The impact of ESG-driven shareholders on M&A activity

Environmental, social and corporate governance issues have become a key consideration for acquirers, but they’ll find gauging the ESG performance of sellers problematic as long as they lack standardised metrics


Mature businessman leading meeting in office conference room

Environmental, social and corporate governance (ESG) issues have been growing in importance in the capital markets in recent years – and the Covid crisis has done little to dampen this trend. 

On the contrary, the events of the past 18 months have heightened demand among investors to fund enterprises that put ESG concerns front and centre. For instance, the Investment Association reported that UK savers had put £7.1bn into responsible investment funds in the nine months to September 2020 – up from £1.9bn during the equivalent period of 2019. 

ESG matters are also playing an increasingly prominent role in mergers and acquisitions. So says Andrew Probert, the London-based MD of sustainability accounting advisory services at global consultancy Duff & Phelps. 

“ESG considerations are absolutely critical in M&A,” he says. “There is a growing appreciation for how such factors can lead to the creation of enterprise value and also help to mitigate the potential destruction of value. If ESG isn’t already integral to a firm’s decision-making process, then it should be considered. It isn’t just an altruistic concern; it’s also increasingly financially significant.” 

The rise of shareholder activism 

Shareholders in publicly traded companies have long wielded their voting power when it comes to issues such as boardroom remuneration, but they are putting companies under increasing scrutiny regarding their ESG practices. 

Take ExxonMobil, for example. A loose coalition of institutional investors, led by a climate-activist hedge fund called Engine No 1, dealt the incumbent executive team a substantial blow at the 2021 AGM in May when it voted in three new directors in a bid to push the oil giant towards greener energy. It was one of several recent stunning victories scored by the environmental lobby over the fossil-fuel industry. 

Companies therefore have a delicate balance to strike: while they still need to deliver returns for shareholders, they also have to ensure that whatever they do to achieve these returns is consistent with the ESG agenda. Their leaders must increasingly demonstrate how ESG considerations influence their decision-making and how robust their firms’ business models are in the face of environmental risks such as climate change. Given that they are facing ever-evolving ESG requirements, this is no easy task. 

Demonstrating ESG credentials 

Getting the balance right will generally require a company to focus on the most material issues – areas of ESG concern that affect the business directly. In the case of a utility company, for instance, its greenhouse gas emissions would be a material issue. 

Yet materiality can vary greatly not only between industries but also between firms in the same industry. And it’s not uncommon for companies and their shareholders to disagree on the importance of certain matters. 

Probert notes that, “for some investors, an issue is material only if it has an impact on enterprise value creation. For others, an issue is material if it has an impact on society and/or the environment. When assessing an organisation’s ESG performance, you should consider metrics that are financially material, ‘decision-useful’ and cost-effective.”

Sam Barr is a senior manager at Bluebox Corporate Finance Group, which advises business owners on how to prepare their companies for sale. He believes that the cultural fit between a buyer and a seller is the critical component for success in any M&A transaction, but acknowledges that ESG considerations have started “playing a decisive role too”. 

He explains: “If potential acquirers conclude that the seller’s ESG strategy is deficient, they may determine that the business in question is exposed to a long-term risk.”

A lack of widely accepted ESG reporting standards means that assessing a seller’s performance in this area during the due-diligence process is not straightforward.

Stuart Faulkner, director and head of M&As at merchant bank Strand Hanson, says: “While ESG has rightly become important in both institutional and retail investment decisions, its impact on M&As is less obvious. This is partly because there is no clear standard for it and partly because, when bidders undertake due diligence for an acquisition, ESG is not typically set up as a separate workstream.”

Sellers often seek guidance on how to report on their ESG activities from various sources, which can come back with differing and, occasionally, conflicting recommendations. Not surprisingly, this can lead to variances in the quality of their disclosures. 

Nearly half (45%) of the valuation experts questioned in a recent survey by Duff & Phelps agreed that the lack of a standardised ESG reporting system is the biggest barrier to effective disclosures.

Barr observes that, in cases where a seller’s ESG disclosures are unsophisticated or lacking in any other respect, a prospective acquirer may “form a view based on its interactions with the seller and its respective teams. Clearly, this will be somewhat subjective.”

Probert recommends that buyers hire external experts in ESG during the due-diligence process. They should be better equipped to discover “potential risks and opportunities, which may not be abundantly obvious based upon the publicly available information” about the seller’s business.

Well before that happens, sellers need to have done their homework, stresses Barr, whose firm typically starts working with clients at least a year before they sell up. 

“Given the growing importance of ESG in mergers and acquisitions”, he says, “it is even more crucial that sellers prepare adequately in advance.”