Why ESG Due Diligence Is Important

why is ESG due diligence important
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Global ESG assets are on track to hit $53 trillion by 2025 — a third of global assets under management, according to a Bloomberg report. Environmental, Social, and Governance (ESG) factors are now key components of the process for investment decision-making and portfolio management.

Sustainable and socially responsible investing is growing significantly. However, at times it can be challenging for investors to know if a target company’s sustainability claims are legitimate since there are no standard criteria for designating these investments. This is why ESG due diligence is important.

What is ESG due diligence?

In today’s merger and acquisition (M&A) market, ESG due diligence can seal or break the deal. The way a target company handles ESG issues can affect its long-term performance and valuation. ESG due diligence provides data and insights into a company’s ESG-related policies, performance, risks, and opportunities.

According to Martec’s partner, Goby, the ESG Platform: 

  • Environmental issues can include pollution, exposure to extreme weather, carbon management, use of scarce resources, waste, water, land use, climate impact, and supply-chain management.
  • Social issues can include product safety, human rights, worker safety, customer data protection, gender pay gaps, and diversity, equity, & inclusion (DEI).
  • Governance issues can include factors such as accounting standards compliance, succession planning, anti-competitive behavior, a strong ESG management process, and consideration for executive pay, data protection, cybersecurity, and risk management.

ESG due diligence sheds light on a company’s controversial or illegal behaviors while providing insight into positive ESG practices. This information helps investors make sound investment decisions that support overall risk mitigation.

How does the ESG due diligence process work?

The ESG due diligence process should start early, ideally at the same time as other due diligence processes. Delaying the process could mean risks and opportunities for improvement might be missed or discovered too late.

Our buyer ESG due diligence assessments can provide the following:

  • Overview of how emerging social and environmental trends are likely to impact the company and its market
  • Market adjacency/white space analysis
  • Ethics and governance (behavior, business ethics, etc.) insights
  • Human resources and environment, health, & safety (EHS) data
  • Quality of products and services analysis
  • Comprehensive view of a company’s material ESG risks and opportunities
  • Benchmarking of the company’s ESG policies, procedures, and performance against peers and sector best practice (via Goby)
  • Insights into how the company’s ESG performance could affect its most valuable intangible assets including reputation, brand value, trust, and relationships
  • Recommendations on adjustments to the valuation

At the end of the ESG due diligence process, the investor or buyer should have a deeper understanding of the target company’s operations and ESG management, risks, and opportunities.

ESG due diligence best practices

When conducting an ESG due diligence review, it is important to note that there is no single standard that directs ESG evaluation. Given the short timeline of the due diligence process and since a target company may have a dozen ESG factors that could be applicable, it’s important to focus on ESG factors that are mission-critical to the company’s success. Ideally, the ESG review should be customized to the prospective investment based on its industry, product or service offering, and geographic reach.

Within the private equity industry, here are some ESG due diligence best practices:

  • Create a formal ESG policy. Developing an ESG policy provides documentation that can be shared with stakeholders and offers a guideline for the due diligence process, Goby advises.
  • Concentrate on ESG materiality. Goby also notes that not all ESG issues will apply to every company. Focusing only on the material ESG issues and risks relevant to the investment will provide proper due diligence.
  • Conduct supply chain due diligence. Even outside M&A context, an ethical sourcing review of a company’s supply chain is also advisable to reduce risk. Complex supply chains of multiple tiers, involving outsourcing and offshoring, require that organizations include both first-tier and lower-tier suppliers in their reviews.

Questions to ask when planning a review:

  1. Does the company have documentation of an ESG policy or goals?
  2. Has the company’s supply chain been evaluated for potential ESG risks?
  3. Does the company have documentation evidencing appropriate employee training, whistleblowing rules, and case management?
  4. How quickly can the buyer and target company integrate their operational models addressing ESG risk and compliance if the deal is closed?
  5. What’s the confidence level that post-acquisition the organization will be able to satisfy material ESG targets and deadlines?

Definitions

According to PitchBook, as sustainable investing continues to mature and generate greater interest from private markets, further definition of key concepts can bring clarification to the opportunities in this important space. See PitchBook’s ESG-related definitions below:

Sustainability: In the context of corporate sustainability, “sustainability” refers to the ability of an entity to consistently create and protect value over the long-term. For investors, that means less downside because risks are mitigated and a potential upside through capitalizing on relevant opportunities. In the context of social and environmental sustainability, “sustainability” refers to the support of human and ecological well-being, health, and vitality over time. Companies claiming to be focused on sustainability may mean the first, the second, or both definitions. Uniting the two definitions, “sustainable investing” is the umbrella under which ESG and Impact fall, with ESG heavily associated with corporate sustainability and both ESG and Impact tied to social and environmental sustainability.

ESG: ESG refers to environmental, social, and governance risk factors and value creation opportunities. ESG-aligned investing is concerned with both inward-facing and internal risks and opportunities and how they affect company performance. An ESG-oriented investor seeks to identify and mitigate material ESG risks and capitalize on value creation opportunities to improve returns. Every company experiences some degree of ESG risk exposure and value creation opportunity, regardless of how “clean” the company or industry may be. What differentiates weak, moderate, and strong ESG performance is how well the company has mitigated those risks and capitalized on ESG opportunities, as well as how it continues to do so. ESG comprises a vast variety of issues, including energy management, ecological impacts, data privacy and security, product quality and safety, labor practices, supply chain management, and business ethics.

Impact: Impact refers to the environmental and social influences a company has on the external world and is concerned with outward-facing effects on society. Impact investing seeks a double bottom line of positive financial returns and positive environmental or social returns. For some investors impact investing may involve accepting concessionary returns, although many Impact investors feel it is completely within reason to target market returns. Impacts can fall into a multitude of categories, including improving access to quality education, clean energy, gender and racial equality, the sustainability of agriculture or food systems, and waste management.

Greenwashing: Generally, greenwashing refers to branding around or claiming to “do” sustainability, whether through ESG, Impact, or other means, but not following through on the efforts stated or implied by those claims. Given the multiple approaches to sustainability, ESG, and Impact, policing those claims can be difficult. There is a suggestion to shift the definition to avoid penalizing differences in philosophies, which are abundant, and instead use the term more properly to call out inconsistencies, inaccurate information, and failure to follow through on sustainability commitments.

Find the full Pitchbook Analyst Note: ESG, Impact, and Greenwashing in PE and VC here.

Resources

In June 2021, to streamline frameworks, the International Integrated Reporting Council (IIRC) merged with the Sustainability Accounting Standards Board (SASB) to form the Value Reporting Foundation, which adopted the SASB Standards; i.e., a set of 77 industry-specific sustainability accounting standards.

The Global Reporting Initiative (GRI) is an international independent standards organization that helps organizations communicate their impacts on issues such as climate change, human rights, and corruption. See the GRI Standards.

The United Nations Global Compact Ten Principles frames coverage of human rights, environmental, and labor issues. This is not a reporting standard but a principles-based approach to doing business that, at a minimum, meets fundamental responsibilities.

In March 2019, Invest Europe published a comprehensive ESG Due Diligence Questionnaire for Private Equity Investors and their Portfolio Companies.

Bloomberg’s ESG Data offers ESG metrics and ESG disclosure scores for more than 11,800 companies in 100+ countries for over 410,000 active securities.

In summary, ESG due diligence helps mitigate risk and add value in the M&A context and beyond. Delivering insights that help investors make sustainable investment decisions is a practice area in which Martec is excited to be participating. For more information, please contact us.

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