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A Swing to ESG as a Value-driver in M&A

Alison Chivers, Partner at Trowers & Hamlins, outlines how momentum is shifting away from ESG being viewed as a risk factor that must be mitigated towards a growth factor and value-driver.

Trowers & Hamlins recently conducted its second annual research study into mid-market M&A in the UK, surveying dealmakers from the corporate, private equity and advisory worlds. We were keen to understand how ESG is impacting M&A dealmaking in the mid-market and to see how this impact has evolved since the previous year. 

It is clear from our data that, even over the course of the last 12 months, ESG has become a much more valued part of the assessment of an M&A target than previously. Twenty-one percent of dealmakers now identify ESG credentials as a top three consideration when weighing the attractiveness of an M&A target, with 11% ranking it as the most important factor. A year ago, only 5% ranked it as the most important factor, and only 12% ranked it as a top three consideration. 

ESG making an impact on dealmaking 

These figures show that a rapidly increasing number of dealmakers are prioritising ESG above all else. However, currently (at least) the majority still do not see ESG as crucial to transacting, with many still focussing instead on traditional value drivers such as financial performance, brand reputation, and existing relationships. Nevertheless, the fact that our data reveals an almost doubling of the percentage of dealmakers that highly value ESG factors cannot be ignored, particularly if this trajectory continues. 

What we have seen is that the weighting of focus on ESG also differs depending on the size, scale and sector of a target business. It is often said that ESG currently remains the preserve of larger corporates, whereas in the mid-market, the views and values of individual founders will hold more sway and determine approach – this view is increasingly becoming outdated however as stakeholder capitalism continues to push ESG to the forefront of the agenda for businesses of all sizes. Not only stakeholder capitalism is at play here, but we are also seeing increasingly that private equity investors and other investment funds are requiring their portfolio companies to adopt and report against ESG policies and guidelines; and this contributes to the funds’ own reporting requirements to its own limited partners. 

Whether small, or large and regardless of the sector, ESG issues are becoming something that cannot be ignored or pushed to the sidelines by a business, particularly in the context of M&A. Only 8% of those surveyed said that ESG does not factor into their decision-making. 

ESG due diligence  

One area of tangible progress around ESG in the last 12 months is in the formalisation of ESG due diligence processes.  Of our dealmaking respondents, 42% said that ESG due diligence has “very much so” become its own area of expertise – characterised in some cases, for example, by the existence of separate, specialist consultants advising on transactions. 

Areas of ESG due diligence will of course vary between businesses but may include the target’s approach to: addressing climate change; energy consumption; water consumption and waste management; biodiversity; diversity and inclusion; health and safety matters; ethics and supply chains; anti-bribery; data privacy and data protection.  

Our respondents were keen to point out that ESG due diligence is no longer about risk management, it is more about the potential for value-add and value creation.  

As part of the diligence process, investors will be looking to post-completion actions to further satisfy ESG goals. Investors with a specialist focus on ESG may include an ESG action plan in equity documentation and put in place ESG policies for portfolio companies to align outcomes and objectives. We have seen some specialist funds link their carried interest returns to ESG outcomes across their portfolio companies; demonstrating to their limited partners that ESG is not merely a box-ticking exercise.  

Although, in comparison to larger funds, ESG due diligence is still in its early days for the mid-market, it is an increasing area of focus in the due diligence process in its own right. Only 4% of our respondents believe that ESG due diligence is “not at all” its own area at this stage with 11% answering “not very much” and the remaining 43% saying “to a certain extent”. 

There is undoubtedly a fast-growing trajectory towards prioritising ESG due diligence and the mid-market is seeing an increasing amount of specialist funds and investors entering this market and trying to take their share of it.  

The marathon continues 

It is clear that the spotlight on sustainability and related issues is not a passing trend. ESG’s disruptive impact on dealmaking is still a work in progress, but will surely continue to increase.  With key targets like UN Sustainability Goals on the horizon, corporate and investor focus on ESG continues to increase, particularly when it comes to environmental impact.  Greater scrutiny of these concepts during due diligence and Investment Committee approvals is one area of focus, while financing may also become increasingly tied to ESG covenants.  ESG linked performance metrics will also likely become more widely used alongside financial targets for management teams and departing shareholders. 

There is a limit to the disruption that ESG will cause in M&A circles in the short term as investors will likely remain primarily focussed on the numbers.  However, there is no doubt that its role is on the up and, even under the “ESG banner”, our data shows that environmental and sustainability issues are gaining more prominence.  Our data shows that sustainability ranks as a top three ESG consideration for 70% of investors and acquirers assessing a potential target, while a target’s approach to climate change was highlighted as a top three ESG consideration by 49% of respondents.  This contrasts to data from a year ago where sustainability was identified as a top three factor by 65% of respondents with climate change picked by 31% of respondents, highlighting the heightened value placed specifically on environmental and sustainability issues in light of net zero targets. 

Looking ahead, it will always be one of a number of factors that dealmakers assess, but the momentum is undoubtedly shifting towards ESG being viewed as a key value-driver.  This change in perspective is already breeding positive results and we expect this pattern to continue throughout 2023 and beyond. 

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