ESG’s Role in Deal-Making
The article below is from our BRIEFINGS newsletter of 28 January 2021
Companies evaluating mergers and acquisitions are increasingly looking at how the transaction may impact their environmental, social, and governance (ESG) strategy, according to Goldman Sachs’ Avinash Mehrotra, global head of the Activism and Shareholder Advisory and Takeover Defense practices. We sat down with Avi to discuss how ESG considerations are starting to influence deal-making.
Avi, can you describe the role of ESG in companies’ M&A strategies?
Avinash Mehrotra: Strategic fit and financial profile remain the most important factors driving a company’s M&A strategy. The ESG rationale can be thought of as one—albeit increasingly important—component of assessing strategic fit. In some transactions, improving a company’s ESG profile may be the primary driver behind the strategic rationale for the transaction. In other deals, the ESG rationale may play a more minor role—if the ESG impact from the deal is neutral, for example. In the current environment, as companies evaluate a potential deal, they are more likely to consider the transaction’s effect on their carbon footprint, supply chains, and social impact, and to incorporate assumptions about those factors into their valuations. Where a company is evaluating a target with a different ESG profile than its own, positive differences in ESG footprints and disclosure practices may be a source of synergies. In other situations, drastic differences in buyer and target ESG profiles can even scuttle deals.
How is ESG entering the deal process? Are companies screening for ESG considerations when they’re looking at potential acquisitions?
Avinash Mehrotra: ESG considerations are becoming an important part of identifying M&A targets and performing due diligence on them. Understanding differences in buyer and seller ESG profiles often cuts to the heart of the social and cultural norms of the organizations and those norms have always been essential to successful M&A. When companies acquire targets with a meaningfully different ESG profile, it can create cultural tensions between the employee bases and broader stakeholder communities. It is critical then that integration strategies contemplate what the pro forma ESG profile of the combined business will be and the effect that profile is likely to have on the target’s stakeholders. At a minimum, companies want to make sure they’re philosophically aligned. We’re working more frequently with companies to also explain the ESG benefits of an acquisition upon announcement. These kinds of disclosures are still in their early stages, but companies understand the potential benefits of announcing an acquisition that is ESG accretive. Conversely, if merger partners don’t address ESG benefits or the strategy for mitigating potential ESG risks, that can raise investor concerns. The mere fact that ESG is now considered a risk factor, alongside reputational risk and cyber risk, speaks to its growing prominence in deal-making.
But to gain an accurate picture of ESG-related risks and opportunities, acquiring companies need to have good data. So is the lack of standardization around ESG reporting a problem?
Avinash Mehrotra: The lack of standardization is a less significant issue in an M&A context because, unlike a retail or institutional investor which may rely on ESG scores, a merger partner is usually going to be involved in a deeper level of diligence to understand the target’s disclosures and practices. On balance, having a more reliable and standardized system of disclosure will certainly facilitate public diligence, but is unlikely to be sufficient for most deals to reach announcement. One important way ESG disclosures influence M&A may be through their impact on relative valuations of those companies with ESG-friendly profiles and best-in-class disclosures from those without. We’re already seeing that the cost of capital or financing for companies with better ESG scores can be lower than the cost of capital for companies with poorer ESG scores. For instance, there is higher investor demand and better pricing for issuers for many green, social, or sustainable bonds versus traditional (non-ESG) issuances.
ESG has certainly been a key focus for investors. How is that impacting corporate strategy?
Avinash Mehrotra: The growth of the assets under management in ESG-focused funds is important because if the investor base—particularly the next younger generation of investors—cares about these issues, that will set the tone for how these funds push forward the ESG agenda. And since those funds are meaningful shareholders in many large companies, that will in turn influence corporate behavior. Companies have noticed that ESG-oriented capital is now the fastest growing segment of the asset management industry and that global, non-ESG fund flows have been contracting. While ESG investing may have initially gained momentum among European pension funds, it is now a fully globalized phenomenon and US-based funds—both active and passive—are rapidly catching up. Additionally, shareholder activists have identified ESG improvements on their growing list of demands when targeting companies. In response, companies are shifting their disclosures, behavior, and culture toward more ESG-friendly practices, and we, along with our colleagues across many parts of Goldman Sachs, are advising our clients on that journey.