Sustainable Corporate Growth: The Importance of ESG Considerations in Mergers and Acquisitions

Article by Solomon Mayers

In the modern commercial world, ESG factors are becoming increasingly pivotal from the perspective of both shareholders and stakeholders. However, they are often overlooked or downplayed in the context of mergers and acquisitions. After defining the key terminology, this article seeks to identify the important role played by ESG factors in the formative stages of the acquisition process to fully capture the risks and opportunities associated with this corporate growth strategy.

Defining key terms

Mergers and acquisitions

Mergers and acquisitions (M&A) refer to transactions between companies to consolidate their operations and assets under one corporate structure. Companies strategically conduct M&As to grow their business, acquire products and expertise, generate value for shareholders, and expand their position in the market to gain a competitive advantage. While the terminology of ‘mergers’ and ‘acquisitions’ are often used interchangeably, there are key differentiating factors; mergers occur where two firms – typically of a similar size and market strength – combine to form a new corporate entity, whereas acquisitions often have a more aggressive nature, with a larger company purchasing a smaller one and taking over its operations. M&As are complex and highly technical processes, creating substantial work for banking institutions, commercial law firms and external consultancy providers to advise on the deal.

ESG

ESG stands for environmental, social and governance and is a term used to ascertain whether a company’s external and internal business practices are responsible, according to applicable laws and recognised industry standards. ESG performance can be measured in light of their commitment to environmental protection through initiatives on climate change, carbon emissions or pollution, maintaining appropriate human rights and labour conditions throughout the supply chain, fostering positive relations with local communities and stakeholders, and strengthening internal governance by tackling corruption, political lobbying, and employee pay disparities. Companies face legal and market-based incentives to demonstrate a strong ESG performance. For instance, legislators are increasingly requiring companies to report on their performance regarding ESG to promote accountability and transparency, creating a strong public relations interest in implementing robust ESG practices. From a commercial perspective, stakeholders’ increased scrutiny of ESG performance alongside a rise of ‘responsible investors’ has seen significant flows of capital being divested and redirected towards more sustainable enterprises. Shareholders are increasingly basing investment decisions on broader standards than financial risk informed by ESG considerations. Indeed, recent financial data suggests approximately 89% of global investors consider ESG issues in their investment strategies, highlighting its growing commercial importance. Thus, companies are incentivised to leverage their commitment to ESG to attract investment, create value for their business and gain a competitive advantage in the market.

ESG and M&A: an integrated strategy

Despite their heightened profile amongst regulators, commercial actors and investors, ESG is often overlooked by parties executing M&A transactions. Although the materiality of ESG considerations is difficult to quantify, a recent survey conducted by Bain & Company suggested that only 11% of M&A executives extensively evaluate ESG performance in the deal-making process (although their importance is expected to increase significantly in the next few years). This is a critical oversight because business growth strategies must be informed by ESG insights to take a sufficiently broad view of the risks and opportunities associated with their proposed corporate acquisitions. Hence, this article explains how and why ESG must be integrated into the formative stages of the M&A process before concluding a definitive agreement.

Pre-deal stage

ESG can play a significant role in the pre-deal stage of an M&A, influencing both the strategic identification of target companies and their willingness to transact. Generally, an M&A is executed as part of a carefully formulated growth strategy that determines the company’s objectives for the deal and identifies ‘target’ companies that ostensibly align with these criteria. Typical growth strategies seek to determine how the target may improve the company’s value or performance and grant access to new business opportunities or markets. ESG performance can be used as a lens for discerning attractive targets in this respect. There is robust evidence to suggest that a company’s strong ESG performance commands a higher valuation, which can be attributed to various factors. Businesses that take a proactive approach to ESG are better positioned to capitalise on opportunities emerging from growing sustainability sectors and evade risks associated with market shifts, tighter regulations, reputational damage and supply chain disruptions. Thus, an M&A strategy informed by ESG considerations enables the acquirer to identify more viable acquisition targets that improve their own ESG standing and unlock value for both shareholders and stakeholders. This can be achieved through establishing a set of initial screening criteria and incorporating relevant ESG considerations into preliminary research on targets.

Due diligence

Once a target company has registered their interest in an M&A and agreed to an initial set of terms and conditions has been agreed for the M&A, parties conduct due diligence against the other’s business, investigating all financial, fiscal, legal and employment circumstances to verify claims made about their operations and identify potential risks of the venture. This is intended to ascertain whether the deal remains a commercially sensible move and whether ESG factors can impact this assessment. For instance, it is standard practice for the acquiring company to review the target’s compliance with applicable regulations, and litigation risks are frequently identified during this process. Growing trends in climate and human rights litigation demand heightened scrutiny be attached to the target’s risk of facing criminal or civil liability due to poor ESG practices. A company’s shortcomings in this respect may give reason for the acquirer to walk away from concluding the M&A deal to avoid the commercial risk of reputational damage or financial loss.

Aside from the purely legal risks of pursuing an M&A deal, ESG factors remain a material concern when scrutinising whether the target’s business activities meet stakeholders’ expectations, especially where the target makes public claims about their positive ESG performance. Due diligence should evaluate the target’s commitments to ESG factors such as carbon neutrality, reducing greenhouse gas emissions, or outlawing modern slavery or child labour practices from the supply chain against their actual performance on these matters to identify whether the acquisition carries the risk of endorsing ‘greenwashing’ or ‘bluewashing’ tactics; this is where a company overstates their commitment to responsible environmental or social practices to downplay the adverse impacts of their activities. Where the due diligence process surfaces tangible ESG concerns, this may affect the operational, financial or reputational risks associated with purchasing the target, which has a knock-on impact on the acquirer’s own business value, investment prospects, reputation and stakeholder relations. Therefore, it is imperative to widen the scope of scrutiny provided during the due diligence process to encompass important ESG factors to ascertain a more comprehensive understanding of the risks involved with the M&A transaction; this should be instructive to the acquirer when making decisions on the commercial viability of the deal.

Conclusion

In a global landscape characterised by emerging contemporary challenges, the influence of ESG factors on commercial actors seeking to maintain a competitive position in their sector is only going to increase. Integrating ESG considerations into the M&A process is a strategic necessity and fundamental to sustainable corporate growth. By incorporating ESG factors at every stage – from pre-deal targeting to due diligence – companies can better identify risks, capitalise on emerging opportunities and enhance their overall valuation. This approach not only mitigates potential legal and reputational risks but also aligns the business with the growing expectations of investors and stakeholders who prioritise sustainable and ethical practices.