Why dealmakers need to take ESG seriously

Dealmakers have rarely experienced a period like this. Records are being broken in private and public market transactions, and new highs are being set in global deal value and volume.

In the first half of 2021 alone, private equity firms engaged in the largest number of buy-outs involving the largest volumes since the data was first recorded in 1980. And a boom in special purpose acquisition companies has given extra momentum to deal making in recent years.

Analysts have described recent M&A activity as a “frenzy”. The opportunities are abundant, and so is the risk of leaving value on the table. 

Naturally, with these opportunities come challenges. M&A transactions are becoming increasingly complex, marked by features that would have been unfamiliar to dealmakers just a few years ago.

And that’s where environmental, social and governance issues come in. Dealmakers should be giving them just as much consideration as financials. Here’s why.

Giving ESG a seat at the table

A recent survey found that 60% of corporate and PE investors had walked away from an investment owing to ESG issues at the target. Increasingly, dealmakers recognise that an acquisition brings with it a series of ESG risks that are highly material, hard to quantify, and subject to shifting goalposts, such as the future costs of carbon emissions. 

As a result, the scrutiny on ESG –  including not just climate change but also employee engagement, wellbeing, corporate purpose and workforce resilience – demands a new level of due diligence detail. 

One important element of future due diligence is that pertinent ESG issues are defined from the start. ESG is a broadly defined subject area and it’s essential that dealmakers address the right issues for a specific deal. It’s not a one-size-fits-all definition in this context. 

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Dealmakers will get different advice based on the background and experience of their advisers, but few tend to come forward to have a broad conversation with clients early on to agree on the pertinent ESG issues for that particular deal. 

Ensuring dealmakers have the relevant ESG data at hand means they can make better decisions. Too late in the process, and it could have a significant negative impact on the deal.

Baking in ESG from the start 

For any forward-thinking target or acquirer, it’s important that ESG is properly embedded into the enterprise. The most effective way to do that successfully within an organisation is to have incentives and behavioral motivation, comparable to financial performance. 

That’s why we’re seeing the emergence of the ESG officer today, particularly in PE, where there’s been a huge move to hire experts into these roles. Until now, ownership of ESG has often been undefined, and as a consequence, key ESG issues have fallen through the cracks within organisations. This can have a serious effect on value as well as a potential legal impact. 

The influence of digital 

Embedding ESG deeper in the DNA of businesses and investor considerations mirrors the evolution of technology since the early 2000s. At one point in time, it was considered an add-on to business models. But now, digital is now at the core of many, if not most firms.

Deeper assessment of companies’ digital assets and practices is increasingly influential in investors’ valuation processes today, and cyber security is also highly material in an ESG risk context. As organisations realise protecting customer data is part of their societal and environmental responsibility, they will increasingly incorporate cyber into their ESG strategies.

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The increasing thoroughness with which investors are now digging into digital credentials is arguably a good indication of how ESG diligence must evolve.

The changing face of due diligence

So, there are three core pieces of advice to ensure the success of future due diligence. Firstly, be forensic. Companies’ potential vulnerabilities and key assets have evolved, and a more focused approach is now required. 

Secondly, ESG and digital must be embedded in enterprise risk management. Cyber, ESG and digital considerations have to be treated with the utmost seriousness, as the associated risks to companies are rising. Fully integrating these into everyday enterprise risk management is the best way of ensuring that they are properly monitored and mitigated. 

Finally, it’s important to keep an eye on the long term. Look at ESG from a five-or-more year perspective, not just as part of the next transaction. That way, investors and companies can start acting now to manage risks, draw on new sources of value, and be ready to maximise returns down the road. 

ESG is no longer a nice to have. It’s a must have. Indeed, in any transaction today, ESG issues require the same detailed due diligence traditionally paid to financials if dealmakers are to create value, mitigate risks, and reap rewards.

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