How Sustainability Helps Shape the M&A Due Diligence Process
Discover how incorporating sustainability issues into the M&A due diligence process can influence valuations and uncover potential risks.
Key Takeaways
Incorporating sustainability issues into the M&A due diligence process is now standard practice in public and private market transactions.
Financial, reputational and regulatory risks can arise from ESG issues that due diligence should seek to uncover.
Valuations and other deal terms increasingly depend on the results of sustainability-related due diligence findings.
Companies of all sizes are always looking to grow. They can do so organically by selling additional products or services to more customers and investing in research and development to create new products or services, or they can grow through mergers and acquisitions (M&A).
The appeal of using M&A to grow is clear: If the price is right, acquiring other businesses can be a relatively quick way of expanding market share, product lines, geographic reach or all of the above. The due diligence process in M&A deals allows potential acquirers to:
Understand the details of the target company’s financial condition and operations.
Identify the extent of value-creating synergies.
Understand any risks that may not be evident from publicly available sources before finalizing transaction details and closing the deal.
One aspect of due diligence is evaluating the target company's sustainability issues. Acquirers should ask: “Are there any material environmental risks, social issues like employee turnover or community relations, or corporate governance concerns that would cause us to adjust the value we assign to the target?” Given the significant financial implications such issues could entail, investors should expect management teams and boards to address them before establishing a final valuation.
C-Suites Endorse Sustainability in M&A Due Diligence
At its core, M&A is about combining entities so that the whole is worth more than the sum of the pre-M&A parts. That means finding ways to create more shareholder value than would have been realized if those entities hadn’t joined forces. Do business leaders believe environmental, social or governance (ESG) issues can meaningfully affect the price an acquirer should offer so that an M&A transaction will lead to value-creation?
A 2024 Deloitte survey of 500 private equity and corporate executives shows the answer is a strong “yes.” Well over half of the respondents use clearly defined metrics to address sustainability issues in M&A deal-making, a notable increase from a similar survey conducted two years ago.1
To quantify the perceived importance of sustainability in due diligence, Deloitte found that nearly 83% of M&A buyers surveyed said they would pay at least a 3% premium to acquire a company with solid ESG credentials, and 14% would pay 6% or more. About 67% of respondents said they would seek a discount of at least 3% if the target company’s ESG performance were weak, up from 36% of those surveyed in 2022.2
The 2022 Deloitte survey involved 260 C-suite, senior and mid-level leaders of corporations with at least $500 million in revenue. Two-thirds of those surveyed said sustainability risks were important or very important in M&A activity, while 32% said they had made acquisitions to improve their sustainability profiles.
Notably, the concept of a separate or siloed “ESG due diligence” process is giving way to a fully integrated approach. For example, decarbonization strategies in the acquiring firm and the target are evaluated for synergies, other possible collaborations and ways to reduce costs.
A recent survey by the Boston Consulting Group and law firm Gibson Dunn shows dealmakers increasingly consider sustainability factors in the due diligence process to support valuations and identify additional value-creation opportunities.
Among the survey respondents, 75% said they had seen deals over the past three years where significant ESG-related findings were identified through due diligence.3 The EU’s Corporate Sustainability Reporting Directive requires large companies doing business in Europe to disclose social and environmental risks, which would impact deals involving large target companies.
Due diligence focused on sustainability issues isn’t restricted to publicly held companies. Law firm Covington & Burling’s Sustainability Toolkit notes a KPMG global survey of private equity general partners in which 54% of respondents said they had reduced an investment bid after conducting ESG due diligence. In one example, a due diligence team uncovered environmental liabilities, poor working conditions, the potential for labor disputes and unsound board practices in the target company. The buyer reduced the price it was willing to pay by $10 million.
Conversely, favorable results for ESG-related due diligence can boost a valuation. In the same KPMG survey, 32% of respondents said they had increased a bid after conducting ESG due diligence.4
Including sustainability as part of due diligence isn’t focused only on reducing valuations. Acquisition candidates with a strong sustainability track record are perceived as lower-risk investments. They tend to have stronger relationships with stakeholders, better regulatory compliance and solid reputations, all of which help increase investor confidence and may support higher valuations from would-be acquirers.
