How poor ESG performance can stop a merger or acquisition in its tracks

Underpayment of wages, bad blood with the local community, a manager whose HR file is full of complaints  — there are a dozen ways a business can experience a hit to its reputation.  

But if that business is also on the market, it should expect its prospects to be similarly under fire. 

Poor environmental, social, and corporate governance performance, together known as ESG, has fast become a deal breaker for M&A, as bidders price the challenges of dealing with social outrage into potential acquisitions.  

Conversely, strong ESG performance — having a positive track record of community action and history of  corporate social responsibility — can strengthen a target’s case for a good valuation and quick sale.  

Not only does a transparent and documented ESG record ease buyer concerns about potential legal action or reputation risk, but the buyer’s own reputation for good corporate behaviour is boosted with these kinds of investments.  

This isn’t an issue confined to Australia.  

In an international report to be released shortly, we found 65% of international dealmakers believe ESG is a key consideration when making investment and M&A decisions. 

Such is its importance that 60% say they have walked away from a deal due to a negative assessment on ESG issues at the target. 

But that still leaves a substantial number of dealmakers who see moderate ESG issues as an opportunity — a way to buy an asset potentially at a discount and transform it into a better corporate performer.  

Weighing up the ESG risks

So how do dealmakers weigh up ESG considerations when considering a target?  

The first point to make is that ESG means different things to different investors.  

For many, the E component — environment — is table stakes.  

Buying a company with poor environmental management is risky, particularly if there are legacy issues of  contamination, or if this behaviour has led to compounding problems, with an angry local community for example, or an expensive capital works program on the horizon.  

Still, there can be an upside in considering targets with a mediocre environmental performance that could be improved with the right management focus and investment.  

Yet even if a company has met every environmental regulation, it can still face hurdles going to market if its assets carry a lingering unpleasant odour. 

We are increasingly seeing corporate carveouts to divest regulated but riskier assets such as coal from companies that no longer want to face investor outrage.  

For these assets, the perceived future impact of the business can matter as much as past behaviour. Buyers must weigh up being left holding an investment that few want in an economy shifting towards energy transition. 

The second issue is social.  

Traditionally the social pillar of ESG has related to the way businesses engage with the people they employ or across their supply chain, including whether they are a good place to work, pay the right amount on time, don’t discriminate and encourage diversity. 

But it has come to include a range of other issues that are fluid and unpredictable.  

Traditional social risks build over time: undercounting hours for casual workers leading to a hefty back-pay  bill some years later.  

New social risks can appear overnight from unexpected sources: a misguided tweet, a rude employee or a decision that misjudges the social zeitgeist.  

There is more scope for businesses to misstep if they are not thinking about the social impact of their activities and how it aligns with expectations of staff, customers and community.  

The third issue is governance, and if there are challenges in the environmental or social pillars of ESG, chances are it’s poor governance that has allowed these to occur.  

For buyers, it can be a red flag of greater problems under the surface, whether it is a cavalier attitude to risk or a lack of integration in systems and processes.  

It can also speak to poor management or wholesale problems in the culture and training of staff.  

In short, ESG might sound like a buzzword but it is a serious business that affects both the target’s bottom line and its potential valuation.  

While a less-than-shiny record can be addressed in the hands of the right investor, buyers will price in the potential problems that need to be fixed.  

But a deal will be dead in the water if the target’s corporate standing needs to be rebuilt from the ground up.