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What does purposeful business mean for mergers and acquisitions?

Posted on 27 February 2023

Diageo's 110-page 2022 ESG report is an informative illustration of the importance of environmental and social governance (ESG) considerations in today's world of business. In the post-pandemic world of extreme weather events and political and civil unrest, these issues have never been more prominent, which is evident in the mergers and acquisitions (M&A) market. This should be of great significance to any business considering their future M&A prospects. In 2021, PwC's Private Equity Responsible Investment Survey concluded that 72% of respondents reported that they always screen target companies for ESG risks and opportunities at the pre-acquisition stage. It is therefore imperative that business leaders take ESG and their business' purpose strategy seriously.

Putting ESG considerations at the heart of your business planning could not only be beneficial in the context of M&A transactions, but has many other associated benefits. This article looks at the benefits of taking ESG seriously at the outset and how it can impact the value of a company.

Creating value and managing costs

ESG strategies can create opportunity which could attract short-term investors such as private equity funds looking to identify opportunity to realise value. For example, a company with better ESG credentials may be less likely to experience work-related incidents or environmental claims which could materially reduce its insurance premiums and legal costs.

It can also create substantial value in the long term. For example, since global consumer conglomerate 3M introduced its 'Pollution Prevention Pays' programme in 1975, it has stated that the programme has saved the company nearly $1.5 billion USD and eliminated more than 3.5 billion pounds of pollutants. Substantial cost savings have also been seen in the water utility industry where companies have reduced water waste significantly by improving preventative maintenance along their pipelines.

Raising capital

The rise in popularity of the ESG agenda has had an impact on raising capital. As credit ratings agencies such as S&P and Moody's have incorporated ESG and climate considerations into their credit analysis and ratings, aiding investment decision-making, we have witnessed a rise in sustainability-linked finance. The associated financial instruments, such as sustainability-linked loans, incentivise borrowers by tying pricing, such as interest rates, to meeting certain sustainability targets. Since its entry into the market in 2017, it has been reported that the sustainability-linked finance market has grown to over $1.6 trillion globally.  

In the context of M&A transactions, positive ESG credentials could therefore also result in cheaper financing options for prospective buyers. On the other hand, selling underperforming ESG companies may become increasingly difficult as funding options become more burdensome and costly.  

Mitigating legal risk and regulatory considerations

The legal risks associated with poor ESG management are far-reaching and potentially very costly and time consuming for a business. According to a Grantham Research Institute et al.'s policy paper, the number of climate-related legal cases has more than doubled since 2015 with the total number of cases in their database reaching 2,002 as at June 2022. Although these larger climate-related group lawsuits are more likely targeted at governments and global market leaders, this trend could trickle down to companies of all sizes. It is also important to bear in mind that ESG issues might not always respect corporate boundaries, with cases such as Okpabi v Royal Dutch Shell Plc suggesting that parent companies may owe a duty of care to those negatively impacted by the actions of a subsidiary.

In addition, regulators in the UK and globally are cracking down on ESG issues, with Germany's new Supply Chain Due Diligence Act imposing obligations on companies to adequately understand human rights issues along their supply chain. The UK's Competition and Markets Authority has also been investigating brands such as ASOS and Boohoo for greenwashing. Any potential buyer will want to ensure that a business has avoided legal action historically and has suitable processes in place to avoid it in the future.

These legal risks will be highlighted during a buyer's due diligence process and could materially impact a buyer's appetite for a particular business. It could also lead a potential buyer to demand other contractual protections such as extensive ESG warranties or specific indemnities.

Modern trends and reputation

The constant media interest in the activities of climate activists – and their targets – means it is increasingly difficult for decision makers in businesses to ignore ESG considerations. Grant Thornton demonstrated in an Event study that regulatory fines levelled at 24 UK-based PLCs in the financial industry equalled 0.045% of market cap on average when compared to the reputational losses of 5.49%. This is likely to be equally relevant to private companies as consumers increasingly pay closer attention to their ESG credentials and update their shopping habits accordingly.  

Investor and other stakeholder engagement

Investors are increasingly focusing on ESG metrics when considering where and how to invest their money and time. Other stakeholders, such as employees, customers and suppliers, are also putting pressure on companies to formulate and implement successful ESG strategies. Increased support and engagement from these stakeholders can lead to a positive change in the culture of a company and may drive value from an M&A perspective as buyers consider how the completion of a merger will impact their own ESG efforts.

For example, ensuring a company has creditable ESG measures in place can assist with attracting and retaining talent. EY recently reported that 74% of Gen Z, 72% of Millennials and 62% of Gen X are 'very likely' or 'likely' to leave their current employment for an organisation whose reason to exist has more meaning to them.

In practice we are witnessing a shift towards non-financial as well as traditional financial metrics being taken into account in business valuations. The findings of the 2022 Edelman Trust Barometer suggest that 88% of institutional investors subject ESG criteria to the same scrutiny as operational and financial considerations. Therefore, to maximise value, it is therefore important for businesses to utilise and harness this fact in the lead up to and throughout the M&A process.

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