Focus on: The growing importance of ESG considerations and the new challenges for the M&A industry

Studio Legale Lauro

Contributed by:

Mr. Bruno Castellini, Professor of Markets and Companies Law at Bergamo State University, in collaboration with Mr. Francesco S. Lauro, Managing Partners Studio Legale Laur

It is widespread perception in the corporate and M&A environment that the importance of ESG considerations and factors are rapidly becoming matters of primary concern for regulators, investors, customers and employees and, likewise, for corporate boards and executives. As ESG gains in relevance in the eyes of decision makers in corporate organizations, it is at the same time the object of increased and more pervasive regulation.

Recent surveys suggest that ESG positive factors are increasingly associated with business quality and that many corporations are inclined to view a properly structured ESG strategy as an indicator for long-term revenue growth.

Some M&A executives indicate that they already extensively assess environmental, social, and corporate governance elements in the deal-making process they run while a significantly higher proportion of them expect the current degree of focus on ESG aspects to increase. There exists a general view that the ability to demonstrate to corporate stakeholders an appropriate level of understanding and management of ESG matters is likely to generate a competitive advantage in pursuing value creation opportunities.

Such considerations are also impacting positively on the focus of corporate executives regarding the quality and reliability of the ESG data that their companies are able to generate, also looking at new technologies, making communication with respect to ESG a critical element for a successful external relations strategy.

ESG (Environmental, Social, and Governance) considerations have gained, and continue to increasingly gain, significant importance in the recent years and, while they have broadly acquired a high rank position in the agenda of corporate policy makers, they have also introduced new challenges for the M&A industry. Among other considerations, recent studies and reports have highlighted the growing importance of ESG, and the associated challenges for M&A, in several areas including:

ESG Integration: companies are increasingly recognizing the need to integrate ESG factors into their business strategies. This includes addressing environmental impacts, social responsibility, and governance practices. As a result, ESG considerations have become crucial in M&A transactions as they can affect a company’s long-term sustainability, reputation, and financial performance.
Regulatory Environment: governments and regulatory bodies are implementing stricter ESG-related regulations, compliance with these regulations becomes a critical factor during M&A due diligence, as non-compliance can lead to legal and financial risks.
Investor Demand: institutional investors and asset managers are increasingly considering ESG factors when making investment decisions. In the context of M&A, investors may scrutinize target companies’ ESG performance and alignment with their own ESG goals, influencing deal valuations and investment decisions.
Reputation and Brand Risk: poor ESG performance or controversies can significantly impact a company’s reputation and brand value. M&A deals can expose acquirers to potential risks associated with the target company’s ESG practices, including environmental liabilities, labor disputes, or governance issues. Assessing and managing these risks is vital to protecting the acquirer’s brand and maintaining stakeholder trust.
Due Diligence Challenges: ESG due diligence has become more complex in M&A transactions. Traditional financial due diligence now needs to incorporate a comprehensive assessment of ESG risks and opportunities. This requires gathering and analyzing large volumes of data related to environmental impact, social practices, supply chain management, and governance structures. Acquirers need to have specialized expertise and tools to evaluate ESG factors effectively.
Post-Merger Integration: after completing a merger or acquisition, integrating ESG practices across the combined entity becomes critical. Merging companies may have different ESG cultures, policies, and systems, requiring careful planning and execution to align them. Failure to effectively integrate ESG considerations can lead to cultural clashes, employee disengagement, and negative impacts on business performance.
Value Creation Opportunities: despite the challenges, ESG considerations also offer opportunities for value creation in M&A deals. Acquirers can identify synergies and operational efficiencies by integrating sustainable practices. For example, incorporating energy-efficient technologies or responsible supply chain management can lead to cost savings and improved performance.

To navigate the growing importance of ESG considerations, the M&A industry must adapt by enhancing expertise in ESG analysis, leveraging data-driven tools, and integrating sustainability into deal strategies. Successful M&A transactions will increasingly require a comprehensive understanding of the target company’s ESG risks and opportunities, as well as effective planning for post-merger integration to realize the full potential of ESG-related value creation.

This trend can be attributed to several factors. First, there is growing awareness and concern about the long-term sustainability and impact of business operations on the environment and society. Climate change, resource scarcity, social inequality, and other ESG-related issues have gained prominence in public discourse, prompting stakeholders to demand more responsible corporate behavior.

Second, investors have recognized that ESG factors can significantly impact a company’s financial performance and risk profile. Incorporating ESG considerations into investment decisions has become a way to manage risks, identify opportunities, and enhance long-term value creation. Consequently, institutional investors and asset managers are increasingly integrating ESG criteria into their investment strategies and engaging with companies on these matters.

Third, regulators and policymakers are responding to public pressure and investor demand by introducing more stringent regulations and reporting requirements related to ESG issues. Governments around the world are setting targets for reducing carbon emissions, promoting sustainable practices, and addressing social issues. Regulatory bodies are also introducing mandatory disclosure requirements, encouraging companies to report on their ESG performance and impact.

As a result, companies are facing a more pervasive regulatory landscape when it comes to ESG. They are expected to assess and manage their environmental and social risks, demonstrate good governance practices, and provide transparent reporting on their ESG performance. Non-compliance with ESG regulations can lead to reputational damage, legal consequences and financial penalties. This context is therefore impacting the responsibility profile of corporate decision makers and their accountability in connection with their ability to manage ESG related matters. Also, the width and peculiarities of the areas impacted by ESG factors require a variety and depth of expertise that need to be reflected in corporate organization and management.

