ESG targets driving wave of M&A amid soaring valuations – advisors

02 June 2021

Sector-specific ESG targets are driving a wave of M&A transactions but valuations remain a point of contention across deals, with some multiples on specific ESG-focused targets sky-rocketing, according to several advisors.  


  • M&A used to improve buyers’ ESG record  
  • Corporate values and reputational expectations key to dealmakers’ decisions  
  • ESG-focused targets seeing sky-rocketing multiples  


Sector-specific ESG targets are driving a wave of M&A transactions but valuations remain a point of contention across deals, with some multiples on specific ESG-focused targets sky-rocketing, according to several advisors.  


There are two waves of M&A deals happening when it comes to ESG, said a corporate lawyer. The first sees buyers with a low ESG record targeting a business with high ESG credentials in order to improve the buyer’s ESG record. The second features assets that have not yet reached their full ESG potential being bought and improved internally. The latter is especially true for private equity funds entering the space, the lawyer said.  


As ESG factors have become a growing focus for companies and their investors, they have also increasingly become important value drivers for dealmakers, an M&A banker said. “ESG is more and more a strategic factor when it comes to M&A deals and motivates parties to transact or not,” said Philipp Beck, EMEA head of M&A at UBS.  


Corporate values, as well as reputational expectations, are key to dealmakers when deciding on mandates or when advising buyers on specific targets, the M&A banker said. These considerations are made at the earliest stage possible in the M&A cycle – “as soon as a buyer starts shopping around”, another M&A banker said.  


Boards are looking for opportunities to shine on ESG and companies can use M&A to help achieve their ESG targets, another banker agreed.   


Over recent years the market has also seen the advent of impact funds, which have strict investment criteria and a dedicated pipeline, said Liam Camburn, Transaction Services Partner at Deloitte.  


For private equity firms in particular, ESG factors are at the top of their agenda as they have investors who are required to disclose what exactly they invest in, the first M&A banker said. Others have bans on certain sectors such as oil or arms manufacture. Others again have preference for social and environment-friendly assets and invest only in these kinds of companies, he explained.  


Within financial institutions group, for example, ESG divisions have been growing and players have looked at ESG targets to improve consultancy services, a sector lawyer said.  


Dealmaking has also been increasingly driven by demand for ESG data, another M&A banker said, citing for example the acquisition of Sustainalytics by Morningstar [NASDAQ:MORN] and of ISS by Deutsche Borse [ETR:DB1].  


Moreover, players from emerging markets are looking for ESG assets in Europe, he said, pointing for example to Mitsubishi’s [TYO: 8058] acquisition of Dutch energy company Eneco.  


Special investment vehicles focused on ESG companies for instance in the electric vehicle and sustainable food spaces is another area that is poised to see increased activity.  


Aside from transition-related M&A affecting supply chains and inducing portfolio optimisation, the notion of stranded assets is also taking center stage, another banker said. Clients who might have business models becoming obsolete due to ESG issues in the next 10 years are focusing on innovation and repurposing to deal with the economic transition, the banker said.


Companies could consider spinning off their core business or some might go private to avoid public scrutiny, the same banker said. Companies will also likely form holding companies that carry high cash flow, high returns but a negative ESG record, according to the banker.  


This will also impact the cost of capital whereby, for example, high carbon emitters will have higher costs of capital compared to a business with low emissions, the same banker said.  


However, this is not a ‘one size fits all’ approach and a lot of ESG issues are systemic in nature which cannot be solved simply through M&A, the banker noted, adding that partnerships and consortiums will be formed to address how companies need to navigate ESG issues.  


High multiples and valuation assessment  


There is a current imbalance in supply and demand of ESG targets which is driving higher multiples, two of the bankers said, noting that well-managed companies which market themselves in a sustainable fashion gain a premium.  


In particular, targets in some specific sectors, such as renewable energy or biotechnology, are in high demand, therefore multiples of these kind of companies have jumped, one of them said.


For instance, there have been about 30 deals announced where the target was in the renewables sector over the past five years, according to Acuris data. Of these, 16 were undertaken over 2019, 2020 and YTD 2021. These deals were carried out at an average EV/sales and EV/EBITDA multiple of 14.1x and 15.2x respectively. This is higher than the average multiple over 2018 and 2017 in which deals were done at an average sales and EBITDA multiple of 5.4x and 13.1x each, Acuris analytics show.  


Sizable deals include KKR’s [NYSE:KKR] buyout of UK waste management company Viridor in 2020 for GBP 4.2bn, or 4.9x sales and 18.6x adjusted EBITDA. Other big deals include the squeeze out of Innogy by E.ON [ETR:EOAN] in 2020 at 1.2x sales and 18.2x EBITDA.  


Also, ESG investments tend to provide higher returns than non-ESG ones, one of the bankers said. That has triggered valuations being higher than before, partly because investors prefer these kind of assets and so the demand is higher. 


It’s hard to tell whether these higher multiples are due to a boom in the market or because their value is so high, argued Camburn from Deloitte. Currently, businesses with a strong ESG alignment command a premium against their peers, but this may over time shift to businesses with weak ESG alignment trading at a discount to their peers, he said.  


There are many different aspects to be considered in the M&A context: environmental, carbon reduction, social issues, health and safety, executive pay, tax strategies to name some highlights, said Phil Cheveley, EMEA co-head of M&A at Shearman & Sterling.  


“Naturally, the buyer of a business with a poor ESG profile will be concerned that there are costs associated with cleaning it up from an ESG perspective. Integration and remedial costs are high on the agenda,” Cheveley said. “Many buyers are willing to pay a premium for businesses with a good ESG profile. Reputation and negative publicity are also important, particularly for consumer driven businesses.”  


Companies are aiming to generate alpha around transition stories and therefore need to include sustainability to their core strategy, one of the bankers said. Greenwashing is a real risk and to a certain extent inevitable while transitioning but the market expects boards to take accountability and implement a set of metrics as a back-drop to increase transparency, according to this banker.  


However, valuation benchmark remains a major challenge as the future cost and value of ESG issues are still difficult to calculate, the corporate lawyer said.  


The big thing that’s missing is the connection between qualitative assessment and valuation,  said Vanessa Jakovich, a partner at Freshfields Bruckhaus Deringer. Some advisers are working on creating a model for that, she added.  


“At the moment, a buyer would have to look at both the transitional and physical risks associated with a business. The risks can be identified, for example, like the effect of climate on a shipping company, but they are difficult to model and to value,” Jakovich said.  


ESG is increasingly affecting the fundamental value of a business and becoming core to what a target is worth, said Fraser Greenshields, head of Corporate Finance, UK & Ireland at Ernst & Young.   


If an ESG strategy is not there yet, the company’s value will be lower with buyers looking at an asset’s ESG protocol and how that flows into projections of the target’s business, Greenshields noted.  


Regardless of the industry the target company belongs to, its underlying business will be affected by ESG considerations, he added.