The conversations around Environmental, Social, and Governance (ESG) strategies and policies have become increasingly present across the financial world. The pressures from societal, administrative, and investment circles is mounting, so incorporating ESG factors into business strategies is becoming less of a ‘nice-to-have’ and more of a necessity for businesses to succeed in a new purpose-driven world.

ESG is a macro issue, of which the effects can only become fully realised if we see movements being made on a global scale. However, with serious ESG considerations being relatively new to the business world, the framework, and mindset, to carry out such considerations is still being forged, and the large-scale effects that ESG could have on dealmaking are yet to be seen.

According to a survey conducted by RSM UK in October 2021 which included the views of over 400 senior executives from UK middle market businesses, ESG is certainly a growing consideration.

It found that over half (56%) of middle market businesses surveyed were familiar with the concept of ESG criteria to evaluate an organisation’s performance. Of those that were familiar with ESG, 74% said that they have a formal plan or strategy outlining their commitments to ESG initiatives. Furthermore, 84% said that their ESG policy will contribute to the future sustainability of their business.

The growing importance placed on ESG by business leaders would suggest that this is influencing dealmaking behaviour, but not so fast. According to a UK survey of top dealmakers from January 2022, only 9% said that ESG issues will be made a priority for boards in 2022. So, is it a case of, ‘if not now, then when?’

Charlie Jolly commented, “A business with a clear ESG strategy, the ability to monitor and communicate how that business interacts with the environment and society, and robust governance, is clearly a more attractive investment than the equivalent business that doesn’t have one. If you can clearly articulate your impact as a business and how you use it to improve your performance, you will attract more investor appetite and a higher valuation.”

All of our experts working across Europe, the US and Latin America voiced concern over the vast array of ESG frameworks and the lack of consistency.

Commenting from a US perspective, Bobby Rooney, shared, “ESG factors are still evolving in the US deal market. For many investors it has created too narrow a lens and led to a barrier to getting deals done. However, there is a proportion of the market where companies are beginning to realise that if they bolster their ESG credentials, it will help them to stand out to buyers who are interested in this. We are seeing more global investors embrace ESG as a key differentiator.

“One of the biggest challenges with respect to ESG is the vast array of frameworks and how companies determine which to follow and how to measure success so that they can communicate this to their current or prospective investors. For example, there are different frameworks coming from the US and others coming from Europe, but how will a multi-national company respond? We are seeing the larger corporations take a lead here, and many small to mid-sized companies are waiting patiently to take their cue.”

It is clear, increased standardisation is needed for investors to make sense of companies’ ESG performance and cut through the confusion created by the current proliferation of frameworks.

Marcel Vlaar commented, “In the Netherlands, we really need to develop so that from a due diligence perspective everybody understands the report and knows what to expect. When it comes to financial due diligence, there are standard processes, but ESG reporting is far more irregular.”

Oliver Smyth concluded, “At RSM in Norway, we are seeing more businesses who want to do the right thing and recognise the benefits, not only to the communities and people they employ but also to future business growth by enhancing their ESG credentials. However, many simply do not understand the reporting mechanisms or factors at play, and require specialist advice to start their ESG journeys.”

Will ESG factors drive deal-making behaviours?

This is not just a trend in Europe. Thomas Alvarado explained, “Latin American countries are beginning to realise that strong ESG credentials can be a real asset. We’re beginning to see sustainable bond issuances on the capital markets become more popular as the appetite for this type of paper increases, so there is definitely a growing awareness of the value these credentials bring to the table.

“For some intra-regional investors in Latin America, it may not be that critical yet; however, it's beginning to come to the forefront. Seasoned investors are beginning to consider the impact of ESG on value as part of their exit strategies, as future buyers are likely to care more and more about ESG.”

ESG and the changing shape of Private Equity (PE)

Oliver Smyth said, “When it comes to M&A, we often hear from the PE firms that they are starting to realise that if they buy a company today with poor ESG credentials, five years down the line they will face challenges in selling it to make a good return. That said, there are PE firms out there that are willing to roll up their sleeves and put in the work to turn a non-ESG focused business into one that has much stronger credentials.”

Charlie Jolly commented, “Private equity firms can be powerful agents of change in middle market businesses. The vast majority of PE investments give the PE firm control or significant influence of the company. Because PE firms generally invest capital from pension funds and other institutions, the governance and financial rigour that comes with that investment is significant. So, PE firms are very experienced in implementing change in their portfolio companies.

“They can bring ESG metrics and measurement frameworks to businesses that otherwise would have limited capability in this area. Some PE firms have become a catalyst for transformation and purpose-driven activities within a company’s overall growth strategy.

“For the PE firms, driving sustainable change is in their best interests. By putting robust ESG frameworks in place that drive measurable change in company activity, that change will be recognised and valued by the future buyer of the company. There are some PE firms that have consistently implemented successful ESG strategies and as a result, they have been able to raise dedicated impact funds.

Charlie Jolly continued, “Almost all PE firms have ESG policies and procedures, however their approaches to ESG vary widely across the industry. The industry faces a real challenge in standardising the measurement of ESG activities so investors in PE funds can assess the differences in approach and performance between firms.

“In response to the challenge, PE firms have been recruiting ESG and sustainability experts to their teams to ensure their policies are appropriate, monitored and successfully implemented. This expansion in the skills sets that PE firms have in-house is in keeping with a broader trend. 10 years ago, a PE firm would have an investment team and a finance team. Today, although investment teams still tend to be central, many are supported by dedicated investor relations, portfolio, ESG, talent, as well as IT and digital teams to help drive value creation in portfolio companies. Recent growth in the industry has initiated a hiring spree of late, and the Head of ESG or Head of Sustainability role is not as rare as it once was. We can expect this broader trend to persist through 2022.”

Although a thorough implementation of ESG considerations in dealmaking is yet to be seen on a global, standardised scale; dealmakers and private equity firms are starting to wake up to the benefits that they can provide. The importance of a robust ESG strategy is a realisation that is increasingly being ushered into boardrooms, despite many companies lacking the knowledge or framework to implement it. The first big steps are being taken, and as important as those steps are, only the future can tell us if they are big enough.

If you are curious for more insights, you can read RSM’s full M&A report here.