Considerations and challenges in evaluating ESG factors in the M&A context
July 2021 | SPECIAL REPORT: MERGERS & ACQUISITIONS
Financier Worldwide Magazine
July 2021 Issue
Environmental, social and governance (ESG) matters have been the subject of increasing attention over the last decade. But only recently have people begun to focus on how ESG considerations fit into existing frameworks for M&A analysis and corporate investment decisions, and how they interact with broader concepts of growing importance among stakeholders, such as the overall movement toward a sustainable economy. This article discusses a few key considerations of implementing ESG goals in the context of a business combination or acquisition.
What does ESG mean?
ESG is fundamentally a theory of investment focused on evaluating a broader range of risk than typical business economics like revenue, compliance costs and similar metrics. Thus, ESG at the corporate level is about the corporate actions that positively affect an investor’s analysis of the business using the investor’s ESG investment criteria.
But what does ESG, the acronym, really mean? At its simplest, ESG factors fall into three groups. First, environmental factors focus on the direct and, in some cases, indirect impact of a business on the natural environment. Second, social factors consider how a business interacts with suppliers, contractors, employees and communities. And third, governance factors centre on the way a business is managed and operated, including with respect to executive compensation, shareholder rights, and how the target holds itself accountable, such as through audits and internal controls. Tax structure is also of increasing importance in this analysis.
Environmental sustainability and corporate governance policies have been deployed internationally for many years. Some businesses have also developed sophisticated social sustainability programmes, which is more common in certain industries than in others. Recently, it has become more common for some businesses to broaden the number of factors that they consider in increasingly comprehensive sustainability strategies – for example by adding to their supplier selection criteria environmental and labour practice considerations, in addition to more traditional topics such as regulatory compliance.
How should ESG be evaluated in the M&A context?
Evaluating ESG in the M&A context is not as simple as comparing standardised ratings or reviewing compliance documentation. Unfortunately, there is not yet a universal consensus on exactly what ESG is, how it should be incorporated into a business’s operations, or even what the relevant policies should be called in the first place. In addition, many businesses have opted to implement standalone policies addressing selected aspects of ESG, rather than implementing an overarching ESG policy.
For example, a company may have an ethical supply policy, an equity, diversity and inclusion policy, and an environmental sustainability policy, each of which may overlap to some extent with ESG considerations. This inconsistency creates a number of challenges in the corporate investment and acquisition contexts, as due diligence review of any target’s ESG-related policies requires a deep analysis not only of whether the target acts in compliance with its ESG policies, but also of the substance of the ESG policies themselves.
However, there is hope. A number of private organisations have emerged to assist in gathering ESG-related information about companies for use by investors and corporate development groups. In addition, several non-governmental organisations have created voluntary standards, and some governmental securities regulatory organisations have created disclosure criteria. There are a variety of reasons for creating these standards and criteria, but all hold the promise of creating comparable data for efficient evaluation of targets.
Nonetheless, a uniform standard has not emerged. Instead, a complex web of standards and guidelines are often applied in different ways to different entities. For example, a US textile company may choose between a number of voluntary labour standards and may also be required to comply with state and federal-level requirements in addition to requirements imposed on it by its major customers. If the company is publicly-traded, it may also be subject to securities disclosure and other requirements.
Valuation
As ESG has increasingly factored into investor or acquirer evaluation of potential targets, so too have valuation difficulties. For an energy company looking to purchase a wind project that generates the same megawatts at a fraction of the cost of a coal plant, the financial advantages are clearly defined and measurable. Evaluating the longer-term cost of that wind farm versus the coal plant makes the valuation analysis considerably murkier.
This process becomes even less clear when ESG-related criteria are used to evaluate more than the financial aspects of an investment, for example for purposes of making an impact investment or acquisition to access specific stakeholder groups. Thus, the value of one company could be dramatically different to different acquirers or investors, depending on how much faith the potential acquirer or investor has in the ability of ESG-related investment criteria to reveal financial risk, or how much reputational or other intangible value they see in a potential target’s ESG-related rating, policies or communication strategies, or indeed how the potential target may help the acquirer’s or investor’s ESG-related reputation.
In fact, the values assigned to B Corporation certifications and other such evidence of ESG bona fides have been steadily increasing. This has led to some concern that these factors are or will soon become overvalued, and that the market may see this ‘green boom’ end in a bust. Another perspective considers that ESG factors have been historically undervalued, and that the recent increase in valuations in this area represents an overdue adjustment to the way in which the overall value of a target is determined.
Given the increasing public attention to ESG factors and the emerging structure of requirements and guidelines surrounding the relationship between a company and ESG considerations, it seems impossible to predict how ESG considerations will be managed five or 10 years from now.
What is an M&A lawyer to do?
Given the variability discussed above, it is not surprising that many attorneys are still uncertain about how to think about ESG in the M&A context. Attorneys should consider taking the following steps.
Know your client. Does it have any policies that address ESG factors? Is this transaction intended to further any of those policies? Is the other party’s compliance with voluntary standards important to your client? Conversely, will they hamper your client’s ability to operate?
Understand the other party. Has it made public statements about compliance with any voluntary standards? If it is publicly traded, is it up to speed on ESG-related disclosure requirements?
Think about what happens next. How will the target company be incorporated into the acquirer’s operations and legal structure? Does it operate in jurisdictions that are new to the acquirer? Do those jurisdictions impose ESG-related compliance requirements?
Keep learning. New ESG-related regulations, goals and standards are announced frequently, and investors concerned about ESG-related risks continue to create change. For example, in May 2021, shareholders of Exxon Mobil Corp agreed with an activist investor that raised concerns about the corporation’s impact on global warming and replaced at least two board members as a result.
Elizabeth C. Crouse and Elisabeth Yandell McNeil are partners at K&L Gates LLP. Ms Crouse can be contacted on +1 (206) 370 6793 or by email: elizabeth.crouse@klgates.com. Ms McNeil can be contacted on +1 (206) 370 7824 or by email: elisabeth.mcneil@klgates.com.
© Financier Worldwide
BY
Elizabeth C. Crouse and Elisabeth Yandell McNeil
K&L Gates LLP
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