The US administration may be challenging its principles, but ESG due diligence has evolved from a tick-box exercise focused on mitigating downside risk into a key lever for value creation that sits at the heart of deal processes. Nicholas Neveling reports.
Environmental, social and governance (ESG) due diligence used to be a ‘nice to have’ for dealmakers, but in recent years it has shifted from the periphery of M&A processes to centre stage, driven by multiple factors.
Investors are paying closer attention to the impact their capital is having on the environment and society. A survey commissioned by the Association of Investment Companies found that just under half (48%) of private investors consider ESG factors when investing.
This focus is mirrored among institutional investors, who have made ESG assessment a cornerstone of their asset allocation strategies. In a survey of limited partners conducted by Bain & Co and the Institutional Limited Partners Association, more than two-thirds of respondents said ESG considerations played a role in private equity investment policies.
Sustainability and climate regulation has also ramped up. In the EU, the Sustainable Finance Disclosure Regulation requires asset managers and other financial markets participants to supply mandatory ESG disclosures, while in the UK large businesses and charities are obligated to report annually on energy and carbon emissions under the Streamlined Energy and Carbon Reporting framework.
Voluntary ESG and sustainability frameworks, such as the Principles for Responsible Investment, Global Reporting Initiative and Sustainability Accounting Standards Board add further ESG reporting obligations, which have to be screened accordingly when dealmakers are running the rule over potential deal targets.
Solid financial returns remain the priority, but not at any cost, and dealmakers are having to do more due diligence on the ESG credentials of M&A deals and show investors, regulators and other stakeholders that they are deploying capital responsibly and sustainably.
“As businesses, investors and employees place greater emphasis on sustainability, governance and ethical practices; considerations that were once optional have now become business imperatives,” says Malcolm Donald, corporate and M&A partner at law firm Burges Salmon. “As these expectations shift and the M&A market’s attitude to ESG matures, bidders are continuing to pay closer attention to ESG compliance and wider practices that can clearly have an impact on deal appetite.”
Case study: ESG on track
When EY was called on to advise Network Rail on a programme of digital transformation, the project was always going to be about more than rolling out a new technology platform.
The digital transformation programme undertaken by Network Rail is illustrative of how an ESG lens can support improvements in other areas of operational performance.
At the heart of the project was the ambition to improve safety for frontline staff and embed sustainability into the business.
EY supported the rollout of a new digital safety tool that has helped to improve compliance with key railway safety performance benchmarks and supported an 18% drop in safety-critical errors and a 43% reduction in near-miss incidents.
Using technology to improve safety performance has boosted other parts of the organisation, including a material drop in errors on line-blockage applications, the reduction in paper usage by 34 million sheets a year, and improved data quality and access.
ESG as a lever
But while compliance and reporting have been key drivers for increased uptake of ESG due diligence, dealmakers now see it not only as a risk mitigation exercise, but also as a commercial lever that can drive value creation and improve financial performance.
“Initially, ESG due diligence was predominantly risk-driven. Increasingly we now see clients wanting to understand and evaluate the value creation opportunities associated with a deal and be provided with a greater level of granularity on the operational and capital expenditure requirements, and potential return on investment associated with key ESG due diligence findings,” says Gavin Hunter, associate director, ESG transactions and sustainable finance at Anthesis.
ESG is not to be viewed in isolation; it is core to the fundamentals of developing a robust business strategy
Indeed, data points to a growing recognition among dealmakers and company owners that ESG and investment returns are not mutually exclusive, but mutually reinforcing. An Investec private equity survey, for example, found that almost two-thirds of companies with backing from private equity investors believed that good ESG performance made a business more attractive to potential partners and acquirers. A study by Kroll, meanwhile, found that companies with better ESG ratings generally outperformed those with lower ratings between 2013 and 2021.
“We are not doing ESG to tick a box or to meet regulatory commitments. We genuinely want to understand what’s material to a business, where there is risk, but also where there is opportunity from a value creation perspective,” says Lucie Mills, partner, value creation and ESG, at private equity firm NorthEdge.
Fiona Place, ESG consultant to the Business Growth Fund (BGF), adds: “ESG due diligence is now baked into the M&A market. At the first level, it is an essential screen that identifies core risks, but increasingly there is an understanding that it is not something to be viewed in isolation. It is core to the fundamentals of developing a robust business strategy.”
ESG scope
As ESG due diligence has become an increasingly important workstream in deal processes and a key lens for understanding legal and compliance risk, as well as commercial upside, scoping deal due diligence has evolved into a more bespoke exercise. “There isn’t really a one-size-fits-all approach to ESG diligence. It is a much better exercise when it is specifically tailored to each deal,” says Emma Murphie, environmental consultant at Ramboll.
There isn’t a one-size-fits-all approach to ESG diligence. It is a much better exercise when specifically tailored to each deal
Dealmakers have evolved the ESG workstream beyond a wide-reaching exercise that ticks the main boxes, into a more curated process that also interrogates deal-specific risk and upside. Place says the BGF has built a proprietary tool that serves as a first ESG screen. The tool covers 200-plus questions across the full array of ESG aspects and topics, and also includes an exclusions list. After this first assessment with the tool, the firm will then commission third-party due diligence to do a deep dive into specific areas of focus for a particular deal.
