ESG set to remain key factor in multinational investment strategies

Across all sectors of society, we are seeing sustainability become a necessity, rather than something nice to have. This is mirrored within M&A, where ESG (environmental, social and governance) factors play a major role in the success or failure of major deals.

Driving this is pressure from shareholders and funders, consumer sentiment and changes in legislation, but with strong ESG performance ultimately correlating with value, the road ahead points towards ESG remaining a key thematic focus for multinationals in their investment strategies.

According to Matthew Cole, partner and co-head of ESG with DLA Piper, buyers have always taken general and industry-specific ESG factors into account when appraising a target business – long before they would have even been labelled as such.

“For instance, when looking at a manufacturing target, a buyer would always carry out extensive environmental due diligence and seek financial protections in the transaction documents,” Cole says. “A buyer in any sector would also usually look at employment patterns as high turnover of staff might indicate a poor corporate or governance culture.”

This has evolved, however, to a point where buyers are taking a more holistic approach to ESG due diligence and drawing all of these strands together. Andreas McConnell, senior partner at Philip Lee, says a number of factors have converged to place ESG at the locus of smart investment strategy.

“We initially saw ESG in public tenders and requests for proposals from international corporate clients and we also saw it increasing in importance in marketing, staff retention and recruitment,” he explains. “The change of gear, however, has occurred further upstream where private equity and large corporations tracking changes in market perception, post-pandemic employee expectations, regulatory frameworks, consumer sentiment and other factors have changed strategy to make ESG more central.”

Jack O’Keeffe, director with Focus Capital, says external factors will continue to guide this evolution. He says companies in “out of favour” sectors, such as fossil fuel-related sectors, will find it more difficult to get additional funding or indeed, will have their funding arrangements more closely scrutinised by existing funders, particularly traditional banking lines of credit.

O’Keeffe notes these factors have led to a “re-rating” of those businesses who up to now have not embraced these ESG factors fully.

“We have also had multiple conversations with private equity funds with specific mandates focused on ESG themes such as decarbonisation and renewable energy. The business rationale for this goes beyond checking a box. ESG can be seen as an investment in resilience, sustainability and future proofing a business.”

Cole agrees: “As corporates develop their own ESG strategy and culture they need to be very conscious of whether a target’s ESG credentials will be consistent with that and whether it might enhance it or detract from it.”

Integrated product

As a result, ESG diligence has become an integral part of the M&A due-diligence process. Cole explains that DLA Piper has partnered with ESG risk-management platform Datamaran to offer one of the world’s first integrated ESG due-diligence products that sits alongside and complements the more traditional due-diligence process. “At DLA Piper we saw that there was a demand for a product like this, but even we have been surprised by the level of take-up from clients,” he says.

Legislation has been proposed by the European Union to provide for mandatory supply chain due diligence, says McConnell. “France and Germany have already moved on legislation targeting human rights and environmental risks in the supply chain. The regulatory framework is set to continue to steadily develop in this area and as this develops so too will compliance obligations and enforcement risks.”

With the increase of funding into ESG-focused funds, it can be expected that companies will increasingly be forced by shareholders to get ahead of ESG trends as they continue to develop, while buyers are looking to rapidly enhance their ESG credentials via acquisition. Green policies coupled with aggressive renewable energy and decarbonisation targets place added pressure on both sellers and buyers.

Additional investment

As ESG begins to affect M&A decision-making and deal terms globally, O’Keeffe admits that in the Irish context he “wouldn’t over-emphasise the impact yet” but he notes that Focus Capital worked on a number of deals in the renewables space last year.

“It will become increasingly important and that will happen quickly driven by international corporate and PE buyers and domestic listed companies.”

And although the impact of this shift in priorities has been largely positive, one negative is the additional investment that will be needed over time to enable companies to improve or maintain their ESG status – O’Keeffe says this will be “significant”.

McConnell points out that Reuters are reporting that ESG funds now account for 10 per cent of worldwide fund assets: “The scale is enormous.”

He highlights the "notable" rise of shareholder activism of ESG investor funds. "In 2020, examples of this activism included the replacement of three directors at Exxon Mobil, the rejection of a $230 million pay package for General Electric Co's chief executive, and a successful call for Union Pacific to make public its workforce diversity statistics," he says.

Of course, it all comes down to the bottom line. A strong ESG performance ultimately creates value, Cole says. “If there are synergies there that actually improve a buyer’s ESG credentials then that has a value – a savvy seller will want to realise that value on a sale and may well find that they have more suitors when it comes to a sale process.”