Sustainability Issues That May Affect M&A Valuations
A thorough M&A due diligence process must go beyond analyzing publicly available records. This may involve walking through a company’s factories or stores, talking to its employees, suppliers and customers, or trying out its products incognito. It now also includes methodically investigating risks that could arise from sustainability-related practices. For example:
An acquisition target’s operations might be in an area becoming increasingly expensive or impossible to insure due to flood risk. Its factory might consume unusually large amounts of power, signaling inefficiencies that could be costly. If its production processes release toxic chemicals into the air or water, that could involve significant cleanup costs, legal penalties and reputational damage.
Problems with workforce retention could signal problems with pay policies or benefits, while poor community relationships or illegal labor practices across supply chains could result in strikes, boycotts or lawsuits. Bringing its practices in line with industry standards or regulatory requirements could impact the business model and valuation.
Inadequate corporate governance could lead to data breaches, discriminatory deployment of artificial intelligence tools, or inappropriate use of customer data, creating legal problems and reputational damage. A lack of commitment among senior management to upholding high ethical standards could create inappropriate interactions with employees or suppliers and may even conceal fraud.
Figure 1 summarizes the types of sustainability risks that acquirers and M&A targets should consider.
Figure 1 | Sustainability-Related Due Diligence Should Cover a Range of Issues
Financial Risks | Reputational Risks | Regulatory Risks | Integrational Challenges | Human Capital Risks |
|---|---|---|---|---|
Companies with poor sustainability practices are generally seen as riskier, which can lead to lower valuations. | Acquiring a business with a poor ESG track record can harm the acquirer’s reputation with its customers, investors and the public. | An M&A target with a record of problems in its environmental or labor practices may lead to greater regulatory scrutiny. | An acquirer may need to make costly investments to raise a target company’s sustainability practices to its standards. | Companies with poor employee relations or bad governance may not have been able to retain talented workers, creating an adverse selection problem. |
Source: American Century Investments.
Details of Sustainability Due Diligence
In the M&A due diligence process, organizing sustainability-related concerns and opportunities for value creation into ESG categories is helpful. Issues that investors want acquirers and acquisition candidates to consider in each of them include:
Environmental
The environmental issues that a due diligence process should examine depend heavily on the target company's industry. For example, in deals involving manufacturing facilities, analyzing energy consumption, water use and waste management would be apparent areas that could present potential liabilities or offer opportunities for cost-savings that could create value through an acquisition.
A potential acquirer should consider how a target company’s operations impact the environment and how climate change might affect its business model and profitability with the increasing frequency and intensity of fires, floods, extreme heat and drought. For example, in the agriculture sector, revenues are highly exposed to climate change and agricultural producers contribute significantly to climate change. Understanding a target company’s mitigation and adaptation strategies in the face of these risks could mean preparing for a material increase in insurance costs or diversifying suppliers to address supplies of critical raw materials threatened by climate change.
Depending on the situation, due diligence might call for an environmental audit. While the extent of an audit varies, at a minimum, it would measure things such as emissions (including greenhouse gases and other pollutants), energy use and water consumption. If the target company needed to expand its physical footprint, how would these things change? Would the expansion convert land for use in a way that harms biodiversity and generates pushback? An audit can uncover potentially material risks the acquirer should consider in a valuation and seek to mitigate.
Social
The social component of ESG due diligence covers policies and enforcement of labor standards, non-discrimination, the right to organize, workplace harassment, meeting minimum wage requirements (some industries have a particularly poor track record in this area) and human rights, including the use of child or forced labor. Acquirers should also examine a target company’s health and safety track record.
In many countries, companies must report violations of these policies and standards, but that may not always happen. In the social component of ESG due diligence, it’s beneficial to “ask around.” Does the company have a reputation for taking care of its employees, or is employee turnover high? Is inappropriate behavior by supervisors or executives tacitly tolerated?
Governance
The governance component of due diligence should include reviewing corporate codes of conduct that cover anti-bribery, anticorruption and whistleblower rules. It should also assess whether the target has engaged in controversial or illegal activities that would violate the U.N. Global Compact, even if it isn’t a signatory to that agreement. How do the board and management respond to questions if an analysis reveals anything questionable? Does the company have the processes and expertise needed to protect customer data and manage other cybersecurity risks?
Any of these risks could negatively affect an acquisition target’s future financial performance, raising questions about its value and long-term sustainability. While many may seem like common sense, without formally evaluating these sustainability-related issues during M&A due diligence, they may be overlooked or ignored to get a deal over the finish line.
