ESG pays: Harnessing the ‘greenium’ in M&A

M&A professionals are increasingly recognising the importance of environmental, social and corporate governance (ESG) criteria in value creation. Having a targeted ESG approach can result in higher valuations throughout the M&A lifecycle. From uncovering the best investment opportunities to securing the optimum exit multiple, strong ESG credentials typically equate to a premium.

In a recent global survey by McKinsey, c-suite leaders and investment professionals said they were willing to pay a premium of around 10% to acquire a company that can demonstrate strong ESG credentials over an equivalent firm with a negative ESG track record. A quarter of those surveyed put the value of healthy ESG credentials still higher at 20-50%. And while the majority (83%) expected ESG programs to contribute an increasing amount to shareholder value in five years’ time, even those who did not were still willing to pay a premium on day one for a higher ESG score.

Quality control

Exactly why ESG credentials and value are linked is open to debate but building a ‘greenium’ into pricing expectations is indicative of the perceived higher quality of that company. Having a strong ESG framework suggests robust risk management, strong employee and customer retention, and – ultimately - a more resilient, sustainable business. And with the global pandemic as a backdrop, business resilience and future-proofing have become more highly valued than ever before.

In practice, businesses that embed ESG throughout their organisation can galvanise financial benefits in a multitude of ways, including:

• Cost savings: more traditionally accepted benefits from a strong ESG approach include lower energy bills or reduced packaging costs.
• Increased productivity: having core values and a strong social purpose at the heart of company culture builds credibility, allowing companies to attract and retain the best talent.
• Investment optimisation: allocating capital more wisely, by foreseeing long-term environmental issues, for example, can enhance investment returns.
• Improved compliance: avoiding potential wrongdoings means avoiding the associated financial penalties and enforcement actions. ESG activities may also be eligible for government support and subsidies.

What’s more, these benefits compound over time – ‘quality’ companies have higher multiples, which then attract more investor attention, leading to sustainably higher multiples.

More than governance

In analysing ESG factors, investment professionals add an extra layer of risk analysis that helps identify potentially material exposures and hazards to the future health of the company. And that doesn’t just cover the governance element of ESG. While the ‘G’ has previously garnered the most attention, the ‘E’ and the ‘S‘ are now wielding similar power. According to McKinsey’s research, a shift in mindset over the past decade has seen the perceived long-term value of environmental and social programs rival - or even exceed - the value attributed to governance programs. The biggest change is in the perceived value of social programs with 93% saying they make a positive long-term contribution to financial performance, versus 77% in 2009.

Wide-ranging impacts

In the private equity space, the impact of ESG analysis is becoming more broad-based, with professionals increasingly recognising its importance at every stage of the investment life cycle. In a recent study of leading private equity firms by sustainability consultancy ERM, 93% agreed that focusing on ESG opportunities would generate good investment opportunities. Half of all respondents found having a strong ESG rating was a differentiator in winning deals while 70% expected ESG criteria to be a staple in sell-side due diligence within 3-5 years. Respondents also noted that effective ESG frameworks maximised value during ownership and robust ESG disclosures on selling made a positive contribution to exit multiples.

The measurement challenge

Fulfilling the obligations of this increased focus on ESG still brings many challenges for M&A professionals. ESG is broad in its scope - from diversity and employment practices to privacy and data security policies – and there is still no widely accepted benchmark for comparing company credentials. According to market research company IHS Markit, however, there are some core ESG metrics that private equity professionals consistently evaluate including:

• ESG policy: a formal ESG policy is an important starting point.
• Assignment of ESG responsibility: adequate distribution of responsibility can indicate the level of ESG integration across the organisation.
• Corporate code of ethics: having a formal code of ethics indicates that a company has the necessary structure and procedures in place to guide management and employees.
• Litigation procedures: any litigation activity, specifically those related to environmental, social and ethical issues, will typically need to be disclosed.
• Diversity policy: diversity across the workforce promotes a wider range of perspectives in decision-making and management processes.
• Environmental policy: having a specific environmental policy gives insights into a management team’s ability to monitor and address the environmental costs of its assets, products, and services.
• CO2 footprint estimate: the ability to estimate the organisation’s direct and indirect emissions indicates management’s efforts to formalise their environmental policy through quantifiable metrics.
• Data and cybersecurity incidents: management needs to demonstrate a track record of transparency in reporting all incidents and their potential legal impacts.
• Health and safety events: measuring incident rates indicates how successful a company is in providing a safe working environment for employees, contractors, and the wider value chain.

Gathering this data to evaluate investment opportunities can be an arduous task. Dealsuite allows professionals to view this data in a more standardised, electronic framework. With the ability to select the metrics that are the most relevant to each deal and each stage of that deal, benchmarking performance becomes much more straightforward.

Market thinking in the ESG arena is evolving quickly and so is the technology to support it. M&A professionals who can leverage the latest ESG tools to build an effective ESG lens into their investment approach look set to retain the competitive edge.