NorthEdge’s approach combines a broad overview with a deep dive in specific areas. “There is a minimum that we do on all deals and then we add additional layers relative to the areas of risk,” NorthEdge’s Mills says.
Zara de Belder, UK lead for ESG transactions and sustainable finance at Anthesis, says there are standard areas of ESG that all dealmakers will review, but that there is growing demand to top up with specialist expertise in particular areas. “We’re seeing increased demand for expertise in thematic topics. That could be climate risk, decarbonisation, human rights or supply chain,” de Belder says. “This reflects a maturity in the consideration of ESG topics during investment analysis and decision-making. It also shows a greater awareness among dealmakers about the potential impact of specialist ESG topics on a target.”
For EY strategy and transactions partner Sunny Aurora, it is crucial for ESG due diligence to focus on what genuinely matters for a target company.
“For it to be meaningful and relevant, ESG due diligence has to focus on the areas that are material to each individual business,” Aurora says. “If you have a supply chain that stretches into emerging markets, then the focus should be on employee welfare and working conditions. If you are investing in a data centre, then power usage and carbon footprint will be the key areas of focus. Every deal is quite bespoke.”
Case study: good health
Specialist healthcare private equity firm ARCHIMED delivered a 4.2x multiple on invested capital and an internal rate of return of 23% when it sold Vita Health Group (VHG) to Spire Group.
ESG was a priority for ARCHIMED during its hold of VHG and progress made by the company in the areas of environmental sustainability, diversity, equity and inclusion (DEI) and carbon emissions was a key driver of value at exit.
VHG is now on a pathway to achieve net-zero emissions by 2050 and has aligned its DEI key performance indicators with NHS standards. Waste management and travel policies have also been drafted with sustainability outcomes in mind.
For ARCHIMED and VHG, good ESG performance dovetailed with an excellent return outcome.
Adviser dynamics
Advisers can play a key role in helping dealmakers to identify the most important ESG areas to focus on, particularly for firms that are still building in-house expertise. Other players will have more developed ESG capabilities, but will still call on third-party advisers to provide arms-length advice and analysis.
“Some clients are still at the beginning of their ESG journeys and are looking for outside expertise to develop their internal knowledge and build up internal policies. Other clients have very detailed ESG policies and investment strategies in place,” Ramboll’s Murphie says.
Mills says NorthEdge works closely with a specialist ESG firm on all its due diligence workstreams. “We have worked with them over time to build a due diligence process that works for us and our ESG approach.”
The more that ESG items can be priced and calculated, the easier it becomes to make comparisons between assets
As ESG due diligence continues to develop, findings and recommendations are becoming more precise, quantifiable and benchmarkable. “The more that ESG items can be priced and calculated, and the more standardised those calculations become, the easier it becomes to make comparisons between assets. This is where clients are directing advisers. They are aware of ESG, but want it translated into a number,” EY’s Aurora says.
Murphie adds: “We are increasingly being asked to quantify ESG risk and upside. Some items – like water or energy use – are easier to quantify, but it’s much more of a challenge for others, such as social issues. How do you put a price on the impact of diversity at board level? Quantifying ESG items is not always easy, but it seems to be where the industry is going.”
Deeper understanding
Adding more layers, rigour and data-backed insight to ESG due diligence unlocks deeper understanding of the ESG risks and value creation levers for financial sponsors. Making it measurable also lays a foundation for better ESG outcomes and accountability.
“When businesses set ESG targets, those targets have to be real rather than just aspirational, and processes have to be backed up with credible data. Understanding where more information is required, and how to produce it, will come into the ESG due diligence process,” the BGF’s Place says.
“You can’t manage what you don’t measure and increasingly good data is required to help you understand what really matters for a business from an ESG perspective to drive enhanced performance and productivity.”
ESG due diligence: optimising the process
ESG due diligence may be an established workstream in most M&A processes, but is still a relatively nascent discipline that many dealmakers are trying to get to grips with. Here are three tips for getting the most out of an ESG due diligence process
1 Don’t boil the ocean
ESG straddles all aspects of running a business, ranging from human resource and supply matters through to carbon emissions and an organisation’s governance structure. In a competitive deal process, where due diligence timelines are tight, it is unrealistic to cover all the bases. Experienced ESG investors will first run a wide-ranging screen across a business, but then select the key items that will be material for a company and drill into those areas in detail, matching up due diligence to the things that really matter.
2 Lean on advisers
Private equity and corporate dealmakers will focus on a select group of deals each year, while specialist advisers will be looking at hundreds. Dealmakers should lean on this collective experience when scoping out ESG due diligence. Advisers will have insight into recurring ESG themes for businesses in particular sectors and will be able to advise on whether ESG red flags that come up in due diligence can be fixed, and what making those fixes will cost.
3 Maturity matters
A young business that is about to take on third-party investment for the first time is less likely to have a full suite of ESG policies and reporting in place than a mature corporate. ESG due diligence for such a business should thus be scoped accordingly and be less about identifying obvious ESG gaps and more about outlining steps to fill those gaps.
