How ESG is Changing Due Diligence for Transactions

Transaction due diligence is a complex process involving the verification, investigation, or auditing of a potential deal to confirm all relevant facts and financial information. It often spans financial, legal, tax, operational, intellectual property, commercial, IT, HR, environmental and regulatory considerations. But in addition to these traditional DD areas, ESG has quickly become an integral part of this process—replacing the historically straightforward ‘environmental’ component of a due diligence report, with a much more comprehensive assessment of not only the ‘E’ but also the social and governance factors that may impact the risks and opportunities of a deal.

But how is this best done? The ‘E’, ‘S’, and ‘G’ each represent a complicated universe of data points, issues and variables. With so many metrics to potentially investigate, how does a due diligence team prioritise their efforts?

One typical approach is to focus on materiality: what financially material ESG factors could have a significant impact – both positive and negative – on a company’s business model and value drivers, such as revenue growth, margins, required capital and risk? Once the list of material ESG factors is created, each can be investigated.

Another common approach is to start with an ESG due diligence questionnaire or checklist, usually built from a template that covers a wide array of topics that are then tailored for the sector. Questionnaires provided to the target in an acquisition (or the seller in a PE deal) may flag issues that the due diligence team can then further examine, maximising the use of resources on only the most important topics.

Both of these methods are very useful and can form the basis of an in-depth and relevant due diligence report, particularly when combined. But depending on the team performing the research, what they deem material, their starting point checklist and the timeframe for execution, these methods can yield a report that lacks insights that could change the course of the deal. The success of the research in both approaches is entirely dependent on getting the list right—be it the list of material factors, or the list of questions. Miss a material factor or pertinent question and you may have the wrong picture entirely, providing a report that is incomplete at best, and inaccurate at worst.

Below are our top 5 topics that we feel often get left out of an ESG DD report or are not investigated as thoroughly as they should be. Sometimes they are not deemed material or are ticked off as ‘investigated’ based on self-reported metrics. But we would argue these 5 are ones to look at in-depth for any large deal, particularly global M&A.

Systemic risk

The distinction between systematic and idiosyncratic (firm-specific) risk is very important in ESG due diligence and when analysing the impact of ESG characteristics on corporate valuation. An investor can typically diversify away firm-specific ESG risk. For example, a PE firm may accept that an acquired company has certain idiosyncratic risks and decide to balance those risks by acquiring another company that isn’t exposed to any of them. Systemic risk however is macroeconomic in nature and is much harder to diversify away from—it typically includes things like shocks in commodity prices, interest rates and inflation. When it comes to ESG, it includes things like ESG regulatory changes, climate risk, carbon pricing and supply chain risks. These factors must be taken into account in the ESG due diligence process, even if they affect an entire sector or peer group, because they may change the cost of capital and subsequently the rate of return to the investor or overall future value of the asset.

ESG impact on intangibles

How does ESG performance affect a company’s most valuable intangible assets such as reputation, brand value and consumer trust? Take a large FMCG company for example. Existing market research shows that 84% of customers buy it versus other brands because they trust the brand—they are confident the company will deliver high-quality products and behave responsibly. ESG due diligence uncovers however, that production facilities in Italy and the United States are potentially polluting local water supplies, ponds, and rivers. While the pollution may not be a public issue at the time of the transaction, it is likely to be in the near future with the increased scrutiny on the ‘E’ and environmental reporting. It may be difficult to quantify the impact of this risk on intangibles such as brand value, but flagging them in the DD analysis is crucial to providing a 360˚ view at the time of the transaction.

Climate change impact

For companies that report using the TCFD, climate change liabilities will likely be detailed in the TDFD report, which could theoretically be incorporated into an ESG due diligence analysis. But often these answers are not backed up by quality data or are too qualitative in their nature. Understanding the risks of climate change in a scenario analysis framework, using a trusted climate change modelling tool to understand the impacts of a, for example, 2.0˚C temperature rise on the supply chain and production facilities, will provide a more accurate assessment of climate risk. Furthermore, incorporating the potential costs of climate adaptation in this modelling will yield an even more accurate long-term understanding of risk.

Share/stakeholders’ view

The shareholders’ view of a transaction is a critical part of most big deals but often not included in ESG due diligence processes. When it comes to M&A, if the target, acquirer, or both are listed companies, shareholders will need to approve the deal in most instances. Often the boards of directors will agree a deal and publicly announce it without shareholder analysis or consultation. The companies’ boards then face not only a backlash on price and terms, but potentially a total rejection of the deal based on ESG considerations or lack of ESG synergy. This is an increasing phenomenon because companies looking to balance their ESG vulnerabilities by acquiring a company that sits on the opposite end of the risk spectrum is naturally not ESG-aligned. For example, an industrial company that would like to transition to new technologies that will help to reduce CO2 emissions or develop ‘cleaner’ processes, will likely look to acquire businesses in this area. But the green business it is targeting may not want to be acquired by what they see as a fundamentally ‘brown’ company.

Assessing shareholder ESG preferences using comparable ESG fund-level data is a good starting point for assessing whether the deal may not make it over the line due to ESG considerations. However critical to the success of this part of the DD analysis is understanding if the top shareholders hold the voting mandate. Often, they don’t.

Time horizon for realising value

If a multi-million-pound investment in solar-powered production facilities, financed by sustainability-linked bonds (linked to KPIs that may not be met due to global supply chain shortages) in an inflationary market seems like a potential red flag in the short term, with a long-term view, the benefits of energy security outweigh the potential increased cost of the capital in the short term. Understanding the time horizon for the venture/investment is necessary for accurately assessing ESG risk. This understanding needs to be threaded throughout the entire ESG DD assessment.

Conclusion

The topics above may not always be possible to include in an ESG DD report if timeframes and budgets are tight. And some of them will naturally be included in the materiality-checklist approach. An experienced ESG due diligence team will have a methodology for incorporating these added-input areas into a systematic research process uniquely developed for the deal at hand. Each transaction is different and ESG DD needs to reflect that, looking beyond materiality analyses and ESG questionnaires, to what can be used as clear and actionable intelligence for the client and the larger DD team. Perhaps the discount rate in the DCF analysis needs tweaking based on the potential climate change liabilities. Perhaps the projected revenue needs increasing based on emerging megatrends that were not previously taken into account. Perhaps interviews at a company’s manufacturing site uncovered Health & Safety issues that will have a clear impact on the valuation of the company. The key thing is that ESG due diligence findings are wholly relevant, concise and capable of being integrated into the larger DD process and valuation.

ESG is touching nearly all facets of life and business— it is a value-driver and a risk creator in a way that no other aspect of a business is. And while for now, it may be possible to execute ESG due diligence as one part of the due diligence process, in the future it will not only be a key part, but a lens through which all other due diligence areas must look.

Written by: Audra Walton

About CMi2i

CMi2i, the world’s leading forensic capital markets intelligence firm, specialises in the world’s most accurate Equity & Debtholder identification service and supports issuers and their advisors with their ESG investment, investor relations, M&A, AGMs/EGMs, corporate governance, shareholder activism and capital restructuring goals through its integrated approach. The company has supported more than 1000 corporate transactions and over 500 clients worldwide.