The rise of ESG as a major factor in merger and acquisition transactions has been nothing less than extraordinary. Just two or three years ago, it was widely seen as a nice-to-have, that was as much about marketing and brand as it was about deal values. Today, it is one of the first topics of conversation in most deal discussions, particularly with private equity (PE) investors.
In fact, KPMG’s 2022 Market Insights Survey into value creation in the PE sector found that more than 70 percent of UK PE firms have stepped away from a deal due to ESG concerns, while almost half of PE firms in the US have done the same.
What’s behind this rapid change in attitudes? Dealmakers have realised that ESG is - and will become ever more so - an important driver of value creation.
Stronger ESG can correlate to higher value
There are two main reasons behind ESG’s growing influence in deals. First is the value attributed to the business which is increasingly being assessed not only according to financial metrics capital, but increasingly by what is fast being coined as “natural, social and human capital”. Businesses that can develop or demonstrate these forms of non-financial capital will reap the rewards. A recent NYU/Stern study, for example, found that leading your competitors and peers in the market correlates to a 12 percent uptick in market capitalisation, whereas being a stand-out leader on ESG is worth 15 percent.
The second key piece here is about the operating model; the way businesses produce their products or deliver their services has to be cleaner, greener and fairer than it ever has before, otherwise this will negatively impact value. This creates two kinds of opportunity for PE buyers: a) businesses that already have strong ESG credentials that can be further enhanced or b) businesses that have weak ESG credentials, that can therefore be bought for a lower price, ‘cleaned up’ from an ESG perspective, and sold at a premium. The real prize for PE is to look at how their portfolio company may well be valued at a significantly higher multiple of EBITDA at exit than the price at which they went in at through business and operating model shift that drives a ESG “high score”. The evidence shows that a business performing well across E, S and G will attract more interest (more bidders) and also higher multiples.
Added to these factors is the increasing pressure that PE houses are coming under from stakeholders, particularly their LPs and (for those with listed entities) institutional investors, to account for and report on their investment decisions from an ESG perspective. Plus, there is a growing set of regulations that require in-depth ESG reporting and disclosure including TCFD (Task Force on Climate-related Financial Disclosures), TFND (Task Force on Nature-related Financial Disclosures), ISSB (International Sustainability Standards Board) and the UK’s own public plans on the transition to a low-carbon future. Going forward, our view is that PE funds will struggle to raise funds if they can’t demonstrate not just compliance with ESG driven regulations but also an activists shareholder approach to changing their investee companies for the better during their period of ownership.
It's all about the data
This transition to a more sustainable, responsible, and resilient future has created a whole new set of non-financial performance measurement, management and reporting, largely on data that is off-system, poorly managed, poorly structured and in often cases not captured. The need now is for PE houses and portfolio companies to step into this data challenge as businesses are unclear on how they’re currently performing and what actions they need, and critically need to be able to tell a connected and evidenced story on their transition.
What does this mean for PE houses? It’s a complex area but here are 3 things to do immediately:
- Measure, measure, measure. Be clear about what you’re measuring and get those ESG baselines in place across the organisation. Not only for ‘E’, but for ‘S’ and ‘G’, too.
- “Connect the carbon throughout your business”. You need to understand where it is, where you are creating it, and what the value is. Then you can start identifying what you can do to reduce it.
- Don’t ignore social value. If you sell to the public sector, for example, departments must apply a minimum of 10% weighting to social value in the evaluation. So, if you can’t demonstrate the ‘S’ in your ESG, that’s a significant chunk of your procurement score written off immediately.
Perhaps the biggest takeaway of all, though, is that PE firms are uniquely positioned to leverage ESG opportunities. They are the controlling shareholders in their portfolio companies. They can and have the responsibility to use that privilege as a majority shareholder to change business for the better during their period of ownership. And in doing so, achieve significantly higher value when it comes to selling it. In short, they “do well by doing good”