The Rising Impact of ESG Factors on M&A Strategy

Historically, the driving forces behind M&A investment strategy have been primarily strategic fit and financial profile. However, Environmental, Social, and Governance (ESG) have become increasingly critical in these decisions. More than ever, ESG considerations are integral to assessing strategic fit – a major shift from ESG as a desirable add-on to a deal-making necessity.

Today, investors are using ESG factors to identify potential targets and determine the purchase price and deal terms – and companies with strong ESG profiles are typically commanding higher valuations and stronger deal terms. For sellers, a robust ESG profile can add value and attract interest. For buyers, a comprehensive understanding of the seller’s ESG profile can mitigate risks and help to avoid potential deal breakers.

Considering global ESG assets are expected to reach $50 trillion by 2025 – one-third of all total assets under management worldwide – ESG’s influence on dealmaking is likely to increase even more over time. Given this growing impact, it’s essential to understand how ESG considerations will drive transactions – and the future of combined entities. Here’s what to consider.

#1. Identifying ESG factors impacting financial performance 

A recent Bain & Co. research brief concluded that sustainable business measures correlate with positive financial performance. Since ESG considerations are relatively new, it’s important to delve into those factors which have the greatest potential impact on economic performance, including:

  • Top-line growth, including building new products and services that align with customer trends and expanding new markets to promote sustainable best practices
  • Decreased legal and regulatory costs
  • Improved capital allocation and asset optimization, driving enhanced returns
  • Cost reduction via energy efficiency and low emission
  • Better productivity due to DEI measures, increased employee morale, and stronger employer branding – and, with it, better recruiting and retention success                                    

#2. Understanding the mismatched ESG profiles

For many, ESG considerations hold double-edged power — they can create value or be an immediate deal breaker. A robust ESG profile helps manage risks and works as a brand differentiator, enhancing the company’s reputation and appeal to stakeholders. On the other hand, overlooked ESG issues can pose significant challenges post-transaction.

Given these mounting considerations and their growing importance in deal sourcing and evaluation, ESG due diligence is critical. During this process, organizations should identify potential issues beyond traditional frameworks. Potential ESG deal breakers include unethical marketing or behavior, reputational and supply chain risks, and inadequate disclosures.

To succeed, dealmakers must learn to value targets under multiple ESG scenarios. This requirement introduces complexity and an opportunity to better understand a deal’s potential risks and rewards.

#3. Keep evolving your M&A strategy 

That said, we’re in a new age of dealmaking, and ESG evaluation is constantly in flux. To future-proof your identification and evaluation processes, it’s key to account for changes in financial indicators and the evolving ESG landscape. Granted, the extent to which ESG considerations play a role varies from deal to deal. In some transactions, elevating a company’s ESG profile could be a primary motivator behind the transaction. In others, ESG considerations may play a less prominent, yet still critical, role.

As the landscape evolves, dealmakers must adjust their strategies to ensure they’re continuously thriving. Today, that means evolving your processes in the context of financing, acquisitions, divestitures, and IPOs – and being laser-focused in updating and continuously iterating those processes.

What Comes Next: Staying Ahead of the ESG Curves 

Given intensifying pressures for portfolios to include environmentally and socially conscious companies, PE firms are tasked to find the best opportunities that both fit growing ESG expectations and within their target segment. SPS equips funds with unmatched granularity in their view of the market – and a deep taxonomy including niche sustainability-focused sectors – ensuring no relevant deal is missed.

With the right policies and priorities in place – and an eye on the ESG trends impacting valuation – investors and dealmakers are in a better position to make smart, strategic deals that drive financial and social impact now and in the future.

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