ESG – how important is it (really) to acquirers and investors in the mid-market ?

Over the last few years, the significance of ESG (Environmental, Social and Governance) considerations in business has increased exponentially. Investors, are ever more focussed on the challenges posed by global warming, social inequality and the evils of child labour, exploitation of the poor, anti-competitive practices and bribery and corruption.

Internationalisation and the increasing complexity and length of supply chains means that high levels of governance are required to ensure that boards do not inadvertently break the law or fall foul of public opinion. One only has to google “failures of governance” to find the opprobrium levelled at Uber and Volkswagen for their respective concealing of a data hack and emissions tampering.

Private equity firms are under growing pressure from their investors to deliver strong ESG credentials themselves, with a gradual erosion of the distinction between “impact” funds, focussed explicitly on businesses that have a positive social and environmental impact, and “normal” funds. The areas of “no go” for investment funds is broadening and PE is tracking society in its focus on “good” business which delivers societal improvement, be it in healthcare, carbon reduction, education or compliance. It is no accident that PE firms are actively seeking to increase the number of females investment executives and to balance their portfolio company boards with diverse appointments. In a competitive fund-raising environment, ESG credentials are as much a business imperative for funds as it is for their investee companies.

So how does this translate into M&A and private equity transactions in the mid-market ?

Well, it clearly drives opportunity for those companies whose purpose is aligned to societal improvement. ESG positive companies can expect, provided they are also growing and profitable, to attract investor and acquirer attention more than those which continue to pursue societally unfriendly activities. Indeed, oil and gas, tobacco, gambling have long been difficult sectors to find investment for, despite their profitability.

At the most basic level, warranties and indemnities relating to compliance with the law have been a feature of transactions for many years. Vendors are required to undertake that no-one within their organisation has breached any rule or regulation, anywhere that the business operates. Vendors often throw up their hands at this, claiming ignorance of what their employees in far flung geographies might be up to, but their only defence in practice is governance; systems, processes and reporting which creates an environment where wrongdoing comes to light and can be eliminated. In the world of indemnities and warranties it is what you should have known, as much as what you did know, that matters.

Now, it is common for private equity investors and large corporate trade buyers to undertake explicit ESG due diligence; a formal review of all aspects of the business operations as they relate to the environment, society and governance. This is usually framed as the basis for setting a future ESG agenda for the business, rather than as a stick to beat the vendors with, and yet a recent survey of private equity firms reveals that more than half of them had reduced the value of a deal in response to ESG due diligence findings.

At its heart, ESG reflects the quality of management within a business. Good management practices are likely to lead to stronger business performance over time and therefore acquirers and investors are going take comfort if the board of their target has already taken steps to consider their ESG footprint and to improve it. Strong ESG policies are seen as a value driver for current investors, helping them to address their own ESG imperatives as well as underpinning strong business fundamentals.

Market and societal trends such as the importance of inclusion and diversity, environmental impact and fair tax are unlikely to reverse and are, therefore, likely to be of even greater significance in a future private equity exit.  As an example, any company unable to point to ESG policies is increasingly likely to find the recruitment of Gen Z difficult and this is going to be an issue for any PE investor with a 5-year exit horizon.  Large corporate acquirers or the public markets will also uncover any ESG skeletons as part of future due diligence processes and these might ultimately derail a subsequent PE exit altogether.

No major corporate or private equity fund wants to find one of their companies splashed across social media for some actual or perceived misstep and they will certainly turn down an acquisition opportunity if they think it represents reputational risk, however remote.

Given the intensification of these trends, ESG cannot be ignored by businesses looking to transact at some future point and we would advise those businesses to undertake an internal review of their ESG profile as early as possible. This will ensure that any red flags are dealt with and that progress, however modest, can be demonstrated.

Simple steps to reduce carbon footprint, increase recycling, actively vet suppliers for their own ESG credentials, consider diversity and inclusion policies and address any supply chain risks with robust policies and reviews (backhanders are still common in many parts of the world!) are very much worth taking and ESG should be on every board agenda as part of a risk register as well as to facilitate recruitment of staff and customers.

In summary, ESG considerations are no longer a question of “green-washing”. They have become a fundamental tool in evaluating and checking business risk as well as a key driver of customer and staff acquisition. All boards, and particularly those contemplating raising investment or considering an exit, should develop and monitor an ESG strategy.


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