Ignore ESG at your peril when evaluating and calculating risk in M&A
|Published
By Andrew Bahlmann
The JSE recently issued a Sustainability Disclosure Guidance as a tool for listing issuers to enable them to voluntarily better navigate the global sustainability and Environment, Social and Governance (ESG) landscape. It has considerable applicability to mergers and acquisitions (M&A).
Some sectors and businesses are more impacted than others by this landscape, though our view is this mega trend of the future is one that all sectors and businesses cannot afford to ignore – including M&A.
We are always mindful of the emphasis foreign investors from different regions of the world place on the ESG categories, with European and US buyers being environmentally driven. Consequently, when we’re talking to a potential acquirer from these areas, we’re cognisant that environmental sustainability is going to be a high priority to them.
The Guidance tailors the global landscape of South Africa’s specific sustainability challenges with the objective of driving improved sustainability performance, accountability and business leadership. In the process, it improves the quality of ESG reporting to enable more informed investment decisions.
The consequence for M&A transacting is that any deal which does not integrate ESG in the due diligence process heightens the risk that the merger will ultimately fail. A company with a high ESG score merging with or acquiring a company that has a low score effectively risks losing its ESG ‘license to operate’ in the future, thereby crashing its market value.
When looking to do a deal, acquirers, therefore, need to ask themselves whether the target company can survive as it is in a future where sustainable behaviour is a societal norm. This answer should determine whether or not negotiations proceed. Our experience in M&A is that poor governance is the single biggest reason for a deal not proceeding, and for this reason, it features prominently in our assessment and packaging of a business when we take it to market.
Only if the answer is yes can the M&A add value to the acquiring company and its sustainability profile. This can only be established where ESG is thoroughly integrated in the M&A cycle from deal origination to strategy, due diligence, valuation, integration, and of course – long-term value creation. This, in turn, requires new skills and focus to quantify risks and opportunities and to address new challenges.
The challenges stem from a need to evaluate both tangible and intangible assets in a transparent and methodical manner. This prompts consideration of how to value intangibles so as to avoid double counting, as well as how to include in the business case social and governance issues.
In South Africa, the social element of ESG is best assessed through the target company’s BBBEE (Broad-based black economic empowerment) scorecard, so we scrutinise its BEE position to identify what may be viewed as a benefit to the acquirer.
It is best addressed through a bottom-up view of key ESG measures that consider the particular factors relevant to the target business and by setting a baseline for each factor. Factors include net-zero, waste, and greenhouse gas emissions not only of the company itself, but it is critical to embrace the entire value chain of third-party raw materials, factories, and logistics. Such indirect emissions can be challenging to estimate but typically represent more than two-thirds of a company’s network.
The JSE’s Guidelines also need to be complied with, and I offer some practical tips on these:
– In terms of environmental issues, net-zero has become the new norm, being the difference between the amount of CO2 produced and the amount removed from the atmosphere. It is reached when the amount a company adds is no more than the amount taken away.
Pressure is increasing exponentially on all operators to reduce their carbon footprint. It may not necessarily generate higher investment returns but will, in future, play a large role in preserving a company’s asset value as customers increasingly shy away from brands with sub-par environmental performance. Furthermore, as consumers and investors are drawn to brands that are more sustainable, these assets will become worth more.
– Disclosure metrics today include governance, strategy and the adoption of ‘green’ operations that meet certain environmental objectives and efficiencies in energy, water and waste services.
– Climate change, risk and cost management are likewise top-of-mind to investors. Increasingly common disruptive situations - whether the Covid pandemic, political unrest and extreme weather events - have put into clear perspective how ESG improves businesses’ continuity plans and resilience by highlighting risk and cost management issues.
– In the social context, ‘impact’ investments aim to generate mutual social and environmental benefits on top of the more usual financial returns. Employee wellness has grown in importance in the wake of Covid, heightening awareness around hygiene wherein employers, landlords and facilities managers have redoubled cleaning routines and public availability of disinfectants and hand sanitisers. Other benefits for employees could include natural light at workstations, healthy food options, mental wellness programmes and exercise opportunities for employees.
– Governance issues relate to a company’s management and owners’ values, ethics and high concept of ‘doing business for the common good’. Many companies have already adopted corporate social responsibility policies as being both impactful and illustrative of a corporate culture and set of shared values for both the company as well as its employees and the communities in which it operates.
If a target company is not actively addressing these points, the prospective new owner has two options.
The first is to consider withdrawing from the M&A transaction and identifying a new target, all the while evolving their use of ESG in their transactional process.
A second is to consider whether the target company could be transformed to match the acquiring company’s ESG values, thereby unleashing hidden potential and value enhancement. This would require transitioning it to clean from dirty and, in the process, score a reputational benefit. It would naturally depend on having the necessary resources and appetite to make such a turnaround possible.
In summary, ESG is transforming M&A by enforcing a longer-term perspective on investments. It is a balancing act of building trust with stakeholders and creating shareholder value at the same time. If any company wishes to remain successful and prosper, then it needs to embed ESG into its long-term growth strategies.
This is what the JSE no doubt felt compelled to address in its Guidelines, given that investors and other stakeholders are increasingly expecting companies to report with the same rigour as for financial reporting, but now to their sustainability impacts, risks and opportunities.
Andrew Bahlmann is the CEO: corporate and advisory, Deal Leaders International.
BUSINESS REPORT