ESG's Impact on M&A Deal Valuation

When one thinks of deal valuation what comes to mind? Is the image geared towards a quantitative framework consisting of a discounted cash flow analysis and an asset based valuation? Whilst this picture is not incorrect, in the wake of a growing tendency towards energy-transition related deals, ESG has emerged as a major-trend with an undeniable impact on deal valuations in M&A transactions. Given the increased importance of ESG in investing decisions, it is critical to consider the role the legal framework plays, particularly in ESG due diligence and disclosure obligations.

ESG criteria has historically been viewed through the lens of risk mitigation and as a secondary component to financial metrics. However, with the increase in sustainability reporting requirements, enhanced stakeholder activism and the need for corporate responsibility, there has been a shift towards ESG’s impact on deal valuation and its role in long-term value creation. An industry survey by Deloitte in 2022 found that “two thirds of the 250 leaders of corporations with revenues above $500 million considered ESG to be of extreme strategic importance in M&A” (Beck, 2022). Similarly, a McKinsey study revealed that most “C-suit leaders and investment professionals have indicated a willingness to pay a 10% median premium to acquire a company with a positive ESG record” (Delevingne et al, 2020). The heightened prevalence of ESG involvement in M&A deal valuation can be attributed to the growing interconnectivity between ESG and financial performance, but also to the increased regulatory pressure.

The emphasis placed on corporate accountability, transparency, and sustainability as cornerstones of reputable business practice has seen regulatory bodies - like the European Securities and Markets Authority and the Financial Conduct Authority - increase their reporting requirements on ESG integration in M&A deal valuations. Moreover, the International Sustainability Standards Board released draft standards on ESG reporting tied to financial statements, which are expected to be adopted under UK law by 2025 (Ward et al, 2022). The escalation in regulatory pressure that companies face entails a growing need for robust ESG disclosure from a financial perspective.

The legal and commercial ramifications of failing to properly adhere to ESG disclosure obligations cannot be understated. This is highlighted by the ripple effect created by the greenwashing allegations brought by the Securities and Exchange Commission (SEC) against Deutsche Bank’s asset-management group in 2021, which led to a $25 million settlement (Palma et al, 2023). The publication of the SEC’s investigation into DWS group led to their shares falling “13 percent on the day and resulting in an overall wipe out of about €1bn in stock market value” (Palma et al, 2023). Moreover, DWS’s misleading ESG disclosure opened the floodgates to litigation, negatively impacted its market value and increased investor scepticism. This cautionary tale highlights the importance of having in-depth and transparent ESG disclosure reporting from a legal perspective in place for companies, but equally for M&A transactions.

ESG due diligence serves as a critical legal mechanism in generating, preserving, and influencing M&A deal valuation and should be approached from a strategic angle rather than solely a standard compliance one. The increased weight placed on ESG performance in M&A decision-making has seen the integration of ESG factors in deal structuring and contract drafting, such as the ‘ESG-compliant clause’ – which creates an indemnity chain – ensuring “that any acquired business continues to comply with ESG criteria” (Ellrott, 2022). The growing role of ESG due diligence in M&A also means that firms will need to adapt to new compliance methods, such as soft laws and codes of practice.

The integration of financial and ESG metrics in assessing a company’s value has garnered industry wide support, from institutional investors to commerce associations, like the Integrated Reporting Council. Acquirors and targets in M&A deals are seeking to leverage synergies arising from companies with similar ESG profiles and ESG due diligence and disclosure is at the core of being able to realise this.