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M&A and investment decision makers must consider the integral connection between
a company's sustainability practices and its future performance. To that end,
conducting due diligence is essential for:
* Assessing a company’s material sustainability issues
* Benchmarking against competitors
* Gaining an in-depth view of risks and value creation levers
Share
M&A and investment decision makers must consider the integral connection between
a company's sustainability practices and its future performance. To that end,
conducting due diligence is essential for:
* Assessing a company’s material sustainability issues
* Benchmarking against competitors
* Gaining an in-depth view of risks and value creation levers
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DUE DILIGENCE
/ ARTICLE
ELEVATING ESG IN COMMERCIAL DUE DILIGENCE
February 27, 2024
M&A and investment decision makers must consider the integral connection between
a company's sustainability practices and its future performance. To that end,
conducting due diligence is essential for:
* Assessing a company’s material sustainability issues
* Benchmarking against competitors
* Gaining an in-depth view of risks and value creation levers
By Jens Kengelbach, Astrid Latzel, Jana Herfurth, Greg Fischer, Ben Morley,
and Roy Huang
Reading time: 12 min
KEY TAKEAWAYS
M&A and investment decision makers must consider the integral connection between
a company's sustainability practices and its future performance. To that end,
conducting due diligence is essential for:
* Assessing a company’s material sustainability issues
* Benchmarking against competitors
* Gaining an in-depth view of risks and value creation levers
M&A and investment decision makers must consider the integral connection between
a company's sustainability practices and its future performance. To that end,
conducting due diligence is essential for:
* Assessing a company’s material sustainability issues
* Benchmarking against competitors
* Gaining an in-depth view of risks and value creation levers
LISTEN TO THIS ARTICLE
This audio was created using generative AI.
Environmental, social, and governance factors are fast becoming key
differentiators affecting a company’s future performance. Recognizing this,
leading companies and investment firms are erasing the distinction between
sustainability and commercial issues when considering M&A and other investments.
This change in perspective has major implications for due diligence.
Traditionally, due diligence focused on a narrow set of value-related commercial
factors, while sustainability assessments emphasized compliance and risk
mitigation. Today, best-in-class corporate and financial investors are
integrating sustainability issues into commercial due diligence. Acquirers are
exploring the connection between sustainability and value creation throughout
the M&A process, and sellers are considering ESG in risk and valuation analyses
to enhance their exit strategies.
Effective ESG due diligence requires a robust methodology that considers
industry- and region-specific information to estimate and validate the related
synergies. By combining a standardized framework with deal-specific deep dives,
companies can conduct a comprehensive assessment that lays the groundwork for a
discussion of sustainability strategies and potential value creation levers.
SUSTAINABILITY IS INTEGRAL TO COMMERCIAL ASSESSMENTS
Companies and investors have many motivations for integrating sustainability
into commercial assessments. For example, customers increasingly factor a
company’s sustainability performance into their purchasing decisions. Moreover,
transitioning to a greener business model may reduce costs both immediately and
over the long term. Although compliance requirements provide some of the
impetus, once companies engage more deeply in sustainability topics, they are
finding strategic and operational opportunities as well.
There are many new requirements that companies must consider when evaluating
acquisitions and other major investments. For example, starting in 2025, the
Corporate Sustainability Reporting Directive mandates social and environmental
disclosures by large companies with a significant presence in the EU or with
securities listed in an EU-regulated market.
Furthermore, two proposed directives from the European Commission have
significant implications. The Directive on Green Claims would regulate how
companies communicate about their environmental impact and performance, with
penalties for noncompliance. In addition, the Corporate Sustainability Due
Diligence Directive outlines steps to identify, prevent, mitigate, or eliminate
the negative impacts of a company’s operations on people and the environment.
The directive includes supply chains within the scope of operations, so
companies will need to carefully scrutinize their supplier base.
To create value through sustainability, companies need better data. Public
companies are now disclosing sustainability data, often surpassing what
regulations require. In private markets, the private equity industry recently
launched the ESG Data Convergence Initiative (EDCI) to standardize
sustainability data and make it more actionable. The EDCI has made strong
progress, offering benchmarks that provide investment firms with
first-of-its-kind guidance on how portfolio companies or potential acquisitions
perform relative to their peers on sustainability topics. These insights are
particularly useful for prioritizing topics for further investigation in due
diligence.
MATERIALITY DETERMINES ESG DUE DILIGENCE PRIORITIES
Although companies of every size and sector can create commercial value through
sustainability, the priorities vary among industries. Some industries, such as
steel, cement, chemicals, and airlines, face a particularly pressing need to
decarbonize. (See “A Plastics Producer Assesses Sustainable Alternatives.”)
However, ESG even affects companies that do not provide physical products or
services. (See “A Software Company Explores ESG Risks and Opportunities.”)
A PLASTICS PRODUCER ASSESSES SUSTAINABLE ALTERNATIVES
An ESG due diligence assessment enabled a plastics producer to identify
bioplastics as the optimal sustainable material for its primary applications,
considering environmental impact, waste reduction, and resource usage.
