Protecting Value-Creation in M&A: ESG and Due Diligence

Protecting Value-Creation in M&A: ESG and Due Diligence

By now, it’s a given—investors, asset managers, corporate executives, and boards of directors know that environmental, social, and governance (ESG) factors can affect a company’s financial performance and reputation (which affects financial performance). Both the persistent and growing demand among stakeholders for more ESG information and the increase in disclosure requirements in this arena reflect this reality.

This all forms a positive, self-reinforcing loop – a greater recognition of the usefulness of ESG information feeds demand for that type of information, which leads to more disclosure requirements. More standardized disclosures increase the usefulness of the data, and so on.

In addition to integrating ESG/sustainability concepts into investment analyses and corporate strategies, mergers and acquisitions (M&A) specialists and investment bankers recognize that not knowing a company’s exposures to ESG-related risk can be financially material and damaging. As a result, ESG analyses have become part into the due diligence process that is at the core of M&A transactions. 

Does ESG really belong in M&A?

Fair question. 

At the risk of oversimplifying things, M&A is about finding ways to combine companies, or divisions of different companies, so that the whole is worth more than the sum of the parts. That means finding ways to create value and/or justify a higher valuation than would be realized if the entities in the proposed deal did not join forces. Can ESG factors affect this? Here’s just one clear example of how it can:

Canadian mining company Teck Resources Ltd. Rejected a US$23 billion takeover bid from Glencore Plc because Teck’s leaders did not want Glencore’s commitment to its fossil fuel assets to degrade Teck’s long-term value. Teck’s CEO stated that Glencore’s thermal coal assets and oil trading would “negatively impact the value potential of Teck’s business.” He went on to say that Teck can only realize its potential value by separating its copper and coal assets into different entities, as the growing demand for electricity and clean energy will increase demand for metals needed to build electric vehicles and wind turbines, but demand for coal will decline.

Law firm Covington & Burling LLP reports that, in a recent global survey of private equity general partners, 54 percent reported they had reduced a bid after conducting ESG due diligence and 32 percent had increased a bid. In one example, a due diligence team uncovered ESG risks in the target that included environmental liabilities, porately, is the board and management on top of protecting customer data and other cybersecurity risks, or is this just a box to be checked?

Many of these things may seem like common sense, and in a way they are. But with working conditions, the potential for labor disputes, and unsound board practices. That didn’t kill the deal, but it reduced the price by $10 million. 

What should ESG due diligence cover?

A thorough ESG due diligence process can identify red flags as well as opportunities for value creation. KPMG reports, in a survey of over 150 active dealmakers in Europe, the Middle East and Africa (EMEA), the number of investors who expect to engage in ESG due diligence “very frequently” is expected to almost double, while fewer than 10 percent do not plan to conduct any ESG due diligence. Over two-thirds of respondents said they would be willing to pay a premium for a target with “a high level of ESG maturity” in areas that are consistent with the acquirer’s ESG priorities.

Here are things to look for in the E, S, and G components of due diligence:

Environmental: The specifics of the “E” component of ESG due diligence depends heavily on the industry of the company to be acquired. For example, in deals that involve commercial real estate or manufacturing facilities, an analysis of energy efficiency would be “low-hanging fruit” in terms of finding ways to create value—greater energy efficiency reduces carbon emissions and costs. Another aspect of the environmental component of ESG due diligence would include a review of internal policies on GHG emissions reduction, water use, waste, and recycling. 

Recognizing the importance of “double materiality” in ESG, a due diligence effort should also examine a target’s understanding of its exposure to climate-related risks. This could relate to the potential for a material increase in insurance costs due to increased fire or flood risk. For a food manufacturer or specialty retailer it could be in the form of a reduced or less reliable supply of critical raw materials, such as seafood that is being threatened by warming oceans and over-fishing.  

Depending on the situation, ESG due diligence might call for an environmental audit. While the extent of these audits can vary widely, at a minimum it would measure things such as emissions (including greenhouse gases and other pollutants), energy use, and water consumption. If an acquisition target is pursuing plans to expand its physical footprint, what would that do to its environmental footprint? Would the developments require deforestation or have a negative impact on biodiversity in an area? If so, that represents a potentially material risk to the acquirer that should be addressed and mitigated.

Social: The social component of ESG due diligence covers policies (and enforcement thereof) covering labor standards, non-discrimination, the right to organize (affirmed by the U.N. 70+ years ago) and workplace harassment, meeting minimum wage requirements (some industries have a particularly poor track record in this area), human rights (including but not limited to the use of child labor and/or forced labor). Acquirers should look at whether a target company takes health & safety issues seriously, as well as issues such as workplace satisfaction and diversity.

In many countries, companies must report violations of many of these policies and standards, but that may not always happen. In the Social component of ESG due diligence it is particularly useful to “ask around.” Does the company have a reputation for taking care of its employees? Does it tolerate inappropriate behaviors, particularly in senior management ranks? Sites such as GlassDoor and JobCase can be useful for this, although disgruntled employees can use them to vent frustrations.

Governance: Last but definitely not least, the governance component of ESG due diligence should include things like reviewing corporate codes of conduct covering anti-bribery and anti-corruption and whistle-blower rules. It should determine whether the target has engaged in any controversial or illegal activities that would be in violation of the UN Global Compact. If so, how did the board’s and senior management’s respond? Sepahout a formal process for conducting ESG due diligence in an M&A transaction they can be overlooked (or ignored) in the excitement of getting a deal done. Contact us to find out how OWL ESG’s data and tools can help your team to pursue M&A deals that achieve their value-creating objectives.