ESG in M&A (Part 2): Is it just a box-ticking exercise?

This is the second part in a two-part series. The first part, exploring what’s driving ESG up the agenda of M&A practitioners and how due diligence is changing as a result, can be found here.

ESG is becoming increasingly important to mergers and acquisitions (M&A) practitioners, both for private equity firms and corporates. But some question how deeply acquirers really consider ESG in the investment process. A former director of a US private equity firm told RI, that “ESG is just a box-ticking exercise” for private equity funds, rather than something that truly impacts their risk assessments and investment strategy.

“ESG is just a box-ticking exercise” for private equity funds.

However, many were quick to disagree, saying ESG is impacting the entire investment process from deal sourcing to a potential exit if the investment isn’t long-term. Adam Heltzer, New York-based head of ESG and sustainability private markets investor, Partners Group, says the challenges around ESG data collection and management mean that some major private equity firms “produce just enough ESG information about their investments to give the impression these topics are integrated, but not much more”. The situation is improving, though, he says. “There is now less focus on one-off case studies and more on how your approach is systematic and a value driver for your investments,” he says. “I’ve also noted that in the US, I’m getting more inbound requests from other managers saying ‘we need to boost our ESG policies – how are you doing it?’”.
Buy-out giant Apollo’s chief responsible investment officer and private equity general counsel, Laurie Medley, says private equity has always analysed ESG without necessarily labelling it as such. “It’s part of due diligence – it would be foolish not to be,” she tells RI.“It’s a way to manage risks but also a value creator.” She says that there is an ongoing ESG revolution across the board – for LPs, lenders and internally – driving the issues higher up the agenda. Beyond ESG due diligence, Apollo asks all companies that its funds own to report on a raft of ESG-related metrics – about 80-100 KPIs, ranging from employee relations and philanthropy to power usage, emissions and waste management – during the holding period. Medley says: “We ask companies for an extensive amount of information.” She acknowledges that this is sometimes a challenge, but says it helps portfolio companies achieve cost savings in the short and long-term. Apollo has for the past ten years reported on ESG matters to its limited partners and in late July the firm made its first ever ESG report available on its website to a wider public audience.
Navigating enormous amounts of data, and ensuring it’s of good quality, is a challenge in the M&A space as in any other. But there are ways to be more qualitative in the way you collect and use ESG data, says Heltzer. Partners Group have ESG key performance indicators (KPIs) for all its portfolio companies and engage with all companies throughout the holding period. For the first time, the firm has also published its ESG dashboard of data collected from portfolio companies during the ownership period – without naming individual companies – to increase transparency on the process (see page 16 Link to report ).
The holding period is often an easier point in the investment process to deeply consider ESG than during the due diligence process, says Martijn Scheltema, a partner focusing on business human rights at Dutch law firm Pels Rijcken: “In the acquisition process it’s a bit more difficult, there’s usually a lot of time pressure, and to really identify [ESG and human rights] risks and analyse how to resolve them requires much more time,” he says. “In the holding period you have a longer period of time to look at board and company practices and find

