How ESG is changing the market for mergers and acquisitions (Part 1)

M&A practitioners have been relatively slow to embrace ESG, but investor demand and a wider uptake of responsible investment is driving it higher up the agenda for private equity firms and corporates. This means the M&A investment process needs to evolve.

Mergers and acquisitions appear to have few immediate synergies with responsible investing. Quick financial growth is often at the centre of acquisition strategies, whether the investor is a private equity firm or an acquisitive corporate. And M&A transaction teams often work under great time pressure to close deals, not the ideal environment to identify and analyse ESG factors and their future potential impact on a target.
However, it is hard to think of any financial decision where managing ESG risks – and indeed identifying sustainable growth opportunities – would be more important than when acquiring an entire company, or a sizeable stake in a business.
M&A is no small-fry market. JP Morgan’s global 2019 M&A outlook says the M&A market reached $4.1 trillion in 2018, the third highest year ever for deal volumes. This was largely driven by so-called mega deals; those greater than $10bn in size. While ESG integration in M&A has been relatively slow, market participants are starting to think that ESG cannot be ignored: “ESG is no longer just a buzzword – it is becoming critical to M&A dealmakers and asset managers alike,” says a report published in May by IHS Markit and M&A newswire Mergermarket. The latter interviewed 30 senior executives from private equity firms, corporates and asset management firms about decision-making related to ESG issues at investment targets. Some 90% of the survey respondents said they conduct ESG due diligence.“The wider focus on ESG criteria across the entire investment ecosystem has led to this now being a more important consideration for M&As,” says George Alexandridis, a professor of corporate finance at Henley Business School, University of Reading. This applies to all M&A practitioners “from search and screen teams in business development divisions, to investment banking advisors, consultants and financiers”, he says.
A number of high-profile corporate scandals and difficulties highlight the importance of identifying and managing ESG-related risks in acquisitions. A June blog post by Toby Belsom, director of investment practices at the Principles for Responsible Investment (PRI), argues that ESG should play a key role in M&A, pointing, for example, to Bayer’s $63bn acquisition of US giant Monsanto as something “Bayer’s management and shareholders may regret” given the legal action around the herbicide, Roundup. He says identifying these potential liabilities is key to protecting shareholder value.
There are also cases of acquirers failing to merge an acquired company’s procedures and standards with their own more robust policies, says Johanna Karoline Schmidt, an independent responsible investment analyst.

Examples include Danske Bank’s money laundering scandal, which centered around the Estonian subsidiary acquired as part of the 2007 purchase of Finnish bank Sampo, she says, while also highlighting a BBC article in July claiming German agency TuvSud’s Brazilian subsidiary – acquired in 2013 – knew the Brumadinho mine was vulnerable to collapse when approving it.

“Both of these are acquisition cases, which I think is very interesting,” she says. “When you buy another company you need to make sure your systems are aligned, and because this is a considerable effort I see a risk there in terms of ESG.”
While it would be difficult to quantitatively link an M&A failure to poor ESG due diligence, says Alexandridis, challenges around ESG compatibility are easier to quantify. A 2015 University of Reading study, written by Alexandridis and Andreas Hoepner, Professor of Operational Risk, Banking & Finance at the Michael Smurfit Graduate Business School and the Lochlann Quinn School of Business of University College Dublin (UCD), among others, looked at ESG incompatibility as a measure of difference in corporate culture and its impact on the financial success of M&A deals. The study analysed 220 domestic and cross-border M&A transactions announced between 2004 and 2012, using a dataset collated by EIRIS (now Vigeo Eiris and part of Moody’s) on a range of ESG enquiries for firms listed on the FTSE All World Developed Index. It found that greater ESG incompatibility between the target and acquiring company “significantly reduces the profitability of M&As”, Alexandridis told RI.
Strong ESG credentials can also be beneficial to buyers in a competitive M&A process. For example, Unilever said in its human rights progress report that its approach to sustainability: “makes us an attractive buyer to many companies/ shareholders who share our values and can be an important differentiator in a field of bidders”.
No wonder, then, that ESG is rising up the agenda of M&A practitioners. “ESG has gone from being a peripheral issue to top 3 for most investors,” says a UK-based M&A lawyer. “Investors are trying very hard to understand [how ESG] will impact potential targets’ underlying activities.” Institutional investors, who make up the bulk of limited partners (LPs) in most private equity buy-out funds and also directly acquire stakes in companies, are increasingly keen to integrate ESG into the investment process, he adds.The M&A investment process begins with sourcing targets and conducting due diligence – traditionally this has focused on a company’s financial performance, while non-financial metrics analysed have focused primarily on a company’s past compliance with regulations and environmental standards. Increasingly, investors want to know how a potential target acquisition is aligned with climate targets and “the deep changes that are happening or expected to happen across most industries,” says a US business human rights lawyer working with private equity firms and acquisitive corporates, adding that “current due diligence isn’t fit for purpose at all”.

