ESG due diligence in an M&A world

With the boom in demand for environmental, social and governance (ESG) services during transactions, many consultancies are offering ESG due diligence for mergers and acquisitions (M&A). However, consultants coming from an ESG background often lack an essential understanding of the M&A process, which hinders their ability to support the transaction. Only by understanding the purpose of a due diligence can ESG due diligence providers give investors confidence in the price and final acquisition.

Due diligence for M&A is about closing a deal with certainty

Although the term “due diligence” is often used in an ESG context to describe an intensive research and disclosure process, it has a distinct and specific meaning in M&A.

M&A due diligence is a structured risk identification process focused on setting the right purchase price.

This use of similar terminologies with different meanings can be a source of confusion and misalignment in an already hectic transaction, a problem that is magnified by the immaturity of the ESG field and its lack of universally adopted standards.

While ESG-focused consultants bring an understanding of the ESG ecosystem, they often misunderstand the process and purpose of due diligence as part of a transaction because their interpretation of due diligence is broader. This misunderstanding creates a focus on ESG strategy and implementation, rather than on quantifying the costs of ESG risks relevant for the transaction.

Unfortunately, this confusion around terminology can lead to acquirers paying for irrelevant services. An ESG strategy, assessment of assets, or an endless list of nice-to-have policies and initiatives that could benefit the target will not provide the quantitative data the acquirer needs to assess and adjust the purchase price.

ESG due diligence providers without an understanding of the core purpose of due diligence can leave an acquirer lacking confidence in the valuation or uncertain about what they are acquiring.

The ESG due diligence process

ESG due diligence aims to identity red flags and quantify any material risks to the transaction. Like financial, legal, commercial, or technical due diligence work streams, it is a company-specific risk assessment of areas impacting the success of the transaction.

An ESG due diligence should include:

  • Identification of issues that the acquirer should immediately consider because they are potential deal breakers (red flags)
  • A desktop or abbreviated materiality assessment that identifies the aspects of interest for the due diligence
  • Identification and quantification of material environmental, social and governance risks
  • A light analysis of competitors to assess how urgent ESG should be to the target
  • A degree of verification of truth, determined through site visits or stakeholder interviews
  • Limitations to the scope based on what other due diligence work streams are performed, which prevents overlap

As with any other due diligence stream in a transaction, the methodology for conducting the ESG due diligence is fixed. What differs for each company is the scope of work and input needed.

Unfortunately, ESG input is often immature or less prepared than the input from more traditional due diligence streams. This incomplete or immature information can reduce the buyer’s ability to accurately value a target and confidently engage in the deal.

Choose the right ESG due diligence service provider

Choosing the right ESG due diligence service provider is the best way for acquirers to ensure a relevant, useful, and accurate due diligence process.

Consider these questions when assessing an ESG due diligence service provider:

  • Does the scope of the planned work reflect that the provider understands our business and industry and elicit confidence in them?
    Confidence in the provider and their ability to identify ESG issues that are material to the company is the basis of any due diligence provider relationship. Providers should be able to give insight into their awareness of major industry or business-specific areas that require extra attention during the due diligence process.
  • Does the provider have any due diligence experience from transactions?
    It is important that providers understand the purpose of due diligence and the scope of other due diligence work streams to prevent overlaps, share findings, and maximise the value for money. If the provider takes a siloed approach to ESG due diligence, the acquirer may end up paying for analyses that are also covered by a technical, commercial, or HR due diligence.
  • Does the provider have a holistic approach, or are they specialised in E, S, or G?
    ESG due diligence requires an initial holistic approach that allows adaptation to the company’s circumstances. For example, providers specialised in environmental risks may not be able to adequately assess risks within S or G that are increasingly receiving attention from investors.
  • Does the provider have the financial skills to accurately quantify the financial effects of ESG risks?
    Many ESG providers come from corporate social responsibility, communications, or environmental backgrounds and may not have the needed financial skills to convey their findings in financial terms. Due diligence requires a provider who can quantify the financial value of findings and understand the implications on the purchase price.
  • Does the provider have experience writing due diligence reports?
    Due diligence reports must follow a commonly accepted format. They include specific sections like the basis of preparation, business overview, sections for executive readers, and more. Due diligence providers must have strong written communication skills, but also work within the accepted standards for due diligence reports.

ESG due diligence impacts sellers, too

Although the due diligence process is often a buy-side effort, a comprehensive understanding of what acquirers and investors look for is important for sellers, too. Owners looking to exit their business should keep in mind that ESG due diligence is specifically about quantifying the financial value of ESG risks, and their exit preparation should align with this goal. When considering or receiving external support to prepare for or complete a transaction, consultants who understand the specific financial focus of ESG due diligence will be better able to identify potential concerns, prepare responses, and support owner priorities.

Better ESG due diligence is worth it

A strong ESG due diligence provider has an understanding of both ESG and M&A, and will not only identify relevant ESG risks, but also aim to quantify their financial implications. Choosing a provider who brings financial expertise and can navigate the ESG due diligence process alongside other due diligence streams facilitates informed decision-making and helps acquirers to feel confident in their acquisition.

Are you frustrated with past ESG due diligence experiences and looking for something better? Reach out to learn more about our work with ESG due diligence.

Are you thinking about an exit and unsure if ESG preparation is necessary? Read more about our exit preparation and ESG services, or contact us for a confidential consultation.

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