- Environmental, social, and governance (ESG) considerations are on the rise across industries, fueled by reputational risks and business performance impacts.
- While M&A experts broadly agree that ESG has become a major factor in deals, companies have been slow to catch up.
- The data is unequivocal: firms with sustainable practices and a transparent, diverse organization do better.
- Companies with higher ESG scores command higher valuations, outperform financially (over companies with lower ESG scores), and avoid unnecessary risk.
ESG may not have been on your radar until recently. If you’re like most companies today, you haven’t fully considered the impact that ESG progress can have on an acquisition. Hopefully that will change after reading this article, companies that get ahead of the curve will reap major benefits, from brand reputation to long-term market leadership.
What is ESG?
The 21st Century has seen a major transformation toward more socially conscious capitalism and transparent organizations. ESG is a broad term that encompasses a systematic, intentional effort toward environmental sustainability, minority representation at all levels of the company, and transparent accountable governance.
Examples of leadership in ESG are creating a more environmentally sustainable business model than other companies in your industry or hiring talent from diverse backgrounds. The G (Governance) includes greater transparency on promotions and executive selections, along with a robust internal audit process to hold all parts of the organization accountable.
There is more to ESG than just social impact. The truth is that there are many benefits for the companies themselves.
The most obvious, immediate benefit is public perception.
A company with a stronger organizational, environmental, and social record is going to be more popular. Companies around the world pursue ESG goals much more aggressively than they did ten years ago, and that’s partly due to increased public pressure. If you acquire a company with a stronger ESG reputation, as Amazon did with Whole Foods, you reap the reputational benefits of their hard work.
Industry leaders agree. A recent Bain study found that “68% of our surveyed consumer products executives see ESG’s value in helping them gain share by improving their brand image.”
Prioritizing ESG shows both consumers and potential acquirers that you share their priorities and are moving the needle toward a better future. That message is important, but the data shows that ESG’s most powerful impact is in the company it creates.
Better Bones, Lower Risk
When a real estate agent says “This house has great bones,” it usually means that, regardless of superficial appearance, the home’s foundations are strong. The house is structurally sound, made with high-quality materials and craftsmanship, and will last the test of time. The realtor’s sales pitch alludes to a core piece of business wisdom: for long-term investments, look for strong structure.
All things equal, companies with better ESG profiles are structurally stronger than their competitors. They’ve done the hard work of building a diverse team throughout the org chart. They have a transparent organization with great information flow. All departments and leaders are held accountable. They have more robust internal auditing procedures, which means less chance of questionable practices or misstated financial performance.
They prioritize environmental initiatives, anticipating changes in the regulatory environment instead of reacting to them later on. They minimize systemic risk through controls on hazardous material, waste mitigation, and humane sourcing practices.
This all translates to lower risk and, in the long run, a healthier bottom line.
Better Bottom Lines
ESG is not just about optics. Research proves that across industries, better ESG translates to better financial performance. A recent project by NYU Stern, in partnership with Rockefeller Asset Management, compiled more than 1,000 research papers on the topic from 2015 to 2020.
It concluded that ESG-based investing outperforms the opposite approach, and that it better protects against broad downside risk, such as an economic crisis. The research also found compelling evidence that ESG drives better financial performance.
The positive impact on profits is especially pronounced when looking at long-term performance. In the case of sustainability, better financial performance could be due to a more innovative product or production process, as well as lower risk exposure. It isn’t a surprise that transparent, accountable governance has a positive effect on financial performance.
Companies with higher ESG scores are a worthy investment for any company, and a major must-have for any acquisition target.
Responsible Companies, Higher Valuations
Companies with stronger ESG profiles command higher valuations and have lower capital costs. An acquirer does not have to apply as deep of a discount to future earnings, because future performance is more secure.
[PM1] Source: MSCI
Research by MSCI confirms the financing benefits for ESG companies. Companies with higher ESG scores had significantly lower costs of capital. Investors needed a lower expected rate of return to invest in these companies.
The difference was significant, nearly 1% in some cases, and consistent across major industries. For larger firms, that equates to millions of dollars in saved interest or equity. The trend held true across the world, in both developing and developed regions.
ESG: Tomorrow’s Kingmaker
Whether you’re on the buy or sell side, now is the time to get serious about ESG. Companies with stronger ESG practices in place are less risky, more highly valued, and do better financially. ESG drives greater innovation, a healthier company culture, and a more resilient organizational structure.
Acquirers and targets need to make sure they give ESG the consideration it deserves, or risk getting left behind by those that do.