Much has been said about the mega-trends affecting businesses today and into the future. They run the gamut from global climate change to shifts in economic buying power and demographics. Such trends present an increasingly uncertain operating environment, resulting in rising natural resource prices, increasing weather-volatility risk, emerging market expansion and mass urbanization. To build more resilient organizations in this context, forward-thinking leaders are focusing on the environmental, social, and governance (ESG) aspects of their strategy more than ever before.
The deal market brings sustainability into sharp focus. It can present them in the form of a target that has built an ESG competitive edge that can be exploited or, conversely, one that lags its peers in ESG focus and so poses a risk to potential deal makers. And these factors can be difficult to measure. Indirect benefits and risks that derive from customer and employee relations, brand value and reputational standing must be evaluated along with the pure financial data. Deal professionals are taking note and are modifying their IPO, M&A and divestiture processes accordingly.
The Buy Side
While due diligence is often a fast-paced whirl, the stakes are such that ESG assessments can and should be built into diligence processes. At a minimum, buyers should look to unearth hidden ESG risks and liabilities throughout a target’s value chain. Examples might include a target that doesn’t properly dispose of toxic waste or employ appropriate health and safety standards, along with other not so obvious issues. Risks should be assessed and quantified so that deal makers can consider whether they can be mitigated or priced away.
Other buyers look to ESG strategies as a path toward value enhancement in a deal. They lead their peers in eco-efficiencies that convert into cost synergies at the target and drop directly to the bottom line. Still others look for new, sustainable products and strategies that could lead to top-line value enhancement as well as improved standing with a variety of stakeholders. Consider an exploration and production company that invests in a renewable energy target. As a result of the deal, the company may gain indirect benefits, such as enhanced relationships with institutional investors, regulators, non-governmental organizations (NGOs), customers and local communities where they do business – in addition to direct cash benefits such as tax incentives and reduced operational costs.
Buyers with robust ESG processes in their ongoing operations are best placed to also manage ESG risks well in the diligence context. ESG risk and opportunity assessments are built into the deal playbook, and ESG experts can be loaned into the deal team. And well-developed ESG risk quantification and valuation tools and methodologies can also be translated into the deal context.
The Sell Side
Whether in the context of an IPO or a sale to strategic or financial buyers, sellers are also paying more attention to ESG issues, in part because investors and potential buyers are asking more questions. As more and more company-specific ESG data is tracked and provided by companies like Bloomberg and Google, institutional investors in particular are paying attention. And as many an unprepared seller has discovered, when potential buyers unearth risk and uncertainty in diligence, pricing nearly always suffers. Undisclosed ESG risks and uncertainties are no different.
As with buyers, sellers with sophisticated ESG management processes already in place are best positioned for ESG scrutiny in an IPO offering or confidential information memorandum used to launch a sell-side auction. Ongoing ESG risk and opportunity quantification and valuation impact can be shared with potential buyers in a transparent fashion. At a minimum, sell-side diligence should address ESG risk and uncertainties in advance of potential buyer engagement and help the seller to consider whether or how to disclose the issues. Sellers that are less than transparent with potential ESG risk and uncertainty may find that pricing suffers in the end.
Valuing Environmental, Social, and Governance Issues
Well-disciplined finance and deal professionals typically use such fairly rigorous, value-based metrics as traditional discounted cash-flow (DCF) and return on investment (ROI) as well as scenario analyses to assess potential deals. But even these rigorous tools can ignore key, difficult-to-measure ESG value drivers. For example, how do you measure the ROI of increasing employee morale or decreasing data security risk? Other difficult-to-measure value components, such as customer loyalty, environmental footprint, or worker health and safety records are also often omitted from both DCF and ROI analyses. As a result, these elements must be handled on the side—qualitatively.
Forward-thinking companies employ established methodologies to quantify the value impact of these “indirect” elements as well as more direct cash-flow elements like increased revenues or decreased costs. Once established for ongoing operations, methodologies for measuring indirect value impact can be adapted to the deal context to help quantify and evaluate ESG risks and opportunities unearthed in diligence.
Why More Companies Haven’t Caught On
The business case for putting a dollar value on ESG initiatives isn’t hard to grasp. But the question remains as to why more companies aren’t doing it. We recently conducted a poll asking over 300 deal and finance executives to identify barriers to valuing their ESG initiatives.
Nearly half (46 percent) cited a lack of expertise, methodology, and/or senior level support. Nevertheless, the same poll found that 68 percent of respondents planning a merger or acquisition, divestiture or IPO in the next 12 months expect to evaluate ESG as part of their transaction process. We expect this trend to continue as an increasing number of companies and private equity firms are indicating they will identify and measure ESG benefits and risks that have the most potential impact on value and ROI in pricing decisions.
Donna Coallier is a partner in PwC’s U.S. Valuations practice. Lauren Kelley Koopman is a director in PwC’s U.S. Sustainable Business Solutions practice.