2 emissions from their procurement from supplier companies or improving their reuse or recycling targets. Given the increased scrutiny of stakeholders on nonfinancial performance, often triggered by evolving regulation, these partnerships along the supply chain to achieve ESG targets are likely to become ubiquitous, as they generate clear value for companies who report on these targets.

Beyond operations, during the exit phase, an ESG positioning helps target companies boost their valuation, with a premium for ESG typically ranging from 10–15%. This premium is in part driven by the improved financial performance of companies with good ESG performance, but also materialises because ESG criteria help target companies access other exit channels and other types of investors putting substantial value on ESG. A global survey conducted by McKinsey & Company on valuing ESG programmes showed that “83% of C-suite executives and investment professionals would be willing to pay around a 10% median premium to acquire a company with a positive ESG profile over one with a negative one”.⁹ Moreover, given the substantial race towards ESG investments and the large influx of resources towards ESG asset classes, there is a fierce competition for ESG investment opportunities that naturally drives up the valuation of companies performing well on ESG too.

Beyond investors and target companies, M&A activities can help scale up sustainability and generate value for society as a whole. Leveraging their extensive network across the value chain, M&A advisors can identify synergies and complementarities between companies along the value chain, and form partnerships that are profitable for all parties as well as for society.

One case in point is the circular economy. GCA Altium, a leading advisor within the ESG and Tech space, helps clients maximise deal value through shoulder-to-­shoulder work with management teams of target companies. With a dedicated senior ESG team, the company is closing above 180 transactions per year, many with substantial ESG premia, with a strong focus on mobility and electric vehicles, natural fibres and eco-solutions, smart-cities, food and agriculture, energy, waste and recycling, as well as healthcare and education.

By leveraging its network of IT companies, GCA Altium was able to connect IT asset management companies (ITAM) – in charge of phases from procurement to end-of life – with IT refurbishing players (ITAD) – in charge of phases from end-of-life to procurement – thereby helping close the loop towards a circular economy. Within their business activities, ITAM typically offer end-of-life disposal services, which grants them access to an important volume of used devices. On the other side, the accessibility of a large volume of end-of-life devices is key for companies active in reverse logistics and refurbishment, as it represents a critical bottleneck to the growth in their activities. As such, a merger would benefit the ITAD player by improving access to used devices, would help ITAM players reduce their end-of-life disposal costs, and would substantially reduce the client’s carbon footprint generated for the use of IT equipment. If the IT assets provided to the customer are refurbished and not produced using a traditional, linear model, the carbon footprint associated with the use of devices is drastically reduced. As such, M&A advisors were able to close a deal benefitting all parties and society, by helping close the loop for a circular economy within the IT space – a highly CO2 intensive industry.

Although ESG has proven central within the M&A sphere given its potential to reduce risks and enhance the long-term value of companies, there remain several challenges to its full deployment.

Firstly, ESG risks are difficult to quantify and translate into financial metrics. Financially material dimensions typically vary from one industry to the other. For example, the mining and extractive industries will generate material negative impacts on the environment – hazardous waste, ecological impacts, CO2 emissions – while the food and beverage industry is typically more concerned with social issues such as product quality and safety or customer welfare.¹⁰ Another example is reputational risk, which is fundamentally a function of both the industry and the macroeconomic and political contexts in the countries in which companies operate, and is therefore complex to quantify and translate into financial impacts.

Secondly, there is to date no harmonised standard to identify the relevant metrics to measure each and every ESG factor. This is illustrated by the low correlation between ESG scores across rating agencies. A research team at MIT found that the correlation across the different ESG scores of rating agencies for the same company at the same period reached only about 0.61, while credit ratings from Moody’s and S&P reach a correlation of close to 0.99.¹¹ Efforts are currently being made by the World Economic Forum, in partnership with the five leading global standard setters – CDP, the Climate Disclosure Standards Board (CDSB), the Global Reporting Initiative (GRI), the Internatio­nal Integrated Reporting Council (IIRC) and the Sustainability Accounting Standards Board (SASB) – to establish a standardised set of 21 core metrics across the Environmental, Social and Governance dimensions. This is a crucial first step towards the consistent measurement, tracking and reporting of ESG performance.

Finally, the integration of ESG criteria within the due diligence process is limited by the lack of availability of data for targets. Today, more than 40% of Private Equity, asset management and corporate executives cite the absence of sufficient, reliable data as the key challenge to performing high quality, timely ESG due diligence prior to acquisition.¹² However technological shifts, through the rise of big data, blockchain solutions and artificial intelligence, will help address this challenge sooner than we expect.

In summary, ESG is becoming an imperative in the M&A due diligence process as companies are increasingly expected to simultaneously perform well financially and make a transparent, positive contribution to society to keep their social licence to operate. Using an ESG lens can not only help companies reduce operational risks – from regulation to civil society advocacy or shareholder activism – but can also boost the profitability of their operations and increase their valuation during the exit phase by granting access to other classes of investors, putting financial value on positive societal impacts.

Though substantial challenges remain, technology combined with the ubiquitous momentum and global efforts made by leading institutions will further accelerate the rise of ESG. Forward-looking investors and M&A practitioners should therefore start to fully integrate ESG within their core activities today to stay ahead of the curve.