Approximately 65% of traditional plastics remain in the environment after one
year of being discarded, and approximately 60% remain after five years. The
mounting environmental impact is propelling a shift toward more sustainable
alternatives. This change has been spurred by escalating consumer and regulatory
pressures, sometimes culminating in outright bans.
The plastics producer’s assessment examined the environmental impact of plastics
substitutes across its value chain, from upstream production (including
feedstock and processing) to downstream end-of-life disposal. The review
encompassed traditional plastics, recycled plastics, bioplastics, paper, and
other alternatives across applications such as shopping bags, waste bags,
agricultural films, food packaging, wrapping, and food service containers.
The assessment found that recycled plastics were best from an environmental
perspective. However, they were not suited to the company's core applications
owing to technical constraints, such as challenges in recycling film and the
quality required for contact with foods.
Paper alternatives are attractive substitutes from a waste reduction standpoint,
with approximately 1% of the material remaining in the environment after 100
days. But paper production is associated with higher CO2 emissions (five to
seven times more than bioplastics) and increased resource usage (approximately
twice the land and more than ten times the water required for bioplastics).
Ultimately, the analysis found that bioplastics would be the preferred
alternative for core applications from an environmental perspective. They
significantly reduce waste (approximately 7% does not degrade within a year),
decrease CO2 emissions (by 25% compared with traditional plastics), and entail
limited resource use (up to 95% less land and 90% less water compared with
paper).
A SOFTWARE COMPANY EXPLORES ESG RISKS AND OPPORTUNITIES
A software company that provides a logistics platform connecting shippers,
carriers, and recipients conducted an outside-in ESG due diligence. The goal was
to evaluate the platform’s performance and associated risks, identify how to
implement best-in-class standards, and highlight potential sustainability
opportunities within the transportation sector. The company intends to use the
insights gained to position itself as a leader in sustainable logistics
solutions, which would set the stage for divesting the logistics platform.
The assessment encompassed three elements:
* Identifying Material ESG Dimensions. The due diligence identified nine
material ESG dimensions. The company is now addressing the associated
potential risks, making the residual risk level relatively low.
* Benchmarking ESG Performance Against Top Peers. The company compares
favorably with the roughly 50% of peers that publicly report their ESG
performance, excelling in most reported dimensions. To elevate its ESG
performance to best-in-class status, the company needs to enhance
transparency regarding governance and policies, increase the representation
of women in management, accelerate its transition to renewable energy, define
science-based targets, and disclose emissions information.
* Assessing Opportunities in the Transportation Sector. Although there is
substantial interest in sustainable products and services, many potential
customers are unwilling to pay for these solutions. However, new regulations
taking effect over the next five years will generate market demand. The
company’s significant opportunities include solutions that facilitate the
following:
* Carbon Visibility: Providing transparent emissions management across all
transportation modes and logistics flows
* Carbon Intelligence: Defining sustainability targets based on industry
benchmarks and insights
* Green Procurement and Assignment: Enabling environmentally conscious
sourcing and task assignment
* Capacity and Route Planning: Optimizing, for example, reverse logistics and
CO2-equivalent offsetting
Exhibit 1 shows how the materiality of each ESG topic varies across selected
industries.
To identify and activate relevant value creation levers, a company needs to
determine the ESG factors likely to affect its financial performance, benchmark
itself against peers, and prioritize improvement initiatives. A well-designed
materiality assessment strikes the right balance between the time and effort
expended and the benefits derived. Although comprehensive assessments can be
conducted as a standalone project, integrating them into commercial due
diligence will have a bigger impact on commercial outcomes. For example, both
sustainability and sourcing teams should participate in identifying
opportunities to create value by decarbonizing the supply chain.
A THREE-STEP APPROACH
The standard approach to ESG due diligence consists of three steps that provide
a comprehensive perspective on performance and value creation opportunities:
* Assess the company’s material factors. Start by determining how profit pools
in the company’s industry are evolving in response to major sustainability
trends. An initial assessment entails evaluating the company’s material ESG
factors using frameworks such as the materiality maps provided by the
Sustainability Accounting Standards Board. These tools assist in estimating
the specific effects of ESG—including risk factors—on financial metrics, such
as future cash flow.
* Conduct a competitive benchmarking. Next, ascertain how the company is
strategically positioned relative to peers to benefit from these trends. The
EDCI’s sustainability benchmarks are valuable starting points. It is often
advisable to augment these by selecting a comparable peer group of companies
based on region and industry against which to benchmark the company’s
position and identify opportunities to improve its ESG competitiveness.
* Understand company-specific ESG-related risks and value creation levers.
Obtain a deeper understanding of any substantial ESG-related risks identified
in the assessment of material factors. At the same time, identify and
quantify value creation levers, such as innovations in adjacent products or
services, operational improvements, or other initiatives to achieve
best-in-class ESG performance. Prioritize levers by considering their impacts
on sustainability performance, EBITDA, and multiples, as well as ease of
implementation.
