This article was originally published on Fortune.com.
When I began my career as an M&A investment banker, the term “ESG” had not yet been coined. The first green bond issuance was still over a decade away, and evidence supporting the financial materiality of Environmental, Social, and Governance factors had yet to be firmly established.
In the intervening two decades, I focused on the markets side of the business, working on trading floors around the world. During this time, I connected with institutional investors for whom ESG was becoming increasingly important, with some directly managing ethical funds while others were striving to align their portfolios to long-term thematic trends. My career has now come full circle: I’m back on the very same investment banking floor I started on, and working closely with product and coverage teams to provide an ESG lens throughout our advisory business.
“Integrating ESG considerations into M&A transactions, and even taking an ESG-first approach to M&A, is an emerging area that I believe will offer new opportunities to create value for our clients.”
There is a growing recognition that ESG considerations play a decisive role at every step of the M&A process, from target selection through to post-merger integration. A survey conducted in December 2020 revealed that 83% of business leaders believe that ESG factors will be increasingly critical to M&A decision-making over the next 12 to 24 months. This sentiment is further reinforced by market data, which found that in the first nine months of 2021, there were 798 M&A deals considered “sustainable” by data provider Refinitiv, representing a 44% year-over-year increase.
The movement towards a stakeholder-centric model is a key factor driving the integration of ESG considerations in M&A decision-making. While institutional investors continue to play a pivotal role in bringing ESG issues to the forefront through investment and proxy voting decisions, a growing focus on sustainability and long-term value creation from a broader range of stakeholders, including employees, consumers, and governments, is having a significant impact on how corporations view ESG issues.
Four practical ways to integrate ESG into the M&A process
From assessing a potential target’s capacity to help deliver long-term value to stakeholders to advising on ESG best practices during the post-merger integration period, companies should consider these four areas when looking for new opportunities.
1.Target selection
ESG considerations are especially important in the early stages of a deal. Corporates are increasingly seeking out transactions that will help improve their overall ESG profile, and, consequently, their ability to create long-term value for stakeholders. For example, our team recently helped a client identify potential tuck-in acquisition targets that would enable them to add significant ESG-related capabilities and insights to their product offering.
My team is actively working with financial sponsors who are seeking to capitalize on the major macro tailwinds that ESG provides. Similarly, some of our clients who are recognized as sustainability leaders are seeking value opportunities where ESG has not been considered previously or where there has been subpar management of ESG issues.
Cultural compatibility is a crucial factor in influencing the success of a merger. If a company acquires a target with a corporate culture that is significantly different from its own, friction between employees and other stakeholders can challenge integration and the realization of the value of the deal. A number of ESG research and ratings providers have developed quantitative measures for corporate culture, and these scores can be used as a proxy to measure and assess the likelihood of M&A success from a cultural perspective.
2.Due diligence
Certain non-financial factors, such as governance structure, have long been assessed during the due diligence stage. Adding a dedicated environmental and social lens opens up new opportunities to identify and quantify different types of risks and opportunities. For example, we recently supported a client in its approach to greenhouse gas (GHG) accretion/dilution analysis which is rising in importance, particularly when the acquirer has set emissions reduction targets. Cross-referencing corporate real estate holdings with floodplain maps can help identify assets exposed to physical climate risk. Cataloging a target’s proprietary emissions reduction technology or intellectual capital can help the acquirer determine how the transaction might help them achieve their own GHG reduction targets more efficiently.
3.Valuation
Recent growth in the quality and availability of corporate ESG disclosures has greatly benefited the valuation stage of the M&A process. Target companies are typically valued using a discounted cash flow (DCF) analysis, and there are several ways in which ESG considerations can be factored into the methodology.
One approach involves adjusting the discount rate, or weighted average cost of capital. A compelling body of evidence suggests that companies with higher ESG scores tend to have less systematic risk exposure, lowering investors’ required rate of return and, as a result, lowering the company’s cost of capital. In a DCF model, with all else being equal, a lower cost of capital is likely to translate to a higher valuation.
There are challenges with this approach, especially in terms of settling on the correct degree of rate adjustment and potentially double-counting risks or opportunities that may already be reflected in a company’s financials. Another pathway to integrating ESG considerations into a financial model involves adjusting future cash flows to reflect ESG issues that are anticipated to have a material financial impact on the company. A controversy, for example, can directly affect cash flows through fines, lawsuits, and increased insurance premiums, as well as indirectly through reputational damage leading to customer attrition. Conversely, a target company with robust intellectual capital related to energy efficiency or renewables could present new opportunities to reduce operating costs.
4.Post-merger integration
Post-merger integration is one of the stages in the M&A process where ESG integration can have an outsized positive impact. This is because many of the factors that have historically challenged the realization of synergies largely correspond with the “S” and “G” factors in ESG, especially human capital, corporate governance, and corporate culture. Our team consistently strives to help our clients realize value during the post-merger integration period by advising on transaction rollout and stakeholder communication, harmonization of ESG targets, and consolidation of a company’s ESG infrastructure, including disclosures and personnel. This post- merger integration period can help to ensure that potential challenges and roadblocks are quickly addressed and mitigated.
There is mounting consensus that making corporate decisions that improve a company’s ESG performance can also benefit the firm’s valuation in the long run, and we continue to see the growing influence of this shared understanding throughout the M&A process. Given these shifting priorities along with a growing body of evidence highlighting the importance and impact of ESG in dealmaking, we expect the movement towards integrating sustainability considerations into corporate strategy to continue and be a top priority for years to come.