Assessing ESG Maturity in M&A
ESG IS HERE TO STAY
Investment strategies that focus on companies with high scores on the environmental and societal scale are becoming more prevalent. Investors recognize that these factors can have a significant impact on a company's long-term financial performance. And by considering a company's environmental and social impact, as well as its governance practices, investors gain a more holistic understanding of the company and its potential risks and opportunities.
What exactly are the factors what make up ESG (Environment, Social and Governance)?
- Environment - a company's carbon emissions, its use of renewable energy, and its compliance with environmental regulations.
- Social - a company’s labor practices, its treatment of customers and suppliers, and its commitment to diversity and inclusion.
- Governance - a company's executive compensation, its board composition, and its commitment to transparency and ethical behavior.
The potential financial risks associated with climate change like stranded assets coupled with the impact of climate-related regulations on a company’s bottom line are sparking investors interests. Consumer awareness is also increasing and driving demand for ESG investments as sustainability and social responsibility tap into personal interests and values.
Institutional investors looking to fuel big returns for large retirement funds are another key factor driving the increased focus on ESG investing. These investors align their investment strategies with ESG, and ultimately their values, to manage risks and find long-term opportunities.
As a result, more and more companies are publicly reporting and disclosing ESG data, and more financial products (such as mutual funds and exchange-traded funds) that incorporate ESG considerations are becoming available.
While large, more mature organizations may be well on their way toward effective measurement and monitoring of their own ESG practices, many, if not most, businesses in the middle market are just beginning to grapple with how ESG principles apply to their organization and how they can be meaningfully measured and, once identified, how gaps can be closed efficiently and effectively.
If an organization would like to make ESG assessment part of their standard operating process, they can start by ensuring they have a thorough understanding of their own current state. This can be achieved through a variety of methods, including:
- Self-assessments: Self-assessments can evaluate an organization’s performance in areas such as energy efficiency, employee engagement, and corporate governance.
- External assessments: External assessors, such as ESG ratings agencies or sustainability consultants, can be engaged by and organization to independently evaluate their ESG performance.
- Benchmarking: Organizations can compare their ESG performance to industry peers or best practices to identify areas for improvement.
ESG practices vary greatly within organizations and there isn’t an agreed upon set of standards for assessing the effectiveness of a business’s ESG practices. This leaves investors wondering how best to evaluate a potential investment on ESG issues; for example, how much ESG-related risk—financial or reputational—could come with a deal to buy the business.
UNDERSTANDING A TARGET ORGANIZATION’S ESG MATURITY
- In the context of mergers and acquisitions (M&A), acquirers can assess the maturity of a target company's ESG practices by asking some key questions:
- Is ESG even on the radar? Determine if the target business already has any policies or procedures related to ESG factors. Look for the existence of clear and comprehensive policies and procedures related to ESG issues, such as environmental protection, social responsibility, and corporate governance.
- Is it window dressing or a real commitment? Are there ESG-related goals? If there are existing ESG practices, is there evidence that the target is committed to improving their performance against those targets? These metrics might include monitoring greenhouse gas emissions, energy use, water consumption, or diversity and inclusion targets. One sure indicator of a commitment to ESG principles is the tying of executive compensation to ESG metrics performance.
- Is there transparency? Look for evidence of transparency in a company's reporting on ESG issues, such as the publication of regular sustainability reports or the availability of data on the company's website.
- Is there feedback (direct or indirect) from stakeholders. Is there evidence of complaints or negative comments from employees or customers about employment practices, environmental issues, business ethics, etc.? Speak with company management and employees to get a better understanding of the company's ESG practices, culture and reputation.
INCLUDE ESG IN INTEGRATION PLANNINGWhether an acquirer finds that a target’s ESG practices are well-developed or non-existent, begin with a list of actions and a realistic timeframe to improve ESG-related practices. If the target is at the beginning of its ESG journey, an acquirer should be clear about the commitment to the principles of ESG and work with leaders to develop relevant and realistic ESG goals. In a situation where the target has well-developed ESG practices, an acquirer might even consider adopting (or reverse integrating) the ESG practices of the acquired organization.
- Take action to ensure solid ESG practices post-acquisition and during integration continue, such as:
- Develop a plan to integrate the target company's ESG practices into the acquirer's overall sustainability strategy or adjust as necessary.
- Communicate the importance of ESG to all employees, including those of the target company.
- Provide training and resources to help employees understand and implement any new or revised ESG policies.
- Regularly review and monitor the target company's ESG performance and take appropriate actions to address any issues or non-compliance.
- Engage with stakeholders, including customers, suppliers, and investors, to gather feedback and input on the target company's ESG performance and the acquirer's plans for integration.
- Continuously improve the company's ESG performance through setting goals, tracking progress.
- Engage or hire a qualified expert to help build and maintain the organization’s ESG and sustainability efforts and reporting processes.
Assessing the ESG maturity of an organization is important for investors because it can provide insight into the organization's ability to manage risks and opportunities related to environmental, social, and governance issues, which, in turn, can affect the organization's financial performance and reputation. It also helps in identifying areas of improvement, which can be prioritized during the investment period. This can lead to improving the long-term sustainability and profitability of the investment. ESG assessment also helps an investor understand the organization's alignment with the investor's ESG priorities, which can be used to evaluate the overall fit of the investment for the investor's portfolio.
Interested in conducting an ESG assessment on a potential M&A asset? Drop us a line or give us a ring, 29Bison can help.