Will ESG factors create or destroy value in your next deal? Six orange flags for dealmakers

Environmental, social, and governance (ESG) issues are transforming the way deals are being done. Just a few years ago, environmental sustainability and social disparities were largely the concerns of activist stakeholders and forward-thinking regulators. Now, these topics are maturing into a set of ESG due diligence criteria with important implications across the mergers and acquisitions (M&A) landscape, from raising financing to carrying out acquisitions, divestitures, and IPOs. As the due diligence conversation shifts from one purely about risk and financial impact to include a broader range of nonfinancial priorities and metrics, dealmakers need to get up to speed and update their processes with some urgency.

Consider an evolving concept at the forefront of many conversations: double materiality. This encompasses financial materiality (activity that has an effect on the company’s cash flows or enterprise value) and impact materiality (activity that affects either people or the environment, whether directly or indirectly). As seen in the integration of the UN’s Sustainable Development Goals into ESG standard setting, double materiality reflects a growing recognition throughout the global community that companies ought to account for their impact on society, not just their financial performance. In an M&A environment, it is being used to determine the potential risks and opportunities associated with a company’s strategy, operations, products, and services, as well as its entire value chain. 

In “pure play” ESG deals intended to capture value-creation opportunities that result from ESG trends—for example, buying a renewable-energy business—the acquiring company needs to perform due diligence on both financials and impact to ensure that the target has the right ESG-derived growth potential and credentials. But, as the examples in this article largely show, broader ESG concerns can arise on any deal, not just deals that are motivated explicitly by opportunities in this area. In dealmaking at large, a range of ESG factors are now responsible for preserving, destroying, or creating value.

Given their potential as value levers, ESG metrics are generating interest among dealmakers. Some private equity (PE) houses are using these principles as a brand differentiator and are making bold moves to integrate ESG into their investment thesis and process. They are seeking to transform the footprint of their acquisitions with an aim to attract sustainable capital—and a set of ESG-minded business owners who are willing to sell their businesses to them. And they are increasingly attuned to the impacts and physical risks posed by climate events. In addition, ESG due diligence has enabled savvy dealmakers to shine a light on likely problems that have been beyond the scope of traditional diligence frameworks. 

Insights drawn from a cross-section of recent deals speak to what we think of as ESG “orange flags.” Unlike red flags that stop a deal from happening, orange flags signal that dealmakers should proceed with caution—and must take careful steps to limit risk and enhance value. We have identified six orange flags across the M&A landscape: unethical marketing, reputational risks, high-risk supply chains, disengaged employees, transformational deals that don’t deliver on wider outcomes, and inadequate nonfinancial disclosures.

Unethical marketing

Unethical marketing is problematic for dealmakers, because it means messages are inconsistent with reality—they don’t align with regulation, stakeholder sentiment, or public positions taken by acquirers. When acquirers sought to buy a vocational education provider, their due diligence took a close look at public statements and found that certain claims about its courses and outcomes for students were wrong. In such instances, regulatory and other penalties can be factored into deal costs, a consideration that underlines the importance of casting a wider net on marketing claims. We see that such claims are related not only to environmental commitments, but increasingly to operations and governance. 

To manage value risks arising from marketing mismatches, it is essential to build a robust corporate control framework, covering compliance with applicable laws, regulations, and reporting requirements—especially those that are due to come into force. Diligence should also evaluate the strengths of processes and controls designed to prevent unethical claims from being made. Dealmakers need to be attuned to inconsistencies in public messages and the efficacy of products, especially in industries where marketing regulation is loose. For instance, words like clean and organic do not have an internationally agreed meaning throughout the cosmetics industry. Value may be enhanced in targets that achieve compliance with agreed standards at an early date and, conversely, may be damaged in targets that miss deadlines.

Reputational risks 

The reputational risks linked to ESG performance are not new. As has been well established by recent high-profile “greenwashing” accusations in the corporate world, failures to meet regulations, internal targets, and stakeholder expectations can lead to negative attention, knocks to consumer and client confidence, and loss of revenue. Forward-thinking diligence on reputation involves gaining a more robust understanding of a firm’s value proposition in terms of market focus and potential, and verifying a wider set of ESG claims. It’s worth examining what competitors are emphasizing most. Is it, for example, their green credentials, their diversity, or other principles aligned to their value proposition?

Reputational due diligence can also be helpful at revealing and addressing deeper issues at a company. ESG can provide a framework—and sometimes the air cover—to handle potentially thorny issues that fall outside standard diligence. In one recent deal opportunity, an acquirer learned about legal issues surrounding sitting members of the target company’s executive committee. By homing in on social and governance issues via due diligence of employee views and organizational culture, dealmakers assembled information that helped them decide to move executives out of the business. Because they were able to rectify governance issues, the sponsors were able to continue with the investment and achieve outcomes in line with their ESG commitments.

High risks in supply chains 

High risks in supply chains are emerging more frequently, as wars, conflicts, and trade tensions persist across global routes—and these risks are heightened by threats from physical climate events. However, the demand for diligence around contracts and the formality of supply chain relationships is growing. Modern slavery, health and safety, and labor rights have also grown in importance, alongside continued awareness of the sourcing of raw materials (as we explore in a recent PwC podcast about sustainable supply chains). For example, due diligence on the supply chain of one apparel manufacturer revealed issues with factory conditions, including subpar health and safety, and poor air quality. To address these issues, parties agreed to raise operating standards in factories and to pursue environmental, health, and safety initiatives. The costs of these measures were factored into deal valuations, and a legal framework was written into the deal terms stipulating that workforce obligations—including further improvements to working conditions—would be taken up by the seller.

