Highest standards equally important for investors
The definition of business success, traditionally measured purely in financial terms, has shifted. Management teams must now consider a broader range of risks, opportunities and the needs of all stakeholder groups, to build resilient and long-term sustainable businesses.
ESG is now a globally recognised abbreviation, however, there remains no set definition of ESG across the dealmaking landscape. Emerging regulation shows signs of convergence, but businesses are still grappling to understand how this impacts them, whilst also maximising the opportunities offered by best practice.
Across the global M&A sector, ESG considerations are being introduced into dealmaking at an increasingly early stage – whether that be investors looking to de-risk themselves when entering into a transaction, or those seeking an exit or investment who want to highlight ESG credentials. The challenge, however, is the different variables, priorities and methodologies required, against a background of evolving and sometimes overlapping regulatory regimes.
Driven by the requirements of their own investors (many of whom have public commitments around climate change and responsible investment), private equity is taking action on ESG, working hand in hand with advisory and due diligence to ensure compliance, identify risks, and exploit opportunities for value creation over the course of their investment.
And while the failures of environmental, social and governance often grab the headlines – stranded assets, PR disasters, greenwashing – it is the positive aspects that have pulled ESG into the financial mainstream.
"Embracing ESG factors – and being transparent about how you are doing so - is now business critical," said Kathy Hobbs, Associate Director for ESG at RSM UK. "It is essential that ESG is pulled into dealmaking at the preliminary stages covering topics such as workforce, supply chain and business resilience to climate change."
Kathy pointed out that those companies with a positive approach to ESG are seen as a step ahead of the competition, making themselves more attractive when it comes to investment and access to finance (better aligned with investors and funders), and better prepared for future regulatory impacts.
A positive ESG reputation can enhance market perception among consumers, who place an increasingly high value on environmental factors including emissions, renewable energy, and waste management. Recruitment is another winner; the global workforce - comprising an increasing proportion of ‘Millennial’ or ‘Gen Z’ workers - is seeking to align with employers who share their values, and place importance on factors such as staff training and development, diversity and inclusion, and workplace culture. In a tight labour market, it is therefore imperative businesses are proactive in these areas.
R is for Regulation
Regulation is a key driver of ESG developments (in particular, environmental action) and rightly focused on larger businesses. However, as it currently stands, regulation alone will not achieve a just transition to a low-carbon economy. Other drivers are more influential in the middle-market – for example the in-house expectations of investors and other key stakeholders – and go beyond the requirements of regulation in order to drive effective change.
"The so-called 'alphabet soup' of ESG standards and frameworks across different geographies and industries can be difficult to navigate," said Hobbs. "Organisations are seeking help from experienced advisors to navigate the constantly changing landscape, and provide an approach tailored to their needs."
"For a long time, the direct impact of financial due diligence findings on business valuation has been well-understood" added Steven Radcliffe, Director for Due Diligence at RSM UK. "However, the lack of a proven track record of collecting ESG data makes it much more difficult to quantify their impact in a deal context. In qualitative terms, though, investors have been seen to walk away from deals on the back of what are seen as ESG shortcomings."
And while convergence and standardisation of reporting and disclosure frameworks such as SFDR, SDR, TCFD and CSRD may be some way off, the direction of travel is crystal clear, with pressure to accelerate the journey building on the back of perceived best practice.
The benefits of embedding ESG into corporate decision-making and strategy far outweigh any costs, according to Radcliffe. "Whilst there can be an administrative burden surrounding the collection of non-financial data and additional reporting commitments, businesses should focus on the upside of embracing ESG.”
Which makes it more than just a collection of letters: adopting robust ESG practices can create a more attractive investment, an enhanced international reputation, a more motivated workforce, and a sharper competitive edge in the low-carbon era.
"Although regulatory requirements are yet to impact many businesses, other stakeholder pressures are forcing businesses to act on ESG, including in a transactional environment,” said Radcliffe. "Whether on the buy or sell-side, businesses should be prepared for the increasing inclusion of ESG as part of the dealmaking process.”