Would you pay more to acquire a business with a strong record on environmental, social and governance (ESG) issues? The answer from both C-suite leaders in corporates and investment professionals such as private equity partners is a pretty resounding yes. McKinsey research suggests they are, on average, willing to pay a 10% premium to acquire a company with a positive record for ESG issues compared to one with a negative record.
Why the premium price tag for ESG outperformers? Once, the answer might have been that such businesses were regarded as carrying fewer risks – they were a safer option. Today, the focus is increasingly on opportunity.
“There is a clear link between ESG and value,” says James Hilburn, UK ESG M&A leader at Deloitte. “We are seeing a real evolution in thinking about ESG – not only in a risk management and compliance context, but also as something more positive – how it can drive value creation.” Of course, value is not the same as identifiable financial return.
The result is that ESG has now become a more important consideration in dealmaking processes than ever. Acquirers worry about discovering potential ESG nasties during the diligence process – perhaps a supply-chain scandal that’s set to break in the months ahead, or maybe a breach of environmental rules resulting in a sanction. And of course issues such as these can be deal-breakers: in a recent survey conducted by Baker Tilly, 60% of respondents were found to have walked away from an investment following a negative assessment of ESG issues.
Dealing with ESG
Dealmakers are now focused on what ESG can deliver: how the right investments and acquisitions – or disposals – from an ESG perspective could help them build more valuable businesses. In some cases, ESG is the prime driver in a transaction; in others, it is at least an important element of the value proposition.
This new focus requires a much more exacting examination of ESG during M&A and investment transactions, particularly given the difficulties dealmakers face. ESG is a relatively new discipline, after all. Judgements are subjective, data quality and standards differ by geography and industry, and disclosure levels are mixed.
ICAEW’s new Guideline on ESG considerations during deal processes, which has been co-authored with Deloitte, will be launched this month, and will provide important support (see box, left). But alongside the issue of how to manage deals from an ESG perspective sits a more strategic question: which areas of ESG should dealmakers prioritise to drive the most value?
“The opportunities will vary from industry to industry,” says Julia Jasinska, principal policy adviser on sustainable finance at the CBI. “In financial services, for example, there is the potential to offer new products that will finance the transition to a greener economy; in energy and industry, corporates are designing and utilising new technologies that support the energy transition; in consumer-facing sectors, there will be opportunities to capitalise on the changing sustainable preferences and demands of customers.”
One obvious example of how a focus on ESG might create long-term value in the current climate is in the area of energy generation and efficiency.
ldquo;Understanding the energy situation of the target company is going to be an absolutely material consideration in any M&A transaction right now,” says Rick Thompson, managing director, investment banking, at Singer Capital Markets.
For a business facing soaring energy bills, acquiring a target that has invested in on-site renewable energy generation facilities, say, could even be the route to insulating the organisation from future energy crisis.
“It’s an example of how issues that once felt theoretical and a little fuzzy are now very tangible,” says Thompson.
Adapt or die?
More fundamentally, for organisations at risk of being left with stranded assets as the environmental agenda shifts, ESG-driven investment and M&A represents an opportunity to accelerate business model change. In the automotive sector, for example, consultant Kearney predicts a significant increase in dealmaking as manufacturers and suppliers attempt to increase their electric vehicle capabilities and capacity. In the natural resources sector, businesses such as Anglo American have been disposing of coal-mining operations.
The opportunity to secure new customers and increase market share is another example of how ESG can drive value creation. In another piece of research, this time from Capgemini, 79% of consumers said they would change their buying preferences based on sustainability. In this climate any transaction that secures exposure to products and services well-placed to benefit from this trend is potentially value-accretive.
Nor is this a phenomenon limited to consumer-facing businesses, with corporates increasingly under pressure to work with suppliers that have strong ESG credentials. One corporate financier recently advised an industrial services client on an IPO to work with an ESG ratings agency, so that the agency could report on its performance to potential investors. They said: “In the event, investors asked very few questions about the report, but the firm’s leading customer, which takes ESG very seriously, was hugely impressed.”
When looking at businesses’ own supply chains, there is also an opportunity to drive value through ESG, points out Susana Costa, a director in M&A ops and ESG at Deloitte. “The ESG imperative is to secure much greater visibility of your extended supply chain,” she says. “That is an opportunity to create a much closer ecosystem of suppliers that will drive resilience.”