Buyers are also looking at the stability of supply chains, with some investors taking steps to add resilience when they recognize geopolitical and ESG vulnerabilities. A firm exploring the acquisition of a target in the sports market learned through supply chain due diligence that roughly 80% of the target’s manufacturing was done at only two factories. That finding revealed a challenge the otherwise successful company had in keeping up with demand. Other social and governance orange flags cropped up related to the factories’ host countries and global trade tensions. Getting the deal done involved establishing five-year plans to diversify and build resilience in the target’s supply chain, and, further, to align the company’s sourcing footprint with its social and governance credentials.

Disengaged employees

Employees, who are often an important voice for the legitimacy of a company’s ESG credentials, continue to be a critical asset at the center of most deals. And workforce issues, such as evidence of disengaged employees, are gaining prominence in M&A. Greater scrutiny of governance, employee development and retention, workforce diversity, and equal pay are now more likely to be factored into diligence. Dealmakers are increasingly looking to diagnose staffing losses through specific assessments of social and governance issues, examining areas such as company culture and employee satisfaction, including input from staff surveys and one-on-one interviews. If an acquirer’s talent practices cause workers in the target company to leave, that destroys value. On the other hand, if an acquirer can impart its good talent practices to a target with subpar talent management, it can create more value. (A PwC study in the US showed that 86% of employees prefer to work for a company that cares about the same issues they do.) One company looking at a target where turnover was higher than the industry average estimated that it could achieve an incremental cost savings of up to US$8 million per year by investing in social factors, such as staff engagement, to bring the target’s employee retention rate up to industry averages.

Orange flags can also crop up because of issues that may not have been part of past workforce diligence, such as staff development. In industries like healthcare, where skilled technicians and professionals are difficult to recruit and retain, dedicated investment, good governance, and a supportive company culture are often critical for learning and development. Acquirers know this, and so they are paying careful attention to the impact of talent management on deal valuation. One acquirer of a healthcare company, for example, chose to have senior stakeholders at the target pledge support and investment for development programs serving junior staff as a way of improving retention.

The transformative deal that isn’t

The challenges to delivering sustained ESG outcomes as a society are large and complex. Dealmakers have an important role to play in ensuring a Just Transition by balancing complex trade-offs among social, economic, and environmental issues with carbon-reduction goals. The opportunities for venture capital and PEs are well understood, given the appetite to help portfolio companies reach sustainability goals and to invest in new and high-growth business models supporting the ESG transition. But progress brings risks, if outcomes are overpromised or underdelivered. As we navigate toward a low-carbon world, technological disruption is generating enormous upheaval, challenging the strategy of companies, their business models, and how they operate. 

Against this backdrop, the nature of dealmaking is changing, from largely static to proactive plays. PwC research shows that climate tech funding in 2022 accounted for more than 25% of all venture spending and investments.

Players that can manage this disruption through heightened due diligence around “future proofing”—for instance, early planning for carbon taxes, cash grants, and other environmental initiatives—will be best placed to protect and create value while making meaningful contributions to a Just Transition. They will maximize their impact materiality, in addition to their financial materiality.

Take the creation of “green jobs” as part of the wider Just Transition. In OECD countries that are undergoing a construction and infrastructure boom and will drive global spending in this area, the construction workforce is predominantly male. As the energy transition occurs and roughly 20 million new green jobs are created, more green jobs will likely be filled by men than women. Without intervention, the gender mix in the green workforce could be even more imbalanced than in today’s labor market.

When dealmakers incorporate ESG into their decision-making, it can go a long way to changing the mindset across an industry. However, achieving ESG outcomes is a collective challenge—these goals won’t be reached with a single deal. Although meeting stakeholder expectations for performance is still the main goal for many dealmakers, the most forward-looking among them are exploring how they can incorporate an ESG agenda to boost both impact and financial materiality.

Inadequate nonfinancial disclosures

What is reported and what is not is an ongoing issue, as is the transparency and validity of data. For dealmakers, inadequate nonfinancial disclosures are an important orange flag. We’ve noted that some companies are reporting physical climate risks and the impact these will have on their businesses as part of their nonfinancial disclosures. However, in some cases they have used climate scenarios that are unrealistic and perhaps favorable to their business. A recent PwC survey showed that 87% of global investors think corporate reporting contains unsupported sustainability claims. Certainly, inadequate disclosures create regulatory or reputational risk. But if an acquiring company fails to envision that a high-warming scenario would create serious physical risks for a target, or an accelerated-decarbonization scenario would create significant transition risks, it could miss out on a lot of value.

Ultimately, companies will need to disclose more information, as stakeholders demand greater transparency and regulatory thresholds are heightened. But in the meantime, dealmakers who see orange flags around disclosures will be wise to value targets under multiple ESG scenarios. 

Dealmakers have known for some time that external ESG issues can influence a company’s ability to create value. Now, the most forward-thinking players are also recognizing that a business’s impact on the world can be material, and they are creating accountability, often at the board level, for such impact. By incorporating an orange flag process to highlight concerns related to both financial and impact materiality, dealmakers will be better positioned to unlock value and create resilience through their M&A.