ESG Factors are Carrying Increasing Importance in Mergers and Acquisitions Dealmaking

ESG Factors are Carrying Increasing Importance in Mergers and Acquisitions Dealmaking
Mergers and Acquisitions

03 of 11

This insight is part 03 of 11 in this Collection.

September 15, 2023 16 mins

ESG Factors are Carrying Increasing Importance in Mergers and Acquisitions Dealmaking

ESG factors are gaining significance in M&A transactions, supporting dealmakers in the due diligence process — and for some, they are the ultimate success or failure of a deal.

Key Takeaways
  1. ESG considerations are increasingly being utilized for evaluating companies’ sustainability, social responsibility, and corporate governance practices.
  2. Throughout the M&A journey, ESG is now considered a crucial component — from target selection and screening to post-merger integration.
  3. Corporate and private equity investors expect ESG scrutiny in deals to increase over the next three years.

Environmental, social, and governance (ESG) factors are gaining importance in merger and acquisition (M&A) activity globally, as dealmakers on both sides of the table have come to recognize the growing relevance of each component in the success or failure of a deal.

Why ESG Matters

From target selection and screening to post-merger integration, ESG considerations are driving investment decisions to help companies meet their own sustainability ambitions and capitalize on the opportunities of a net-zero economy. Buyers are increasingly scrutinizing whether the target company is acting in a socially responsible manner.

According to Aon’s M&A Risk in Review, 96 percent of corporate and private equity investors say they expect ESG scrutiny in deals to increase over the next three years, with 48 percent expecting it to increase significantly.

Whether the transaction is public or private, ESG issues increasingly require the same level of due diligence that is typical for other workstreams, including financial, legal and human capital. Dealmakers recognize that any acquisition also brings with it a series of ESG risks that can be highly material, hard to find, and subject to shifting goalposts.

“Regulators are demanding disclosures at much greater granularity, investors are demanding greater transparency, and employees also want to see commitments matched by actions,” says Luise O’Gorman, Aon’s Global Head of ESG Transaction Advisory Services.

Globally, overseas buyers are expanding requests for ESG-focused due diligence when purchasing companies, and governments around the world are stepping up reporting requirements. Specifically:

  • In India, three of four Chief Experience Officers said they were assessed on ESG performance before finalizing a deal.1
  • As part of its green transformation project, Germany is working to meet its environmental targets, accelerating the legal and social transition from corporates and individuals.
  • China is also making a push for ESG and is said to be planning to make ESG disclosures mandatory for firms listed on domestic markets.2

How ESG Components Impact M&A Dealmaking

Failure to disclose environmental and social issues, or realize there is a disconnect between ESG commitment and action, creates a post-transaction risk of litigation. Such risks may be intensified in public transactions given the rising number of ESG disclosure requirements in many markets.

There is no one-size-fits-all approach to ESG. It should be tailored to the particular sector of a company and its maturity. “For one target, this may be the carbon footprint and the credibility of net zero targets; for another, it may be the labor standards and human rights in the supply chain that may pose a more material risk,” says Laurence Hesleden, Aon’s Director of M&A and Transaction Solutions in Australia.

Each component of ESG may impact M&A deals in different ways:

  • Environmental

    Forecasting the consequences of climate change is still a developing science. Investors, however, must assess how the changing climate will impact a potential target. This includes physical risk, such as the increased frequency or impact of extreme weather, and transitional risks including policy, technology, market, and reputational risks.3 Also, long-term, open-ended investments, which can be relevant to real estate and infrastructure, can carry a more significant exposure.

    Aon’s M&A Risk in Review found that nearly one in four corporate and private equity investors say environmental litigation creates the most concern with respect to potential disputes in a deal — up from just two percent in early 2022.

    Investments in the transition to a low-carbon economy are becoming increasingly important, affecting companies’ costs and margins. This is especially true in certain industries, such as the energy and transportation sectors. In many cases, M&A can be used to acquire technologies or capabilities to help build and transform these environmental efforts. However, in the technology sector, carbon footprint reduction is not a core consideration as building a diverse organization may take more focus, which can bolster a brand’s reputation and lead to increased revenue.

  • Social

    Social risks include how a company affects its employees, suppliers, contractors, and consumers. It also includes the associated negative social impacts, which can occur through direct operations and value chains.

    Failing to address human rights, inclusion and diversity, fair pay, privacy of sensitive customer data, or investing in projects or sectors with severe health implications is risky, as these all fall under social risks. As the international legal framework around ESG issues continues to change, so does conducting human rights due diligence in the context of M&A.4

    This evolving legal framework includes the recently adopted Corporate Sustainability Due Diligence Directive within the European Union. The directive establishes a corporate due diligence duty, which includes core elements of identifying, ending, preventing, mitigating, and accounting for negative human rights and environmental impacts in the company’s own operations, subsidiaries, and value chains.5

  • Governance

    Governance involves the assessment of decision-making timing and quality, the integrity of the process, its structure, and the distribution of rights and responsibilities across different stakeholder groups — all in support of positive societal impact and risk mitigation. Two core governance components include:

    • Corporate governance: This relates to the way a company “governs” itself through policies, processes, and controls to achieve compliance and secure transparency.
    • Business integrity: This focuses on how a company avoids corruption and bribery, as well as openly engages with politically exposed individuals who may cause reputational risk to the brand.

Beyond each of the ESG component points that should be considered for a target company, supply chain risks also fall under each of the ESG components and must be considered as well. These are some of the key considerations:

  • Carbon footprint
  • Exposure to extreme weather events, which can lead to business interruptions
  • Human rights and labor standards
  • Business ethics and corruption

“The extent to which you can analyze these points in the context of a deal and deal timelines, however, can be challenging,” adds O’Gorman.

Steps for Buyers and Sellers to Successfully Navigate the ESG Process During M&A

To provide optimal valuation, buyers and sellers in M&A transactions are encouraged to consider these best practices:

  • Sellers
    • Prepare due diligence around ESG plans, including disclosure requirements.
    • Establish a task force to monitor how the firm is upholding ESG obligations and take necessary actions across all ESG elements to provide the best chance of optimal valuation.
    • Solidify the firm’s ESG ratings.
    • Have a compelling ESG story to share with prospective buyers.6
  • Buyers
    • Implement a due diligence process to fully understand the risks of the target company and use these insights to make informed decisions about deal terms.
    • Look for evidence of greenwashing — a continual concern — along with litigation and regulatory actions.
    • Use ESG as a test. If the company is not living up to its ESG commitments, what else is it missing?

For many years, ESG has been an underutilized tool in M&A transactions. However, ESG is here to stay. Recent trends have brought its growing importance to the forefront as a method for both mitigating risk and enhancing value.

Contact the Aon M&A team for more information on the impact of ESG in an M&A transaction.

General Disclaimer

This document is not intended to address any specific situation or to provide legal, regulatory, financial, or other advice. While care has been taken in the production of this document, Aon does not warrant, represent or guarantee the accuracy, adequacy, completeness or fitness for any purpose of the document or any part of it and can accept no liability for any loss incurred in any way by any person who may rely on it. Any recipient shall be responsible for the use to which it puts this document. This document has been compiled using information available to us up to its date of publication and is subject to any qualifications made in the document.

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