The concept of environmental, social, and (corporate) governance – popularly known as ESG – has been gaining traction among many investors in recent years. Institutional investors, individuals, Strategic Buyers, and PE firms are all getting on board. It’s become a serious factor in deal-making in the M&A world.
The idea is that the societal impact or sustainability of a company, how it does business, and the products it produces must be considered before investing. In some cases, these so-called “non-financial” factors (which actually have a lot of financial relevance) are given just as much, or more, weight than potential returns.
ESG could cover how the company is reacting to climate change, their use of natural resources, their production of hazardous waste and how they dispose of it, or how they treat their workers and manage their supply chains.
It also includes issues around the running of the company, like transparent accounting practices, the diversity of the board of directors, engaging in illegal or unethical business practices, inappropriate political lobbying, and that shareholders are involved in making decisions.
People today, especially younger investors, care about the pollution a company produces, the sustainability of its products, its use of renewable energy, and labor practices.
They’re increasingly investing not just with a return in mind but based on their values. And the returns often follow because companies seen as rating poorly in ESG (say if they mistreat workers or regularly spill pollutants into the environment) in the minds of investors – not to mention consumers – can see their financial performance suffer.
It’s estimated that ESG investing represents about a quarter of all professionally managed assets globally. It’s increasingly seen as vital to assessing corporate risks, strategies, and operational performance.
In fact, a 2014 study by George Serafeim, Bob Eccles and Ioannis Ioannou (professors from Harvard Business School and London Business School) found that sustainable companies’ stock tends to outperform that of companies with low sustainability ratings.
ESG had its origins in a report by Ivo Knoepfel called “Who Cares Wins.”
Knoepfel, who coined the term and is founder and managing director of onValues Investment Strategies and Research, asserted that considering ESG factors when investing isn’t just the “right” thing to do for society, it actually leads to more sustainable markets. These criteria can also help investors avoid companies that are facing financial risk due to their environmental or other practices.
According to a report from Winston & Strawn LLP, how companies have responded to the threat of the COVID-19 pandemic has recently become a key ESG criteria. As they put it:
“COVID-19 has highlighted that companies face much more than just financial market risks, and the failure to take due consideration of such non-financial risks and related ESG factors could spell disaster.”
The Winston & Strawn report highlighted five ESG considerations public companies must address:
- More robust disclosures and transparency with stakeholders (customers, suppliers, employees, shareholders) regarding contingency planning and crisis management.
- Use of ESG rating systems to see how companies are performing on these indicators and how they compare to competitors.
- Sustainability planning and reporting, including whether there is a long-term strategy to account for marketing disruptions like climate change, pandemics, and other “market shocks.”
- More diverse supply chains, including the increasing use of more local suppliers and redundancies so that resources don’t dry up in times of crisis. (Think of the lack of face masks early in the pandemic.)
- The ability to support their workforce in times of crisis, including work-at-home programs, good medical coverage, and other support programs.
You’ve seen ESG in action. Whole Foods, for example, strives to drive global change in food by seeking suppliers that use organic items.
But ESG investing is not without its issues. An investment fund could maintain they are only making socially-aware investments, which is all fine and good until they discover that their most profitable investment is doing business with a rogue country or involved in the destruction of the environment.
What should their next move be? Divest their top performing holding?
Take CalPERS, California’s pension system for government employees, which has more than $400 billion in assets. It’s under pressure from activists to divest from fossil fuel companies, which are top performers.
Take away those investments and how will this massive fund pay out to all those ex-employees, their spouses, their kids, and others? It might not be financially possible.
Besides, the rules are always changing. What is environmentally friendly today might not be tomorrow.
So, it’s clear that ESG investing is not without its challenges. But going forward, PE firms, Strategic Buyers, and other deal-makers must keep it in mind when eying potential acquisitions. And not just because it “looks good” – it can have a real impact on the long-term success of a company.