If climate factors are significant for a given investment or divestment, buyers
or sellers should expand the standard three-step approach by conducting a
detailed analysis of these topics. This may entail developing and assessing an
asset-specific decarbonization fact base that encompasses improvement levers,
CO2 abatement potential, and possible revenue streams.
Companies can apply the results of their due diligence assessments to identify
concrete, granular initiatives and actions, including adjustments to the
business plan and implementation roadmap. Exhibit 2 highlights initiatives that
companies can take to address a selection of the most pressing ESG topics by
industry.
BUYERS AND SELLERS GAIN VALUABLE INSIGHTS
Both buyers and sellers can apply the insights gained from due diligence to more
effectively align their strategies with evolving standards and industry-specific
sustainability topics, ensuring balanced and informed decisions.
Buy-Side Evaluations Pinpoint Risks and Rewards. Prospective buyers should
ensure that they are fully aware of the ESG-related risks and opportunities tied
to a potential acquisition target. In the initial stages, they can use publicly
available data for a materiality assessment. As the due diligence progresses,
they can use the target’s available data to probe more deeply into materiality
and evaluate synergies and direct impacts, such as the acquisition’s effects on
ESG ratings, risks, or financing requirements. This may entail assessing the
acquisition’s impact on the buyer’s own sustainability strategy and
transformation needs, including goals for decarbonization or net zero emissions.
(See “A Steel Maker Assesses the Challenges of Adopting Emissions-Reducing
Technology.”) The assessment should also consider the enablers and a roadmap for
harmonizing the parties’ strategy execution. Such an assessment should be
carried forward to support the realization of synergies and post-merger
integration efforts.
A STEEL MAKER ASSESSES THE CHALLENGES OF ADOPTING EMISSIONS-REDUCING TECHNOLOGY
A steel manufacturer was considering the acquisition of another player in its
industry. A primary issue was the target’s need to adopt new emissions-reducing
technologies to reduce the costs of CO2 emissions certificates. These costs, per
tonne of CO2 produced, were projected to more than double between 2022 and 2029.
The acquirer conducted a due diligence assessment to determine the feasibility
and financial implications of adopting emissions-reducing technologies:
* Identifying Alternatives. The assessment identified natural gas, green
electricity, and green hydrogen as potential technology alternatives.
* Benchmarking Costs. A detailed benchmarking pinpointed the most economical
technology alternatives considering operating costs and capex. This was
complemented by a scenario analysis covering the next five years, for base-
and best-case cost projections, with ROI calculations for each scenario.
* Assessing Feasibility. The company’s experts assessed the operational
feasibility of the alternative technologies, considering each technology’s
maturity and compatibility with the existing infrastructure. The assessment
also looked at potential risks, such as the local supply of green energy
sources and the need for additional construction.
* Understanding the Financial Implications. Financial analyses revealed that
adopting these technological alternatives could lead to a double-digit
reduction in EBITDA and a period of negative cash flow in 2029 and 2030.
The bottom line: during the period reviewed, the savings from reducing the costs
of emissions certificates would not compensate for higher capex and reduced
EBITDA. However, from a longer-term perspective, the company must adopt the new
technology to continue operating in the emerging regulatory environment and
compete with sustainability-conscious rivals. The due diligence analysis laid
the groundwork for selecting the most effective approach to transition to green
steel production.
Sell-Side Assessments Support Valuation. For sellers preparing to divest a
business, ESG due diligence can provide essential information for the equity
story presented to potential buyers. Sellers should identify whether ESG has a
significant up- or downside for the business, as well as investments that could
improve performance. They should integrate a sustainability strategy into the
sale process, ensuring its alignment with the commercial strategy. The
sustainability strategy—whether existing or developed in preparation for a
divestiture—should include quantitative data (such as KPIs) and qualitative
information that highlights the risks and opportunities for acquirers. If
sustainability does not present a significant advantage, sellers should address
it on a limited basis in standard due diligence to preempt questions or
valuation discounts.
--------------------------------------------------------------------------------
Sustainability is not a compliance checkbox but a crucial consideration for
creating value. M&A and investment decisions must therefore consider the
integral link between a company's commitment to sustainable practices and its
commercial strengths. Buyers and sellers in private equity and the corporate
realm need to rigorously assess industry-specific ESG themes and adapt their
strategies to the evolving standards. Integrating ESG into the commercial due
diligence agenda is crucial to meeting this imperative.
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AUTHORS
Jens Kengelbach
Managing Director & Senior Partner; Global Leader of Mergers & Acquisitions
Munich
Astrid Latzel
Managing Director & Partner
Berlin
Jana Herfurth
Associate Director, Transaction & Integration Excellence
Vienna
Greg Fischer
Partner & Director
London
Ben Morley
Partner & Associate Director
Boston
Roy Huang
Managing Director & Partner
Shanghai
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