Impact on Deal Structure and Financing
Based on risks and opportunities uncovered through sustainability due diligence, a would-be acquirer may require changes before finalizing the deal, lower the valuation it offers to compensate for risks or even walk away from the transaction. Conversely, a target company with in-demand sustainability-focused products or innovative environmental technologies may attract higher valuations as it may help to capture market share and drive future growth for the acquirer. In other words, ESG factors have real consequences for M&A deals, as Figure 2 shows.
Figure 2 | M&A Transactions Can Be Modified to Reflect Sustainability Issues
Earn-out Provisions | Financing Terms | Integration Planning |
|---|---|---|
• Acquirers may require earn-out provisions as part of the deal structure to address ESG-related risks. | • Lenders and investors now consider ESG factors when evaluating financing for M&A transactions. | • Acquirers should plan how they would integrate their sustainability practices into the target company to ease the transition and anticipate any areas of friction. |
Source: American Century Investments.
Case Studies
While sustainability issues rarely cause a proposed M&A transaction to fail, they may increase an acquirer’s motivation to pursue certain deals, as these examples highlight:
In 2016, Total, a French multinational oil and gas company, acquired Saft Groupe, a French battery manufacturer, for $1.1 billion. The acquisition was heavily influenced by Total's strategic shift toward cleaner energy sources in response to the global push to reduce carbon emissions. Total viewed the Saft acquisition as an opportunity to diversify into the renewable energy sector, which allowed Total to enhance its capabilities in energy storage, which is essential to the broad adoption of renewable energy.
Also in 2016, Unilever acquired Seventh Generation®, a pioneer in sustainable product innovations. Seventh Generation’s products are designed with environmental and human health in mind. At the time of the acquisition, the president of Unilever’s home care division said Seventh Generation was “leading the industry in sustainable innovation while attracting new generations of conscious consumers,” and “the addition to Unilever’s product portfolio will help us meet rising demand for high-quality products with a purpose.”5
In 2023, Lennox, which provides energy-efficient climate control solutions, acquired Alabama-based AES, an HVAC and refrigeration company focusing on sustainability. AES offers HVAC recycling at each of its centers, and its AES Reclaim program provides the ability to reclaim assets through recycling at the end of their useful life. Lennox is “dedicated to sustainability and creating comfortable and healthier environments” while reducing their customers’ carbon footprints. It also views AES as “a strong strategic and cultural fit.”
Authors
Senior Sustainable Research Analyst
Sustainability: It’s in Our Genes®
Sustainability isn't just something we practice; it is part of who we are as a company and as global citizens.
Deloitte, “2024 ESG in M&A Trends Survey: Rising influence of ESG,” accessed August 21, 2024.
Jim Tyson, “Most M&A Buyers Would Pay 3% Extra for a Company with a Good ESG Profile,” CFO Dive, June 3, 2024.
Jens Kengelbach, Jana Herfurth, Dominik Degen, and Dirk Oberbracht, et al., “The Payoffs and Pitfalls of ESG Due Diligence,” Boston Consulting Group, April 18, 2024.
Covington & Burling, “Sustainability Toolkit: Key Considerations for M&A and Joint Venture Transactions,” accessed August 27, 2024; Tomas Otterström and Martin Viehöver, “Integrating Environmental, Social and Governance (ESG) Due Diligence Into Deals,” KPMG, 2018.
Rowena Lindsey, “Unilever Acquires Seventh Generation, Polishes Its Green Image,” Christian Science Monitor, September 21, 2016.
Sustainability focuses on meeting the needs of the present without compromising the ability of future generations to meet their needs. There are many different approaches to Sustainability, with motives varying from positive societal impact, to wanting to achieve competitive financial results, or both. Methods of sustainable investing include active share ownership, integration of ESG factors, thematic investing, impact investing and exclusion among others.
References to specific securities are for illustrative purposes only and are not intended as recommendations to purchase or sell securities.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
Many of American Century's investment strategies incorporate sustainability factors, using environmental, social, and/or governance (ESG) data, into their investment processes in addition to traditional financial analysis. However, when doing so, the portfolio managers may not consider sustainability-related factors with respect to every investment decision and, even when such factors are considered, they may conclude that other attributes of an investment outweigh sustainability factors when making decisions for the portfolio. The incorporation of sustainability factors may limit the investment opportunities available to a portfolio, and the portfolio may or may not outperform those investment strategies that do not incorporate sustainability factors. ESG data used by the portfolio managers often lacks standardization, consistency, and transparency, and for certain companies such data may not be available, complete, or accurate.