Understanding the Impact of Sustainable Finance: What Does ESG Mean for M&As?


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Thursday, February 10, 2022

ESG is an important factor for modern businesses, but how does it factor into M&As? Here are some of the things CFOs should look out for.

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Understanding the Impact of Sustainable Finance: What Does ESG Mean for M&As?

Environmental, social, and governance (ESG) factors are becoming more important for modern businesses, and this is increasing rapidly as time goes on. A FactSet study found that ESG issues were only mentioned five times in the earnings calls of S&P 500 companies in Q1 2018. By Q4 2020, this topic was mentioned 129 times.

While in the past this has been dismissed as a fad, ESG is very much here to stay. As more millennials enter the boardroom and gen Z enters the workforce, ESG issues are going to be viewed with increasingly greater importance.

“The direction of travel is clear: ESG issues are taking a more prominent place in the boardroom as a rule, including in the context of acquisitions.” - Paul Davies, partner and co-chair of the ESG Task Force at Latham & Watkins

When it comes to mergers and acquisitions (M&As), ESG issues are playing a surprisingly large factor. Many companies are allocating financial values to ESG metrics - such as greenhouse gas emissions or producing goods with positive environmental benefits - and using them to assess the worth of a business for an upcoming M&A. Here are just some of the ways ESG is influencing the world of M&As.

Renewable energy M&As

One of the most simple manifestations of sustainable finance is investing in renewable energy. The more money that enters this industry, the more energy can be generated from renewable sources and the less fossil fuels will be used. This is an increasingly important sector for private equity, with 94% of fund managers expecting to invest in energy over the next five years and 97% describing the outlook for renewable energy as positive.

This in turn means M&As focusing on ESG industries are becoming more common, both as a way of diversifying existing portfolios and improving the reach of existing renewables firms. A PwC report found that the number of M&A deals in Japan’s solar power industry had more than doubled from 2016 to 2020, rising from 21 to 44.

The same report looked at companies’ integrated reports and found that strategy and sustainability were inextricably linked for many businesses. For example, Panasonic listed ten ESG concerts and categorized each as an opportunity that enhanced its corporate value, a social responsibility that minimized risk to its corporate value, or both. Taking this into account is vital for an M&A strategy going forward.

M&A due diligence

ESG factors are not just a moral concern. When it comes to M&As, they also contribute heavily to the long-term performance of firms. For example, demand for renewable energy increased by 3% in 2020 despite demand for all other fuels declining, this trend is set to continue in 2021. Investment in a non-renewable energy sector could therefore have a large negative impact on the financial performance of a firm.

For this reason, ESG metrics are playing an increasingly important part in the due diligence stage of M&As. Global independent financial and strategic consulting firm Accuracy has been observing this trend for some time, and said:

“Identifying ESG risks now can prevent a business acquiring problems that will be costly to rectify in the future and can damage their brand significantly. In a constantly-changing regulatory environment, no business should assume that an emerging ESG risk today cannot become a substantial cost tomorrow.” - Robert-Jan Drenth, Senior Manager at Accuracy

This means companies must take into account the testimony of ESG experts when conducting due diligence if they are to avoid falling into the trap of failing to fully understand this complex area during an M&A.

ESG making firms more valuable

While so far we have focused on the risks of not accounting for ESG, there are also significant benefits that can be reaped through M&As that focus on sustainability. One is that companies that do well on ESG issues are likely to do better financially, with McKinsey’s Robin Nuttall pointing out that there are over 2,000 studies on the topic and 70% of them show a positive correlation between financial performance and ESG performance.

This means there is increasing interest in ESG during the disclosure stage of M&As, with companies becoming more aware of the benefits and risks of ESG issues. Climate-related financial disclosures increased more between 2019 and 2020 than in any previous year, and during an M&A this information will be crucial in order to properly assess the value of a company before going ahead with a deal.

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