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How to incorporate ESG into M&A due diligence and integration

By Dean Kepraios and Shankar Raman | November 18, 2022

When making an acquisition, it is important to have a clear framework for ESG assessment and strategy for deal success.
Climate|Medioambiental|Mergers and Acquisitions
ESG In Sight|Mergers and Acquisitions

We recently hosted a roundtable with HR and M&A experts at several companies to discuss how they approach environment, social and governance (ESG) issues during a deal. These companies operate in every country on the planet and they take their ESG commitments very seriously. Their approaches and insights apply to any company interested in accelerating its ESG journey.

While the participating companies have different approaches to different types of deals, they all agree on the need for a standard framework to assess whether and how to proceed with an offer.

Start with a thorough checklist

When evaluating a prospective acquisition (or merger), conducting due diligence, planning the integration and then implementing it, companies at our roundtable progress through an assessment framework that begins very much like this:

Target evaluation

  • Does the target have stated ESG-related goals – even if it is not using the term ESG?
  • Where is the target on its climate agenda?
  • Will a deal strengthen or weaken our ESG position?

Due diligence

  • Does the company have a climate strategy?
  • What are the climate-related risks to the business?
  • What are the target's approaches to diversity, equity and inclusion (DEI)?
  • How is the company doing on governance issues? Is the board diverse? What compliance risks does the target face?
  • What are its supply chain practices?

Integration planning

  • What should the ESG goals be for the acquired entity? And how will the ESG goals of the acquired entity influence the acquiring company’s (or acquiring company receiving entity’s) ESG goals and measures?
  • What capabilities, tools and structures will be needed to progress on these ESG goals?
  • What new investments/funding may be required?

Integration implementation

  • How do we execute on our collective ESG objectives?
  • How do we reconcile the needs of the two companies if they are not aligned?

A fundamental challenge in assessing ESG practices

The foundation of exploring a potential acquisition’s ESG commitments may appear straightforward; but evaluating and measuring them is another story. To begin with, some companies are privately held and don’t report their ESG initiatives and outcomes. For public companies, reporting standards are inconsistent. The Securities & Exchange Commission (SEC) has one approach. And there is a separate International Sustainability Standards Board (ISSB) initiative that is taking shape to combine the Task Force on Climate-Related Financial Disclosures (TCFD) and the Sustainability Standards Board (SASB) frameworks into a single standard. When this happens, with one uniform standard, acquirers will benefit from a more systematic, consistent evaluation process.

Six key takeaways

  1. 01

    Prioritize ESG early on

    ESG investigations are coming up very early in the deal process, with larger deals getting involved in ESG sooner than in smaller “bolt-on” deals. This early focus is due to the close monitoring of organizations’ ESG promises and implementations by stakeholders, including boards, shareholders, customers, the media and employees.

  2. 02

    Hold up a mirror to your ESG strengths and weaknesses

    Where are you with your own ESG targets? As you think about the companies you’re planning to bring on, your ESG state will inform the extent of change that the acquired company and the acquiring company will experience. As with any due diligence, it presents an opportunity for each side of the deal to determine whether it wants to combine with the other. Having this “baseline” will give insight into how ESG metrics will change and whether any mitigation techniques will be necessary. A potential deal could allow you to improve your own ESG capabilities.

  3. 03

    Recognize that we’re not quite there yet when it comes to standardization and reporting of ESG maturity

    When you read multiple companies’ annual reports or 10-Ks, it’s pretty much apples-to-apples within a given accounting standard (e.g., U.S. GAAP). Not so with ESG reporting. Not to mention, ESG reporting is not required. There’s no set standard, but rather several.

    Also, consider that when you’re assessing a business for a potential deal, it’s standard to evaluate specific functions or domains, like the supply chain, HR or IT. ESG is so broad making it harder to evaluate. It touches practically every aspect of a business. The “E” may be overseen by the sustainability group, “S” encompasses HR and the business’ civic presence, and “G” falls under the legal/compliance umbrella, as does HR. But even if distinct ESG responsibilities are overseen and implemented by specific teams, ESG crosses all areas of an enterprise.

    Keep in mind, however, that ESG can even vary within a company based on location. The environment has been the priority in Europe, while North America focuses on social and Latin America and Asia-Pacific focus on governance. Increasingly, companies will need to demonstrate commitment to all aspects of ESG.

  4. 04

    Be clear-eyed about inevitable challenges arising when bringing start-ups into a legacy operation

    While the prospect of acquiring a sought-after start-up is exciting, consider how daunting the governance component of ESG might become for the acquired workforce and, consequently, potential employee retention challenges. Start-ups tend to have flat management structures. In contrast, large, established companies often have hierarchical processes and protocols. Acquired employees may balk at these processes and protocols especially if applied immediately after an acquisition. On the other hand, many at the acquired company are excitedly anticipating working within a long-established infrastructure for an organization that provides broad career development opportunities, robust benefits and, possibly, better job security. Balancing between “we don't want to swarm you and overwhelm this acquired company” and “we do need these things to get done” can be difficult. You don’t want to “break what you bought.”

  5. 05

    Consider if the valuation will change depending on whether you’re folding in the new entity or if it will “stand alone”

    As with every deal, determining the valuation of the target is critical. If the intent is to integrate the acquired company into the acquiring company, then be certain to incorporate the acquiring company’s structure into the valuation model when identifying synergies. This is especially important in the context of ESG depending on how each “side” of the deal contributes to the ESG strategy.

  6. 06

    Evaluate the optics

    If you’re acquiring a business to help advance your company’s ESG goals, consider what kind of message that sends to current employees. Suppose the acquisition is being placed into an existing product or service line. In that case, you’ll want to focus on helping legacy employees feel connected to your evolving ESG mission, not that the organization is trying to fix an existing ESG vulnerability with the acquisition. Where each company is on the ESG maturity curve will influence employees’ experience with the integration.

Conclusion

ESG is evolving rapidly, and it introduces challenges and opportunities for deal-makers. In fact, some incorporate ESG into their deal strategy, whether that is acquiring to accelerate progress toward their own ESG goals or divesting a part of the existing business that does not, or may not in the future, align with their ESG goals — or may be too costly to reform. Regardless, having a clear framework for ESG assessment and strategy in all deals is necessary for deal success.

Authors

Senior Director, Mergers and Acquisitions
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Senior Director, Health, Wealth & Career
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