The CBI’s Julia Jasinska says there’s another key group of stakeholders that organisations should not overlook the importance of. “In a very tight labour market, your organisation’s performance on social and environmental issues could give you a real competitive edge,” she argues. Most obviously, a business that’s recruiting from a broader pool of talent, and investing in reskilling and upskilling of its employees and communities, has more candidates to choose from. In addition, many employees say they want to work for organisations whose values they share and support. Improving ESG performance can therefore drive recruitment and talent retention.
ESG in capitals
In addition, the ESG approach can affect the cost of capital. “The growing range of financing options, such as green bonds and sustainability-linked loans, gives businesses with stronger ESG performance access to a wider – and often cheaper – range of finance,” says Deloitte’s James Hilburn. “Equally, when it comes to equity, shareholders are rewarding businesses that perform more strongly.”
None of these benefits is simply theoretical, or only available over the very long term: a growing body of evidence suggests that businesses are already seeing tangible dividends from ESG work. One recent Deloitte study revealed that more than half of respondents had seen a positive impact on revenue growth and overall company profitability; 48% reported increased customer satisfaction, and 38% said an embrace of ESG values had enhanced their ability to attract and retain talent.
Those benefits, in turn, are supporting richer valuations. Deloitte’s work suggests a clear correlation between a business’s ESG rating and its valuation multiple in every industry assessed. Businesses given the highest ratings on ESG by analyst Refinitiv had an average enterprise value to EBITDA ratio of 18.55, compared to just 7.26 for those with the lowest ratings.
One implication of the contrast is that actively targeting ESG advances through investment or M&A is becoming more costly. This fits with McKinsey’s findings that corporates and investors alike are prepared to pay a premium for businesses with stronger ESG performance, but it also suggests that ESG-driven M&A strategies come with an increasing price tag.
The role of regulation
That, of course, makes it even more vital to focus on successful deal execution, particularly since the focus on ESG is only set to increase as further regulation in both the UK and internationally concentrates minds.
Environmental disclosure requirements under the Task Force on Climate-related Financial Disclosures (TCFD) recommendations already apply to 1,300 public and private companies, and the scope is expected to be extended by 2025. New rules under a UK version of the European Union’s Sustainable Finance Directive are on the way, as is the UK taxonomy, setting out legally binding environmental definitions and criteria.
Elsewhere, reporting requirements are also increasing in areas such as modern slavery, gender pay and the representation of minority ethnic groups. In addition, this spring’s Queen’s Speech introduced more than a dozen bills with some implications for corporate governance.
The effect, suggests Singer Capital Markets’ Rick Thompson, will be to accelerate the trickle-down effect that has seen more smaller companies follow the lead of larger organisations in embracing ESG issues, with even more deals incorporating a discussion of ESG value. “The challenge for all of these businesses is not to see this as a compliance burden or as some form of box-ticking exercise,” he says. “Rather, the focus has to be on the tangible benefits of ESG, and which are most relevant to the M&A process.”
ESG in M&A guideline
ICAEW’s new Guideline on ‘the practical aspects and considerations of ESG in transactions and investment decisions’ reflects the reality that ESG is now a central consideration in every M&A and investment deal, says Katerina Joannou, ICAEW senior manager, capital markets policy, corporate finance.
Written in collaboration with Deloitte’s specialist ESG M&A team, and peer-reviewed by expert members, the Guideline explores the role ESG plays across the M&A lifecycle. It provides practical guidance on integrating ESG into the M&A process and, in particular, identifying and quantifying its value potential.
ESG levers offer multiple opportunities to create positive value and impact through a transaction, says Joannou: “The ESG landscape is evolving and there are still many moving parts, but there is a growing consensus that ESG is not only a compliance issue but also a positive force. Focusing on ESG within the deal process will be an important route to driving growth, securing competitive edge and accessing more affordable capital.”
Nevertheless, there are significant challenges for those pursuing this focus. The complexity of quantifying ESG risk and opportunity, increased by limited comparable data and the subjectivity of assessments, is daunting. “We need to ensure businesses, dealmakers and investors are better informed about these considerations and equipped to ask the right questions,” she adds.
Professionalising ESG approach
Private equity firms are increasingly leading the charge on ESG, working across their portfolio businesses to professionalise the approach. Lucie Mills, a partner with responsibility for both value creation and ESG at PE firm NorthEdge, says her role reflects the clear link between those two areas. “ESG is sometimes seen as a buzzword but fundamentally, this is about building better businesses,” she argues. “It’s about how they manage and mitigate risk, focus on having the best people in their business, spot opportunities for market leadership and ensure the quality of the partners they work with.”
