As consumers are more and more considering sustainability, environmental and social externalities into their decision making when buying goods and services, the business world is similarly adapting to changing principles. At first this demand originated from consumers, however, progressively more businesses are considering the impacts of their general business activities. Companies started to take account of their activities in the light of corporate social responsibility (CSR), with which they aim to be a “good citizen” of the overall society. CSR is judging the impact of activities on “all aspects of society, including economic, social, and environmental” (Fernando, 2021). In recent years these considerations are increasingly being used to not only assess business activities, but also investment choices. Consumers and businesses are looking for a way to invest consciously into socially responsible companies. To facilitate this trend a set of standards has emerged to allow screening of investment opportunities. The criteria are set into the categories of environment, social and governance (ESG) assessing how a company performs towards nature, its relationships with stakeholders and the governance of leadership, audits, and internal controls (The Investopedia Team, 2021).
From this the question arises if the inclusion of ESG criteria into decision making during M&A, the most significant investments activities of a company, brings any benefits or should the current standard remain status quo?
The inclusion of impact ratings, such as ESG, into the M&A decision making has been associated following the stakeholder theory, in which managers take into account “the interest of all stakeholders in a firm, including not only financial claimants but all those whore are affected by the decisions made by the firm” (Piperni, 2020). M&A deals are specifically under examination “because success highly depends on the approval of the firms’ various stakeholder groups” (Swiatkowski & Frey, 2021) This stands in contrast to the shareholder theory, in which focus is solely on maximising the firm’s profits (Piperni, 2020).
As more companies are shifting to a more holistic approach to sustainability and inclusion the importance of ESG is expected to further grow with intensive investor focus. Investment companies and funders are increasingly concerned especially about environmental factors (Franklin, 2021), as pressure from external groups and governments to act responsibly in this category is growing in the light of accelerated climate change and the resulting natural catastrophes. In surveys it has been identified that by now 70% of companies have an ESG policy and it is mostly based on the desire to do the right thing, although it is still unlikely that environmental, social and governance issues are to disrupt a deal altogether (Franklin, 2021).
The benefit to including ESG rating into the due diligence process is that companies can identify hidden risks and adjust valuation accordingly (Piperni, 2020). Thereby these efforts can reduce information asymmetry, increase transparency and in turn improve post M&A performance (Feng, 2021).
In some sectors (e.g. utility, mining and energy) ESG factors have been relevant for a number of years (Piperni, 2020), as companies within these sectors are under extensive scrutiny regarding their general business activities and impact on the overall society.
The increased transparency and reduced risks by the inclusion of ESG ratings also affects the prices paid and target/acquirer selection of companies during M&A activities. Research supports the view that bidders are valuing the ESG commitments of targets through identification of a positive correlation between the target’s ESG performance and acquisition premium (Pettinari, 2020) (Ung & Urfe, 2021). Furthermore, companies can improve their own ESG ratings through gaining ESG-related capabilities such as knowledge, culture, reputation, and stakeholder relations by merging with a high ESG-rated partner (Ung & Urfe, 2021). Thereby improving the ESG rating could be a motive itself for seeking the acquisition of or by a highly rated company (Ung & Urfe, 2021). These types of acquisitions gain greater support from all affected stakeholders (Swiatkowski & Frey, 2021). This even holds true in the case of a hostile takeover attempt as “target firms’ stakeholders are less likely to oppose the acquisition because of the potential increased reputation of the combined entity” should the takeover be attempted by socially responsible acquirer (Piperni, 2020).
However, studies show that not only the premiums are affected by ESG ratings but also the target and acquirer performance. It was identified that acquirers with high ESG ratings benefit through higher stock returns in the long-term and, on average, have positive and significant announcement returns when compared to low ESG rated acquirers (Piperni, 2020).
Furthermore, the difference in ESG ratings between the merging companies plays a significant role in the realised value gains through the transaction. Especially the “degree of ESG similarity between the acquirer and the target is a potential driver of performance” (Piperni, 2020). Although, as shown above, companies benefit from deals with a high ESG rated partner, higher dissimilarity of ESG ratings and company cultures between acquirer and target leads to significantly lower returns (Swiatkowski & Frey, 2021). Cultural distances between companies thereby also affect the implemented ESG policies and present a significant risk for deal failures, especially within the performance during post-merger integrations. The market is adjusting for the increased risks of M&A activities between culturally distant companies through reduced deal premia and the perceived lower deal synergy realization potential (Swiatkowski & Frey, 2021). This is supported by the findings that M&A activities between companies similar in culture and ESG rating showed significantly greater returns on average (Swiatkowski & Frey, 2021). Therefore, depending on desired results from the acquisition, companies should search for the acquisition target with the fitting ESG rating and policy to optimize returns and values gained from deal partners capabilities.
In conclusion ESG ratings can be a helpful tool as they “can be thought of as the systematic and quantitative measurement of a firm’s CSR practices and impacts” (Chen, 2021). The current trend of increased investor focus on ESG ratings will likely continue within the future. Findings from the studies have shown that ratings provide further transparency and thereby reduce risks due to reduced information asymmetry within M&A deals. Furthermore, it was shown that companies should consider their own and the targets’ ESG rating as higher company ratings do not always provide greater returns but choosing the strategically fitting ESG-rated target offers the greatest benefit.
Based on these research findings and our experience we therefore advise that companies should include ESG ratings and considerations early on within their M&A activities. It is best to think about the strategic goals of the planned deal and align the screening criteria for targets or potential acquirers according to needs regarding ESG. We support many clients in strategically choosing the right approach to their M&A activities to achieve the greatest returns on the pursued deals.
Chen, R. L. (2021). Bang for Your (Green) Buck: The Effects of ESG Risk on US M&A Performance. Durham: Duke University.
Feng, X. (2021, August 17). The role of ESG in acquirers’ performance change after M&A deals. Green Finance, 3(3), 287-318.
Fernando, J. (2021, September 04). Corporate Social Responsibility (CSR). Retrieved from Investopedia: https://www.investopedia.com/terms/c/corp-social-responsibility.asp
Franklin, J. (2021). ESG set to take larger role in M&A in 2020. International Financial Law Review.
Pettinari, N. (2020). Sustainable M&A: The value of ESG. Do bidders prefer to acquire or create sustainability? LUISS.
Piperni, C. (2020). Does ESG Affect Shareholder Value Creation? Evidence From The M&A Market. LUISS.
Swiatkowski, J., & Frey, F. (2021). Short-term Wealth Effects of Corporate Social Responsibility? – Empirical Evidence from ESG Ratings of Firms Involved in M&A Transactions. SSRN.
The Investopedia Team. (2021, March 05). Environmental, Social and Governance (ESG) Criteria. Retrieved from Investopedia: https://www.investopedia.com/terms/e/environmental-social-and-governance-esg-criteria.asp
Ung, T. A., & Urfe, M. N. (2021). ESG – Does it Pay in M&A? Bergen: Norwegian School of Economics.