Is sustainability really changing the M&A deal landscape?

It’s almost a truism to say that ESG issues are rising to the top of boardroom and investment committee agendas.

The combination of political and regulatory pressure is beginning to have a significant impact on the allocation of capital and that impact is only likely to grow.

The challenge defining ESG

Against that backdrop, it’s not surprising that ESG now increasingly dominates boardroom agendas.

But dig a little deeper behind the many company pronouncements and it is clear that we are still at the very early stages of this shift in boardroom thinking.

The difference is that now these issues are being viewed holistically, rather than in isolation, as was often the case in the past.

Indeed, ESG is a catch-all term covering the whole gamut of what it means for a company to operate in a truly sustainable way and in the broadest terms. And it calls for businesses to take a much deeper and wider approach to assessing assets and deciding where to allocate capital.

Increasingly, investments will be measured by looking at the whole range of interlinked sustainability measures. An investment in a solar energy project, for example, may tick all the boxes from an environmental perspective, but not if the target has questionable employment practices or operates in a jurisdiction where bribery and corruption are rife.

In the absence of a common approach to this kind of assessment, many investors are only just beginning to get to grips with this need to shift perspective and re-order investment priorities. 

PE and financial investors lead the way

Thanks to a a high volume of ESG-related regulation targeted at the financial services sector, PE funds and other financial investors are moving faster to address the sustainability agenda than many trade buyers.

Many funds are seeing the opportunity that lies in addressing ESG risk within their portfolio companies.

The impact they can have on addressing these long-term issues is significant even if the time horizon of their investment remains relatively short, typically between five and seven years.

Where M&A transactions are concerned, action on ESG matters is currently limited to two main areas of change:

• PE investors have stepped up their use of scientific modelling to assess climate impacts on assets they are considering buying. They may, for instance, be looking at the likely impact of 1˚ or 2˚ increase in temperatures when, say, assessing infrastructure or other assets, vulnerable to climate, in the knowledge that such impacts are now being felt in the near term.
• Under pressure from much tougher regulation, they are also focusing much more intently on supply chain due diligence. Here, they are broadening out their assessment of risk beyond traditional areas such as bribery and corruption to encompass wider ESG factors such as human rights and climate. The Covid-19 pandemic has only accelerated this trend, raising the awareness of economic and human vulnerability to unexpected, high-impact events.

We are not seeing the same level of activity in non-financial sectors, where the weight of regulation is, so far, much lighter. However, this is very likely to change in the near future, not least because the pressure on banks and other financial investors to justify their green investments is beginning to have a waterfall effect on the wider corporate sector. 

And we are not yet seeing ESG factors derail proposed private M&A deals, despite that being suggested by some commentators, although governance issues might on their own knock a transaction off course. By contrast, sustainability has become an issue in some public M&A deals and in equity capital market fundraisings.

Focus on ESG is here to stay

Where the transactions market is concerned, we are still in the early stages of seeing an ESG impact.

But increasingly, political pressure and regulatory change will bring buyers into the market who see an opportunity to create value by moving towards a more sustainable and holistic way of assessing assets and deploying capital. Change in law risk invariably stimulates transaction activity.

In that sense, ESG is sure to have an increasingly significant and long-term impact on M&A markets.