NorthEdge’s approach is to work systematically to improve ESG practices in each portfolio business. The firm has a centralised team with specialist ESG capabilities, but each investment director focuses on ESG too, as they work with individual businesses.
The aim is to help portfolio companies work through their ESG considerations, which inevitably vary according to the nature of their business. On environmental issues, NorthEdge has already helped half its portfolio develop their own net zero roadmaps, and expects the rest to do the same over the next couple of years. On social factors, it is focusing on how employee engagement, diversity and inclusion can drive recruitment and retention. On governance, it is focused on putting the right structures in place in its investee companies – an area where PE has always been committed.
The advantage of working within and across a portfolio is the opportunity to share best practice and pursue joint endeavours. For example, NorthEdge holds an annual ESG forum for the management teams of its portfolio companies, providing education and training as well as the chance to share ideas.
“Our focus is absolutely on the link to value creation, and we see the results,” Mills says. “The impact of ESG activities on the bottom line may not always be direct or immediate, but we can see how ESG is driving reduced employee turnover, for example, or underpinning stronger relationships with large corporate customers that all now have a laser focus on ESG.”
The environmental add
Dealmakers in M&A processes are increasingly looking for ESG reports, akin to the survey provided to a housebuyer, says Tomas Sys, a principal specialising in environmental consultancy and ESG at the adviser Ramboll. “ESG is fast becoming another routine diligence stream alongside financial and legal,” he says. “Buyers want to understand both the risks and the opportunities from an ESG perspective.”
Sys is commissioned equally by buyers and sellers in an M&A process – particularly by PE investors, often via investment banks. Sellers feel there is value in having a report on how the business is performing against various ESG metrics to present to prospective buyers. “Our role is to set out the facts impartially,” he says. “Buyers may look to us to provide reliance for their debt finance providers; sellers may look for reliance to be provided to the acquirer on our report.”
Sys’s work starts with materiality mapping, aiming to identify the specific ESG aspects relevant to the business so these can be assessed. They will vary by industry sector and geography. The assessment detail is driven by the level of ESG maturity of the parties in the transaction. Some businesses, he points out, work to a far more sophisticated understanding of ESG aspects than others: ESG is a journey, not a destination.
Inevitably, the work involves a level of subjectivity. Even in areas where there is some consensus about standards and metrics, businesses may not yet be capturing them. Assessing a business’s carbon footprint during diligence process may be difficult, for example, if it has no emissions data at all; the due diligence window is often too short to allow starting from scratch. On other aspects of ESG, standards are often nebulous and answers are not always clear. For some businesses, however, many ESG aspects can be embedded in the supply chain.
Nevertheless, Sys’s role is to report on where the business stands today from an ESG perspective, and what/where the opportunities exist for improvement. Buyers may even ask him for a 100- or 200-day action plan to engage with the business and develop ESG-related key performance indicators. “Whatever our findings, it is ultimately the client’s decision about whether to proceed with the deal,” he adds.
ESG tech demand
With businesses worldwide under pressure to respond to regulatory scrutiny and demands for greater visibility on ESG, technology companies with solutions that can help meet the challenge are selling like hot cakes.
During the first six months of 2022 alone, there were 93 acquisitions of ESG technology businesses globally, according to M&A adviser Hampleton Partners; this represents a 173% increase on the same period in 2019.
“There is an urgent need for companies to improve their use of ESG tech to support the real-time recording, analysis, reporting and visibility of their ESG data,” says Lolita White, a senior analyst at Hampleton. “That’s why we are seeing increasing numbers of software and services firms specialising in facilitating ESG reporting capabilities, garnering interest as M&A targets.”
While many of these targets are smaller enterprises with specialist ESG technology solutions, there have also been a number of larger transactions. In January, US cloud software business Blackbaud paid $750m for Everfi, which has developed ‘impact-as-a-service’ software products to support public and private sector organisations in social impact work. In February, the private equity group Apax Partners paid $813m for risk and compliance software firm Alcumus Group.
Valuations in the sector continue to climb. The average business changed hands at a multiple of 13.6 times EBITDA in the first half, Hampleton’s analysis shows, but a number of transactions have completed on substantially higher valuations.
First published in Coporate Financier, Issue 246, October 2022