pathways for improvements.” There are plenty of examples of post-acquisition ESG efforts in M&A. KKR said in its 2018 CSR report that it worked with 11 companies across its private equity and real estate portfolio to develop recommendations for energy and water efficiency projects, in a move expected to result in USD $11 million cost savings when fully implemented this year. Partners Group conducted 35 ESG engagements across its portfolio in 2018. Hearthside Food Solutions, the US consumer goods manufacturer, plans to implement an energy management system to reduce energy consumption, while it is working to strengthen the visibility and sustainability of its Indian retail franchisor Vishal Mega Mart’s supply chain. Carlyle says in its 2019 CSR report that it injects capital into its portfolio companies to “get the ball rolling” on ESG initiatives.
Mid-market firms are also integrating ESG post acquisition. Beth Houghton, a partner at UK-based mid-cap investor Palatine Private Equity, says it has worked with The Alchemist to boost its ESG management since acquiring the UK bar chain in May 2015, for example through installing LED lights, reducing pressure on bar taps to save more than 85% of water previously used per tap and improving recycling and waste management. Beyond environmental considerations, it has also changed its recruitment and training processes and reduced staff turnover dramatically, she explains. Houghton says implementing ESG policies in portfolio companies “has a tangible impact on EBITDA”, the most important financial indicator in PE-backed acquisitions (M&A valuations are usually referred to in EBITDA multiples).
Generating positive financial results from ESG efforts is, of course, significant. But is ESG ever considered in M&A situations unless related to financial risks or opportunities? Most acquirers say their ESG policies go beyond financials, but some observers are sceptical. “I don’t believe any of that,” says the former US private equity firm director, who believes ESG is simplyabout box-ticking, unless a firm was specifically set up to focus on sustainable investment: “I don’t have any evidence supporting my view but it’s built on years of practice in the industry,” he says.
When asked whether the group would work on a company’s ESG credentials even though there was no clear financial benefit of doing so, Heltzer at Partners Group says “the short answer is yes, selectively”, partly as a way to prevent reputational risk, which is linked to potential future financial risks. For example, when one of its portfolio companies in an emerging market considered employing prison workers to manufacture some of its products, Heltzer sensed potential reputational risk for Partners Group and its clients. “I contacted the colleagues who were working most closely with the company and they explained the government’s efforts to reduce recidivism by partnering with industry to place prisoners in work environments prior to release is a proven way to reintegrate ex-prisoners into society,” he says. “While we understood the value of this practice, we still really needed to make sure it was in line with our ESG standards before proceeding, so we hired an independent organisation to perform audit against the International Labor Organization’s standards for such programmes,” he adds. “There was no direct financial benefit to this, but it was clearly an important exercise to uphold our principles.”
Meanwhile, new ESG-related clauses are starting to emerge in deals documentation in another sign that the theme is being taken more seriously in the M&A space. “While ESG assessments for M&As typically focus on things like labour and human rights standards, greenhouse gas emissions, consumer protection and business ethics, a good example of how prevalent ESG assessment has become are the so-called ‘Weinstein Clauses’ we increasingly see in M&A agreements, making it a requirement for target firms to disclose misconduct allegations,” says George Alexandridis, a corporate finance professor of Henley Business School,
University of Reading. He refers to the increasingly common clause named after Harvey Weinsten’s sexual misconduct, which came to light and led to the MeToo movement: “Such clauses can have implications on the likelihood to complete a deal as well as the final offer price,” he adds.
A US business human rights lawyer agrees that ESG is starting to make its way into M&A contracts, saying: “yes, I actually just revised some term sheets (a document signed by a target and prospective buyer setting out the terms of a proposed acquisition)” to improve provisions around ESG. Scheltema adds that there is potential to improve legal contracts significantly to reflect the importance of ESG and human rights in M&A deals. “Investors often don’t have sufficient information on what’s happening on the ground at their company,” he says. “We’re exploring a complaint mechanism on the ground where people affected by human rights issues [as a result of a company’s operations] can complain, and the complaints are provided upstream directly to the investor,” he says. The information the investor receives would be anonymous and aggregated into data on the nature and number of complaints. “This would tell the investor something about the situation on the ground. For this to work you need a contract that incentivises or requires the establishment of such a mechanism,” he says.While most contractual obligations focus on provisions around deal execution and responsibilities during the investment period, there is also potential for a seller to require a buyer to adhere to particular existing ESG policies. When Unilever sold its global spreads business – including brands like Becel, Flora and ProActiv – to KKR in 2017 in a €6.8bn deal, KKR agreed to continue to work towards the goal of sourcing 100% sustainable palm oil by 2019.

A good example of how prevalent ESG assessment has become are the so-called ‘Weinstein Clauses’

There is increasing anecdotal evidence that companies who are ESG leaders in their sectors secure more bidders and higher price tags than their laggard peers when they decide to sell, say market participants spoken to for this article.
“You can get a better exit and better price – it’s risk management, but also [finding] new opportunities at the end of the day,” says the US business human rights lawyer. To M&A practitioners still not convinced ESG is increasingly important to acquisition strategies, he says: “The train is leaving the station with or without you! ESG is not going away.”