During the course of 2012, companies across the globe invested in excess of US$2.2 trillion in mergers and acquisitions (M&A) activity1. As well as putting vast amounts of money and a company’s reputation at stake, considerable management time is needed to complete and meet transaction goals.
Although there are a significant number of M&A success stories, there are perhaps a disconcerting number of transactions that fail to deliver on their initial promise. Common reasons behind such shortfalls include cultural mismatches, post-acquisition integration problems, and the failure to identify, anticipate, and manage risks.
Some of these risks fall under broader sustainability considerations (for example environmental, social and governance factors - often referred to as non-technical risks), which have yet to become a systematic component of transaction processes. For example, the World Economic Forum’s Global Risks 2013 Report cites challenges such as water supply crises, rising greenhouse gas emissions, and failure of climate change adaptation in its top five risks2.
Although most deal teams routinely consider “traditional” environmental risks and liabilities (eg subsurface soil and groundwater contamination), and some have evolved to investigate limited health and safety factors, this is no longer enough in a world where sustainability and profitability are becoming materially linked. Neither is just having a sustainability and/or Corporate Social Responsibility (CSR) reporting program. In our experience, such sustainability considerations have not quite made their way into the companies’ transaction processes and CSR reports don’t always cover the most material sustainability issues that need to be considered as part of a transaction, for example additional capital expenditure requirements to meet new regulatory requirements or impact of water scarcity in operating regions.
ERM estimates that less than 20 percent of companies consistently and systematically consider broader sustainability issues and opportunities as part of their transaction processes.
This statistic implies that even those companies with the strongest sustainability track records can potentially impact their progress with a poorly evaluated investment, which could in turn undermine shareholder value and the company’s overall reputation.
For example, one company in the mining sector had to shoulder in excess of a US$80 million write-down on an acquisition after climate impacts in the form of low precipitation and drought conditions meant it could no longer rely on the hydropower needed to run its new energy-intensive site. Unfortunately, this regional environmental risk was not taken into account during the due diligence process.
Extending the Sustainability Scope
To minimize risk and maximize return from their investments, companies need to extend their due diligence to include broader sustainability factors across the value chain - from natural resource usage, biodiversity and product stewardship to supplier culture, working conditions and community issues. This evolution – and it is evolutionary as opposed to revolutionary – is illustrated in the following diagram:
Given a constantly evolving business landscape subject to both heightened regulatory control and stakeholder requirements, past performance and precedent is no longer a good indicator of future impacts. By making an incremental investment in forward looking risk management and opportunity identification, companies are now identifying new untapped pockets of value creation. For example, a recently acquired chemical manufacturing facility relied on river barges to transport its finished products. During the due diligence process, when the deal team considered how low river levels caused by drought might prevent the facility from continuing this mode of transport, the estimated financial impact topped US$10 million. By identifying this issue during the due diligence process, the buyer was able to put in place an appropriate contingency plan to manage this risk post-transaction.
Given these challenges and opportunities, some progressive companies are undertaking a strategic review of their investment processes - some of which were designed many years ago - to ensure the scope and approach for transactions addresses current requirements and future issues.
In ERM’s experience, these holistic reviews can help companies identify areas for improvement, which can in turn minimize the material value erosion risks that can be caused by past or present sustainability issues.
Hardwiring broader sustainability considerations into transaction processes and building the capability of M&A teams means that sustainability risks and opportunities can be effectively and efficiently addressed in the context of a transaction.
It’s important to remember that sustainability is not always a ”risk play”. For many companies, it is also an opportunity for new products and new revenue streams or operational cost savings; factors that must also be considered when evaluating the viability of a merger or acquisition.
Balancing Risk with Return
Assessing performance across a broad environmental, social and governance agenda admittedly adds cost and complexity to the transaction process, especially if there is limited information available from the target company.
Given the potential material consequences of not being aware of and proactively addressing such issues, investment in additional due diligence is often well worth the effort. For example, by identifying the potential water supply constraints associated with a chemical manufacturing plant being acquired by a client, ERM was able to help the acquirer undertake an appropriate level of due diligence to prevent business disruption (which had the potential to cause multi-million US$ impact) and also factor in a CapEx investment of US$1.5 million as part of its bid.
To help accelerate the due diligence process and manage costs, there are sophisticated screening approaches, including ERM’s proprietary External Factors Review process, that capture and consolidate information from a range of public sources to provide an initial sustainability snapshot of an individual company or site. In subsequent stages of the transaction or when a company has exclusivity, a more in-depth and rigorous assessment can be undertaken to follow up on these initial material findings.
As well as enabling clients to “de-risk” acquisitions, this information can be used to support divesture and other strategic activities. For example, ERM helped a global oil and gas company ensure non-technical risks became part of its due diligence process for not only acquisitions and divestures but also expansion into emerging markets and geographies. As a result, the client has been able to reduce its exposure to financial, operational and reputational risks, which had the potential to cause value erosion in the order of billion dollars across its portfolio, and maximize long-term value of its assets.
By providing greater disclosure on sustainability issues at exit stage, backed by facts and data, and demonstrating active management of such matters, companies can also protect the value of the asset being sold while reducing transaction timelines and proactively addressing buyers’ concerns.
Total Portfolio Stewardship
Whether a company is acquiring, merging or selling, they need to ensure that sustainability – that is, the components of sustainability that are material to the business – remains a priority throughout the lifecycle of the transaction.
Although due diligence will initially be focused on evaluating the viability and liability of an investment, it can and should also be employed to drive long-term business performance improvement, which will result in a steady stream of environmental and sustainability success stories over time. Best accomplished during 100-day planning and post-transaction integration programs, ERM refers to this approach as Total Portfolio Stewardship.
ERM’s recent experience proves that clients can effectively leverage the sustainability-related information captured during the evaluation of a deal to develop short, medium and long-term plans for driving better business performance results. In particular, the information can help newly acquired companies make environmental, social and governance improvements and align interests and expectations.
The due diligence process can also unlock new opportunities, such as identifying innovative product and service lines or centers of excellence to drive operational improvement and ongoing cost reduction programs, such as energy and resource efficiency.
As sustainability increasingly becomes part of ”business as usual”, companies need to ensure that the same level of rigor and the same systematic approach are applied to this stream of transaction due diligence as other core areas of the business.
By evolving due diligence at the initial transaction stage and casting a wider sustainability net, companies can ensure they make the right investments to drive their business forward while safeguarding their sustainability credentials, maximizing their shareholder value, and elevating their brand.
Contributions from: Rosie Brown, Adinah Shackleton, Jeff Gibbons and Jaideep Das
(2) World Economic Forum, Global Risks 2013 Eighth Edition