Top 5 Keys to Addressing ESG in M&A
Gordon Pennoyer | DrivePath (drivepathadvisors.com)
2021 marked a record year for M&A with more than $5 trillion in global deal volume — a trend experts predict to continue through 2022. As M&A activity increases, so does the importance of ESG in evaluating the merits of a proposed transaction. To be successful in meeting stakeholder expectations, firms must remember the following five principles when promoting the value proposition of a transaction:
ESG May Not Win the Day, But It Can Lose It: When a transaction is announced, the initial analysis by the investment community will center on the projected financial performance of the combined entity. If a proposed transaction fails to demonstrate accretion to key financial metrics the deal is unlikely to be well received, regardless of a positive ESG impact.
Here's a real-world scenario to illustrate: If an oil and gas company acquires an asset to lower its methane emissions profile (let’s say by 95%) but the asset simultaneously increases the company’s pro forma debt by 95% and decreases its projected pro forma free cash flow by 95%, investors are unlikely to support the deal. However, considering the opposite — a transaction that offers positive financial benefit but raises the company’s emissions profile significantly — it is safe to assume that the added risk presented by such a change would cause investors to question the deal (and perhaps the capital strategy as a whole). Even with strong financial elements of a deal, negative ESG impacts could cause investors to view the transaction unfavorably.
1+1 Must Equal 4: Historically, a transaction was considered successful if investors believed that the union of two companies could create value beyond the simple math of combining operations. In other words, 1+1=3. Today, ESG has raised the bar.
No longer must a transaction simply be accretive to key financial metrics, it also must demonstrate enhanced ESG performance. Wise companies spell out a transaction’s ESG benefits as part of their deal marketing — highlighting an equation that clearly communicates value (1+1=4).
Progress is More Important Than Perfection: The pro forma outlook of a proposed transaction is one of the most important views a company can provide its stakeholders to promote a deal’s value proposition. Where possible, the same level of clarity provided to future financial performance should be applied to ESG.
This means not overpromising on ESG performance and recognizing the progress and path needed to deliver improved performance. Thoughtful deal communications should include current ESG impact (as represented by the transaction) and quantitative objectives divided into short-, medium-, and long-term time horizons to offer both a clear strategy and accountability for stakeholders.
The Cover Up is Always Worse Than the Crime: Transparency is critical when communicating performance and ESG is no exception. Attempting to hide or spin the negative ESG impact of a proposed deal presents significant reputational risk — harming a company’s credibility with stakeholders and potentially leading to unwanted attention from regulators.
At a time when information is accessible to all, the short-term pain of poor ESG disclosure pales in comparison to the consequences of omission or hiding information. If faced with poor performance, upfront transparency and communicating a plan for improvement and measurable goals for accountability are often well-received by stakeholders.
Here Comes the SEC: As the SEC recently released proposed rulemaking shows, matters of ESG are squarely in the sights of the SEC. This means firms should expect increased disclosure requirements around ESG performance, especially regarding climate. While the specifics of the new SEC climate requirements remain in flux, it’s safe to assume that there will be added scrutiny of the ESG impact of proposed transactions. Forward-looking companies will best serve their stakeholders by proactively and voluntarily disclosing the ESG impact of a proposed transaction.