Further, recent surveys suggest that ESG positive factors are increasingly associated with business quality and that many corporations are inclined to view a properly structured ESG strategy as an indicator for long-term revenue growth. Such surveys and studies have indicated a positive correlation between ESG performance and financial performance. These findings have prompted many corporations to view a well-structured ESG strategy as an indicator of long-term revenue growth. Among other aspects, reasons why ESG is increasingly associated with business quality and viewed as a driver of growth include:

Enhanced reputation and stakeholder trust: companies that prioritize ESG factors tend to develop stronger relationships with their stakeholders, including customers, employees, investors, and communities. By demonstrating a commitment to sustainable practices, social responsibility, and ethical governance, companies can enhance their reputation and build trust, leading to increased customer loyalty, investor confidence, and employee satisfaction.
Risk management: integrating ESG considerations into business strategies can help companies identify and mitigate potential risks. By addressing environmental risks, such as climate change and resource scarcity, and social risks, such as labor practices and community impact, companies can minimize potential disruptions to their operations, supply chains, and brand image. Effective risk management is vital for long-term business stability and growth.
Access to capital: investors are increasingly incorporating ESG criteria into their investment decisions. Companies with strong ESG performance are often seen as more attractive investments, and they may have better access to capital, lower borrowing costs, and improved credit ratings. Furthermore, sustainable investment funds and ESG-focused investors are growing in number, indicating a rising demand for companies that align with ESG principles.
Innovation and operational efficiency: adopting sustainable practices can drive innovation and operational efficiency. Companies that prioritize ESG factors are often motivated to find innovative solutions that reduce environmental impact, improve energy efficiency, and optimize resource usage. These efforts can lead to cost savings, increased productivity, and a competitive advantage in the market.
Regulatory compliance and legal risks: governments and regulatory bodies are increasingly implementing stricter regulations and reporting requirements related to ESG issues. Companies that proactively address ESG factors are better positioned to comply with evolving regulations and reduce legal risks associated with non-compliance. By staying ahead of the regulatory curve, companies can avoid penalties, reputational damage, and potential legal issues.

In summary, the association between ESG positive factors and business quality, as well as the perception of ESG strategies as indicators for long-term revenue growth, stems from the potential benefits of enhanced reputation, risk management, access to capital, innovation, operational efficiency, and regulatory compliance. As sustainability and responsible business practices continue to gain importance, integrating ESG considerations into corporate strategies is becoming a key driver of success in the business world.

When evaluating potential mergers, acquisitions, or other deals, considering ESG factors has become more than just a box-ticking exercise. It is seen as a crucial component of due diligence, risk management, and value creation. By integrating ESG considerations, executives can identify risks, uncover new opportunities, and drive operational efficiencies.

Additionally, stakeholders, including investors, customers, employees, and regulators, increasingly prioritize companies that demonstrate a commitment to ESG principles. Incorporating ESG into the deal-making process allows companies to showcase their responsible business practices, strengthen stakeholder relationships, and enhance their reputation. This, in turn, can lead to improved access to capital, increased market share, and enhanced brand value. Overall, the trend towards considering ESG elements in the M&A process is expected to continue and potentially intensify. Companies that proactively address ESG issues and can effectively communicate their commitment to stakeholders are likely to gain a competitive edge in pursuing value creation opportunities.

Besides ESG considerations are impacting on the focus of corporate executives regarding the quality and reliability of the ESG data that their companies are able to generate, also looking at new technologies, making communication with respect to ESG a critical element for a successful external relations strategy.

As stakeholders, including investors, customers, and regulators, demand more transparency and accountability regarding ESG performance, companies are recognizing the need to collect, analyze, and report accurate and comprehensive ESG data. To meet these requirements, companies are adopting new technologies and tools to improve their data collection and reporting processes. This may include implementing advanced data analytics, automation, and digital platforms that facilitate data aggregation and reporting. By leveraging these technologies, companies can enhance the accuracy, timeliness, and consistency of their ESG data.

However, generating reliable ESG data is only part of the equation. Effectively communicating this information is equally critical for a successful external relations strategy. Companies need to articulate their ESG initiatives, progress, and performance in a transparent and compelling manner to engage with stakeholders effectively.

Clear and concise communication about ESG efforts helps build trust and credibility with investors, customers, employees, and the broader public. It enables companies to showcase their commitment to sustainable practices, demonstrate the value they create beyond financial metrics, and align with the expectations and values of their stakeholders.

Moreover, companies that effectively communicate their ESG strategies and performance can differentiate themselves from their peers, attract investment capital, and strengthen their reputation. It becomes an essential component of building positive relationships with stakeholders and maintaining a social license to operate.

To sum up, as ESG considerations increasingly impact corporate decision-making, the focus on generating reliable ESG data and effectively communicating it becomes a critical element of a company’s external relations strategy. By ensuring data quality and employing new technologies, companies can meet the growing demands for transparency. Simultaneously, clear and transparent communication of ESG efforts helps foster trust, build reputation, and gain a competitive advantage in the market.