ESG Diligence: The key to sustainable M&A transactions

10 May 2024

By Alasdair Green, ESG Partner, AAB

In today’s dynamic investment landscape, the integration of Environmental, Social, and Governance (ESG) factors has become more than just a trend. It is emerging to be strategically imperative alongside other more traditional performance measures such as profitability and financial performance.  As a result, we are seeing an emergence of ‘ESG Diligence’ being conducted in M&A transactions.

This is a trend that is becoming increasingly evident in the world of private equity investment.  While financial returns remain a primary focus for investors and their funders, the lens has widened to include broader considerations of sustainability, ethics, and long-term value creation.  This is a competitive environment, so the ability to measure and report on the ESG impact and performance of portfolio companies has become a key priority to Private Equity organisations.

For the very same reasons, ESG diligence is emerging to be a crucial component of decision-making processes for Private Equity and other investors.

WHAT IS ESG DILIGENCE?

ESG diligence involves evaluating the environmental, social, and governance risks and opportunities associated with an investment or portfolio company. This goes beyond traditional financial analysis to assess how companies manage their impact on the planet, their relationships with stakeholders, and the quality of their corporate governance structures.

An important step further for Private Equity and other investors is an understanding of double-materiality.  In other words, a consideration of how environmental and social factors may affect a business, as well as how a business’s activities may impact the environment and society. Double materiality is important for a company to have a clear understanding of how ESG factors in the world affect the financial value of an investment or portfolio company.

WHY SHOULD ESG DILIGENCE BE A CONSIDERATION FOR PORTFOLIOS?

• Risk Mitigation-ESG factors can present significant risks to investments, ranging from regulatory non-compliance to reputational damage. By conducting thorough ESG due diligence, investors can identify and mitigate these risks early in the investment process, safeguarding both financial returns and reputation.
• Value Creation-Beyond risk management, an in-depth understanding of ESG strategy and diligence can also reveal opportunities for value creation. Subject to business activity or sector, ESG risk can be turned into opportunity when there is a clear understanding of how ESG factors may impact the financial value of a business.  And evidence suggests that companies excelling in environmental sustainability, social responsibility, and strong governance often outperform their peers over the long term. By identifying and investing in such companies, investors can enhance portfolio returns while contributing positively to society and the environment.
• Stakeholder Expectations-Investors, consumers, employees, and regulators are increasingly scrutinising companies’ ESG practices. PE firms and investors that neglect ESG considerations risk alienating stakeholders and facing a backlash that could erode value. By prioritising ESG diligence, firms demonstrate their commitment to responsible investing and align their interests with those of their stakeholders.
• Regulatory Compliance- Regulatory frameworks around the world are evolving to incorporate ESG considerations. From mandatory reporting requirements to stricter environmental standards, investors must stay abreast of these changes to ensure compliance and avoid legal and financial consequences.
• Long-Term Sustainability- Sustainable investing is not just about short-term gains, it is about creating enduring value for future generations. By integrating ESG diligence into their investment processes, investors can contribute to meeting net-zero targets, and building a more sustainable economy while securing their long-term viability.

WHAT DOES THE ESG DILIGENCE PROCESS LOOK LIKE?

A process to assess ESG in a transaction is similar to and can be carried out in conjunction with other diligence exercises such as financial, operational or commercial.  The detail of the scope will be subject to the sector-specific topics in addition to business size and regulatory conditions where it operates.

TYPICALLY, THE PROCESS WILL INCLUDE:

• Understanding sector-specific issues related to the business and analysis of the material topics
• Collection and evaluation of the business’s ESG data used for reporting
• Assessment of business data and KPI reporting risks and opportunities
• An ESG diligence report with recommendations

A clear understanding of ESG performance and diligence is no longer a nice-to-have for investors and in private equity, it is now a necessity, one that we expect to see growing in popularity in the coming years. With a clear evaluation of ESG factors, private equity and investors can mitigate risks,  create opportunities, meet stakeholder expectations, ensure regulatory compliance, and contribute to long-term sustainability.

At AAB Group, our ESG Services team includes experts in data collection and measurement, materiality, strategy and reporting, assurance, and diligence.  If you have any queries about ESG Diligence please do not hesitate to get in contact with Alasdair Green, ESG Partner.