“Current due diligence isn’t fit for purpose at all”

The UK M&A lawyer agrees, saying buyers need to try to predict whether a target will be impacted by ESG-related changes in regulation, public opinion or consumer demand. This is no mean feat. More than a quarter of the respondents to Mergermarket’s survey identified “analysing future ESG risks at target companies” as the greatest ESG due diligence challenge. “Because ESG due diligence is still in its infancy, many respondents emphasise the need for ongoing study and experimentation,” the report says. “Due diligence has absolutely changed […] in terms of the ESG risks we look at, it changes almost daily,” says Laurie Medley, general counsel, private equity, and chief responsible investment officer of US investment firm Apollo Global Management, which has about $77bn of assets under management in private equity. “When I started doing this [just over a decade ago], the G in ESG was the easiest thing,” she says. “Now, I’d say it’s almost
where the most risk lies.” As an example, she says the public opinion of plastic straws – and subsequent regulation – has shifted very rapidly. “You would never have thought about it if you bought a company making plastic straws, say, five years ago.”
The more forward-looking approach to due diligence could lead to a wait-and-see approach in the M&A space, says the UK lawyer. “I’ll give you an example – I need to buy a new car soon, and the question is, do I buy another diesel car or do I want a little until it’s expected that [electric vehicle market conditions] will be better? It’s very similar in the M&A industry now – regulations and market conditions are changing too quickly for a firm to take a view.”

Private equity LPs and company shareholders are also pushing for ESG to be analysed in more depth in M&A transactions. Asset managers and corporates need to try to adapt in order to ensure they can invest the huge amount of dry powder – private equity funds alone are sitting on some $2 trillion of unallocated capital, according to data provider Preqin – it has raised in line with investor requirements. “This is becoming a nightmare for asset managers – it’s like ‘hey we’ve just raised 10-15bn dollars to invest but our LPs told us we can’t invest in X, Y, Z, or if we do we need to show how these companies are improving,” says the UK M&A lawyer. “I don’t expect anyone to feel sorry for asset managers, [but] if you want to be strict on ESG it will likely narrow your opportunities.”All acquirers contacted for this article say there is a big universe of potential targets that have good ESG credentials. They also say they would reject – and already have, in some cases – potential investments solely on ESG grounds even if the investment made financial sense. A former director at a US private equity firm questions this, particularly in PE-backed acquisitions: “If ESG poses an investment risk it would be fully taken into consideration – but that’s just like any other financial risk. But, ESG alone wouldn’t be a deal breaker – if a company had poor ESG ratings but was expected to be a successful investment, PE funds would invest.”
And an outright rejection of an investment because of ESG is, unsurprisingly, not the preferred strategy for some investors. “While we do sometimes decide not to do deals because of the ESG, regulatory, or reputation-related risks, it is because we believe they will pose challenges to the long-term success of the business and our investors,” Elizabeth Seeger, director of sustainable investing private equity giant KKR, says. “More often, we are seeking to understand how we can manage a particular risk or opportunity to create value during the period of our investment, and we have built the internal expertise and external networks to enable this.” Medley at Apollo emphasises that ESG isn’t just about risks, but also about opportunity. “Our key focus is on how we can help companies improve.”