By Alistair Lester, Global Co-CEO of M&A and Transaction Solutions, Aon

It’s an extraordinary time for dealmakers. The M&A market is on track to hit a record $6 trillion by the end of 2021, the capstone to a year that has seen records broken on a quarterly basis. “Turbocharged” is the word you often hear, and it fits. But in this frenzy of activity, there are, as always, risks. Private equity firms mulling a purchase should of course closely analyse a target company’s financials, but there is, in today’s M&A environment, something else to pay attention to: ESG.

Also known as environment, social, and governance⁠, ESG has come to play a significant role in M&A transactions in recent years. According to a recent survey, 60% of corporate and PE investors have dropped a potential investment after learning of ESG issues at the target. With shareholders and regulators ramping up scrutiny of ESG practises, this should come as no surprise. In fact, it is my sincere belief that in 2021, ESG is now equally important to financials when it comes to M&A due diligence. A failure to properly assess a target’s ESG could spell disaster further down the line.

The many risks of inadequate ESG

There’s a school of thought that writes ESG off as a nice extra—as, merely, do-gooder stuff, great to have but not essential. This, it should go without saying, could not be further from the truth. In fact, quality research has demonstrated beyond a shadow of a doubt that profitability is strongly correlated with ESG. An engaged, diverse workforce, for example, is a good thing in and of itself⁠—but it is also an established marker of profitability.

And that’s not even to mention the environmental aspect. To take on a business is to⁠—invariably⁠—take on its future carbon emissions, and their potentially astronomical costs. Any model that neglects to take these costs into account will almost certainly generate an inaccurate picture of future earnings.

There is also the fact that an inadequate ESG process might leave a company open to ruinous post-transaction litigation. The rise of ESG has, perhaps inevitably, been accompanied by a rise in serious ESG-related litigation. For this reason, it’s essential that buyers understand any ESG-related commitments on the part of a target company, as well as the progress (or lack thereof) that the target company has made in fulfilling those commitments. If, for instance, management has publicly promised an increase in employee diversity, and subsequently have failed to live up to that promise, there is a real risk of litigation. 

Transparency on the part of the target company is, in this and every other respect, crucial.

Defining ESG parameters from the beginning

So, we’ve established why ESG matters. The next question is: how can buyers ensure that their ESG process is as good as it can be?

One important step on that front: defining pertinent ESG issues as early as possible. There are dozens of separate and interrelated issues at play under the broad heading of ESG, from energy use to pollution levels to working conditions to shareholder transparency (and many, many more). Not every one of these is going to be relevant to a given firms’ inquiries. By winnowing down their areas of interest at the very top of the process, buyers can ensure that their resources are put to good use, while avoiding overwhelming sellers with ultimately irrelevant requests.

To that end, for sellers, an ESG officer is crucial⁠—it’s no surprise that the field has grown substantially over the last 20 years. Companies with dedicated ESG officers are far better-equipped to hit the ground running when a potential buyer comes calling. 

Why cybersecurity matters when it comes to ESG

ESG is a living, breathing thing: the issues that constitute it evolve with the culture, and new areas of emphasis spring up constantly. While not precisely a new concern, it is undeniable that cybersecurity has entered the first rank of ESG issues in recent years. The list of companies that have suffered serious reputational hits because of hacking scandals is long and ever-growing. Increasingly, companies are realizing that data security is inextricably tied to the public welfare: dealing with, for instance, sensitive customer information comes with a real degree of social responsibility. No proper ESG process can neglect this component.

The risks here are, of course, massive.  What if a target company’s connection ports are vulnerable? What if its sensitive data is floating around for sale on the Dark Web? Investigating these issues well in advance of an acquisition⁠—using the many excellent tools at buyers’ disposal⁠—can prevent serious future issues.

What due diligence looks like in 2021 and beyond

As part of a recent report, I spoke with corporates, PE firms and advisers to get a clearer sense of how ESG is changing the face of M&A. Synthesising their guidance, I’ve arrived at three key insights. First, a laser-focused approach is essential, especially as assets and vulnerabilities have evolved. Second, cybersecurity⁠—as mentioned⁠—absolutely must be fully integrated into day-to-day enterprise risk management. And third, ESG is not a short-term endeavour: assessing it from a five-year perspective allows companies and investors to get ahead of risks, take advantage of new sources of revenue, and, of course, maximise future returns.

Dealmakers who keep all of this in mind⁠—who attack ESG assessment with thoroughness and vigour⁠—will be doing their future selves a tremendous favour.