ESG Is Becoming a Critical Element of M&A

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June 22, 2022


Overview

Environmental, social and governance (ESG) considerations are becoming an increasingly important part of doing business — and that includes the due diligence process for mergers and acquisitions (M&A).

The process of examining a potential partner or acquisition through an ESG lens is becoming more formalized, requiring a level of detail similar to that traditionally paid to financial records. Effective ESG due diligence in M&A also requires a keen focus on what’s important to the acquiring organization as well as to its own investors and shareholders.

“ESG due diligence in today’s world is all about helping the buyer understand whether the target company meets its stated ESG criteria and does not pose a reputational risk to the business,” explains Alistair Lester, global co-CEO of M&A and Transaction Solutions at Aon. “The implications of getting it wrong through the broad ESG lens these days can be genuinely meaningful. It can have not just financial and regulatory implications for an acquirer or investor, but also personal liability for the individuals involved in the decision-making process.”

In Depth

Growing climate change concerns have prompted many businesses to focus on the environmental aspects of ESG. But more and more organizations are also prioritizing other areas of ESG strategy. In addition to social initiatives like workforce wellbeing, supply chain management and strengthening relationships with customers and communities, companies are recognizing the value of clearly defined governance models in day-to-day business success.

“If you have the right operating frameworks and the right governance, then you can manage the business in a way which is going to enable it to thrive and grow, and have a positive impact,” says Lester.

Including ESG in M&A Due Diligence

Though today’s formalized ESG due diligence may seem new, many elements of this process are well-established features of M&A deals.

“A number of due diligence work streams that have been around and executed for some time — like management integrity, environmental health and safety and cyber due diligence — are morphing into more of a broader-based ESG proposition,” says Lester.

M&A dealmakers and their advisers are increasingly building in a more structured approach to assessing ESG considerations as an integral part of their due diligence. However, given the variety of areas that can fall within the scope of ESG, M&A principals need to tailor their approach to focus on what’s most relevant to them in the transaction, when viewed through this lens.

“There is no one overarching solution or answer,” says Piers Johansen, managing director of M&A and Transaction Solutions at Aon. “There are multiple different layers and depths to which you can go in any particular area, across a wide range. The art is understanding where and how to focus the review to capture those priorities most effectively and how to address the results of that review through applicable solutions and strategies, such as risk transfer, improved controls and procedures or better engagement.”

Making the Most of ESG Due Diligence

While the importance of ESG due diligence in M&A is growing, business leaders, however, must contend with the current variability and limits of ESG data.

“It’s very hard to give clear advice in different situations because the data set can be limited,” says Lester. Instead, much of ESG due diligence relies on subjective opinions and references to similar situations. “That will evolve over time,” Lester adds.

Much of the advice that comes out of ESG due diligence focuses on actions that should be taken post-closing. “These aren’t things that need to be done to ensure or to satisfy the completion of an acquisition, but they are things that are going to need to be done — or should be considered — as part of the 100-day plan or the 12-month plan post-acquisition,” says Lester, adding that these actions should continue for the longer-term, as part of a continuing strategy. “You’ve got to be able to understand how it’s going to have positive impacts over a two-, three- or five-year horizon.”

Johansen adds that M&A principals are thinking about the steps that need to be taken post-closing to ensure the proper integration of ESG criteria into the combined business, the creation of a cultural synthesis, to provide the platform for creating value through this lens. “It’s not just at one point in the transaction that this should be done. It’s something to re-evaluate over time, especially if you’re looking to exit, as a private equity investor will be in due course.”

Sellers Can Benefit as Well

There’s growing recognition of the importance of ESG among target companies, and many potential sellers strive to promote their company’s ESG objectives and achievements early in the process.

“The challenge for some firms will be the companies they bought in the past before ESG was a due diligence consideration,” says Lester. “They’re going to need to work extra hard to tell the positive story on an exit. If you bought something without reviewing it through an ESG lens, in trying to sell it the review through that ESG lens is going to be harder.”

Looking Into the Future

Ultimately, the goal of ESG due diligence in an M&A deal is determining whether the target company has a future.
“The scope of ESG is expanding all the time,” says Lester; for example, cyber risk might not have been a business consideration in M&A deals 10 years ago but now it can be a major threat to the business and sits squarely within the scope of ESG.

“It’s an incredibly diverse set of topics which are interwoven and connected under this broad ESG umbrella,” Lester says. “Because ESG continues to evolve, if you do not pay it enough attention, then you potentially miss opportunities to identify issues which are going to protect you from downside. And, on the sell side, you’re going to miss opportunities to present the most positive story you can about the company, which will cause you to miss out on value and upside.”