How will ESG performance help shape your future?

30 Jun 2022
By Esa Tolonen

EY Finland, EY-Parthenon, Partner

Esa Tolonen is Partner in EY-Parthenon in Finland.

30 Jun 2022

In this article, we look into the heart of ESG due diligence and clarify how investors and acquirers can benefit from it.

In brief

  • ESG due diligence identifies the most critical sustainability risks and converges with finding and capturing value creation opportunities.
  • Indicators of sustainability-driven financial value are becoming more evident and recognizing them requires a more commercial and strategic focus.
  • We have only seen the first waves of sustainability trends and impacts on industries – investors and acquirers need to shift their focus to the horizon.

Sustainability has risen to the top of investors and corporate leaders’ M&A agenda as ESG (environmental, social, and governance) issues have become a critical part of both the investment thesis and the deal value capture of individual acquisitions.

ESG due diligence: identifying sustainability risks and finding and capturing value creation opportunities

The emphasis between environmental, social, and governance aspects in a single due diligence varies highly as each acquisition case is dependent on the type of material for the company, its industry and the markets in which it operates in. Hence, focus on the most material issues is critical to avoid boiling the ‘infamous ocean’. However, this can be a devastating task without access to professionals with a multidisciplinary understanding of often seemingly unrelated topics or the ability to benchmark the state of target’s operations both globally and locally.

Many companies and investors have already started to use external advisors to conduct due diligence on their acquisition targets’ sustainability issues. However, only a few have looked beyond the material risks that most reports focus on. This is not at all surprising! The cause-effect relationship between material ESG issues, i.e., non-financial and financial metrics is rarely self-evident or easily quantifiable. This does not mean that it couldn’t be reasonably probable to find a link between ESG and financial value creation since many market trends are already indicating it.

Investors demand ESG disclosures

The EY Investor Survey in 2020 already indicated that firms failing to meet investor expectations on ESG factors risk losing access to capital markets. This has led investors to demand ESG disclosures. While ESG performance has become a guiding factor to avoid ‘unsustainable companies’ for some investors, others have taken steps towards impact investing by seeking targets with already high ESG performance and high future potential.

One of the core challenges for most investors and acquirers remains the lack of comparable ESG performance figures and reasonable certainty to assess the target. Luckily for the investors (although burdensome for most companies), the increasing number of sustainability regulations (e.g., EU taxonomy, CSRD) are about to provide some long-needed comparability. Though, this still might not necessarily be in as clear a format as comparing financial metrics between companies’ financial reports.

Investors and acquirers are becoming eager to identify the sustainability-driven financial value in acquisitions. This is a cause-effect relationship arising as the ESG performance of companies is gradually becoming more transparent and standardized. Such value may originate for example via:

  • Shifting value drivers on customers’ willingness to pay for sustainable offerings
  • Lowering customers green premiums via target’s handprint capabilities
  • Attracting and retaining diverse and sought-after talent
  • Inducing lower costs of capital via strong ESG performance
We have only seen the first waves of sustainability trends and impacts on industries – investors and acquirers need to shift their focus to the horizon.
Esa Tolonen
EY Finland, EY-Parthenon, Partner

Recognizing sustainability-driven financial value in ESG due diligence

To recognize sustainability-driven financial value in ESG due diligence, investors and acquirers need to combine materiality with risk-driven expertise. This hybrid should be tapped with commercial and strategic perspectives on the target’s market, competitors, customers and current strategy.

At EY-Parthenon, we believe that to succeed, ESG due diligence has to move closer to traditional commercial due diligence engagements with a strong focus on answering the following key questions from investor’s/acquirer’s perspective from a sustainability point of view:

  • What are the present trends in this industry? What kind of opportunities does that reveal?
  • How is the company positioned against its competitors? What will this hold for the future?
  • What are the key opportunities and threats? How should we plan around them?

In this way, both the investors and acquirers are able to seek growth opportunities and sources of competitive advantage leveraging the sustainability waves approaching in the horizon.

We have only seen the first waves of sustainability trends and impacts on industries – investors and acquirers need to shift their focus to the horizon. Global sustainability trends are already reshaping entire industries by raising the bar for having a license to operate. Although regulators have typically set the benchmark, we are now starting to see that customers and suppliers are increasingly resistant to conduct business with companies that are considered unsustainable. The unwritten rules of staying in the game are growing stricter.

Sustainability trends and M&A – conclusion

Sustainability trends are changing the means of success against competition. The ongoing changes open new opportunities for companies to build new sustainable products and services and expand into new markets and customer segments. Businesses have to now start looking at sustainability as a source of opportunities for long-term value. By doing this will be more likely to remain economically competitive and viable, while also doing what is right for the environment and society.

Summary

Sustainability has risen to the top of investors and corporate leaders’ M&A agenda as ESG issues have become critical in investments and individual acquisitions. ESG due diligence identifies the most critical sustainability risks and converges with finding and capturing value creation opportunities. Emerging indicators of sustainability-driven financial value are becoming more evident and recognizing them in due diligence requires a more commercially and strategically oriented focus.

About this article

By Esa Tolonen

EY Finland, EY-Parthenon, Partner

Esa Tolonen is Partner in EY-Parthenon in Finland.