PRI study highlights the increasing materiality of ESG issues in M&A of private equity portfolio companies

  • Poor performance on ESG factors has prevented a deal, or the willingness to do a deal, according to two thirds of those that took part in the survey.
  • Poor performance on ESG factors has also lead to reduced valuations and is often used as a tool to negotiate on price.

LONDON, 10 January 2013 – The United Nations-backed Principles for Responsible Investment (PRI) Initiative commissioned PwC to conduct a survey to assess the attitudes of trade buyers of private equity companies to evaluating environmental, social and governance (ESG) risks and opportunities in their M&A activities. It found that over 80% of companies had reduced the valuation of an acquisition target or not gone ahead with a deal because of poor performance on ESG factors, while 75% said poor performance in this area had prevented a deal from taking place.

Sixteen corporate buyers from a range of sectors, including Alliance Boots, Centrica, EDF and Xstrata, were interviewed on the following issues: integration of ESG factors into the due diligence process; integration of ESG factors into M&A price, sale and purchase agreements (SPA); and integration of ESG factors in the post-acquisition period. The majority of these companies had made between one and three acquisitions over the previous two years.

James Gifford, Executive Director of the PRI Initiative, commented:

“This report shows why ESG considerations should be a fundamental part of any private equity dealmaking process and how they can affect not only whether a deal happens but also its price. Today, trade buyers are an important exit route for private equity investments and Limited Partners (LPs) are better able to influence fund terms – including seeking commitments on ESG management and reporting from their General Partners (GPs). The PRI has seen growing interest from PE companies in ESG issues and now counts over 150 GPs and more than 130 LPs as signatories. The recent decision by private equity group Cerberus Capital Management to sell its investment in gun manufacturer Freedom Group following the tragic Sandy Hook school shootings in the US underscores the increasing influence of LPs and the growing materiality of ESG issues on investment risk, return and reputation.”

Key findings from the report include:

  • ESG factors can affect the likelihood of a deal occurring. Two thirds of respondents said poor performance on ESG factors had prevented a deal from taking place, or affected their willingness to do a deal. A third of respondents said they believe good performance on ESG factors adds to the reputation and brand of a company. 
  • Poor performance on ESG factors can have a significant negative impact on deal valuations. Over half of respondents said they would expect a discount for poor performance on ESG factors, which can impact the value of a company in a number of ways.    
  • ESG factors are sometimes used by trade buyers as a lever in the sale and purchase agreement (SPA) to negotiate downwards on price. Over 80% of companies have included ESG factors in a SPA. Trade buyers may include draft ESG-related indemnities and warranties that they know ultimately cannot be delivered by a GP seller who may be keen to make a clean exit. These clauses are sometimes removed at the last minute in return for a reduction in price. 
  • The cost and difficulty of bringing a target company up to the trade buyer’s standards with regard to managing ESG factors is a significant consideration in the deal process. A number of respondents stated that if it appears to be too difficult or expensive to integrate a target company and bring it up to its own internal standards on management of ESG factors, their willingness to do the deal would be seriously impacted. 
  • ESG factors are increasingly important in M&A activities. Companies realise supply chain risk is no longer confined to reputational damage associated with labour standards or the environment. Increasingly, they see operational risks linked to changing weather patterns and natural disasters (e.g. flood and drought) as a threat to business continuity and want to understand them better. 
  • Companies are developing a more systematic approach to ESG due diligence. The survey found a general trend towards the standardization and formalization of the ESG due diligence process. However, this is affected by the size and location of the deal and the sector concerned. 

A full copy of the report can be downloaded from the Publications page.

Principles for Responsible Investment

The United Nations-backed Principles for Responsible Investment Initiative (PRI) is a network of international investors working together to put the six Principles for Responsible Investment into practice. The Principles were devised by the investment community. They reflect the view that environmental, social and corporate governance (ESG) issues can affect the performance of investment portfolios and therefore must be given appropriate consideration by investors if they are to fulfill their fiduciary (or equivalent) duty. The Principles provide a voluntary framework by which all investors can incorporate ESG issues into their decision-making and ownership practices and so better align their objectives with those of society at large.