Why and how investment firms should consider integration of ESG factors in due diligence as value creation
Alternative asset managers face a rapidly evolving industry driven by investor trends and increased regulatory complexity. Regulators around the world are imposing new standards in terms of due diligence, transparency, sustainability risks and climate scenario analysis.
In addition to an increasing investor demand for sustainable or ESG-compliant products, alternative investment firms now recognise the necessity to adapt for new opportunities and to be able to mitigate not only their risks but also their impacts.
Beyond the consideration of risks and impacts, we will see how due diligence is increasingly becoming a driver for value creation and a backbone for the ESG strategy.
The ESG due diligence as a tool for mitigating material-related risks
The regulation has given a huge responsibility to financial market participants to address sustainability risks beyond the fact of wanting to be ESG or not. The Sustainable Financial Reporting Directive (SFDR) and the Alternative Investment Fund Managers Directive (AIFMD) now compel financial market participants to consider their sustainable risks.
Understanding the risk profile and exposure of a target company or a portfolio has become a basic requirement for transparency before the creation of any value. Indeed, if risks are not managed efficiently through due diligence a company opens itself to potential short-term and long-term risks.
In this case, due diligence is a crucial additional step in the acquisition process which gives the investor the possibility to minimise ESG material risks that could impact both the acquirer and acquiree’s reputation and increase financial liabilities.
However, adopting ESG due diligence to manage and mitigate material-related risks allows only to maintain the value of an investment, leaving it with the risk of seeing its value erode in the long term.
ESG due diligence as a driver to create value
On the other hand, with the double materiality, the integration of the principal adverse impacts (PAI) and sustainability preferences in the regulation, we have seen more and more asset managers and investors using due diligence.
It is being used not only to assess the material-related risks, but also to avoid any negative impacts and create value while having a positive impact.
Firms putting ESG and sustainable investment at the heart of their strategy will be the ones avoiding value erosion while simultaneously creating value.
Alternative investment funds are progressively more aware of the importance of ESG in due diligence as a means to mitigate material related risks but also as a value-creating and potentially exploitable opportunity. This will also be the objective of the new Corporate Sustainability Due Diligence Directive (CSDD) which will require large entities in Europe and with operations in Europe to assess and mitigate their risks and impacts.
In this sense, we see more and more due diligence processes done by asset managers on assets to position them or assess their potential for either reducing the negative impacts or creating a positive impact on people and/or the planet.
It will also be the objective of the new Corporate Sustainability Due Diligence Directive (CSDD) whose objectives will be to require large entities in Europe and with operations in Europe with and without high risk sectors to mitigate their adverse impacts in order to reduce the externalities on people and the planet.
Investors and asset managers are using due diligence with the goal of introducing thresholds or setting clear objectives aligned with the vision and the strategy implemented by the funds and being able to see their potential in terms of sustainability.
PwC’s 2021 Global Private Equity Responsible Investment Survey found indeed that 66% of survey respondents rank value creation as one of their top three drivers of responsible investing. Concurrently, 49% of respondents integrate material ESG issues into their commercial assessment of investments.
Regarding the question “How does ESG create value?”, we see that the following drivers are pushing the market
1. Regulations imposing new rules as reduced carbon costs for example.
2. Investors wanting to not only minimise the financial risks on their operations, but also create value for selling assets which reduce their impacts on externalities. In this case, the premium will be larger depending on whether the assets mitigate their negative impacts or create a positive impact.
3. Employees increasingly wanting to belong to companies that are sustainable. It is now proven that companies that are more sustainable improve retention and have lower recruitment costs.
4. Customers having an impact on the volume sold and on the price of goods and services of companies perceived as more ESG conscious.
The ESG due diligence as a driver for exit and M&A transaction
We are seeing that more firms are identifying value creation opportunities to manage their portfolio and ultimately deliver a better investment at exit or in the context of an M&A transaction.
Up to now, and in most of the cases, ESG and mainly sustainability have been largely underestimated as a value creation lever. The traditional “buy and sell” strategy in private equity still has not required ESG factor integration as the financial value was not influenced by the integration of such considerations.
However, with the drivers mentioned above pushing the market of alternative investments firms substantially, firms will certainly consider more and more ESG factors as “value levers”. ESG, and above all sustainability considerations, are garnering increased attention in due diligence processes as it becomes a catalyst for transactions.
Conclusion
To summarise, the integration of sustainability risks with the consideration of negative and positive impacts through the due diligence process will help reduce uncertainties and maximise both shareholder and stakeholder value. By having balanced and optimal financial returns in combination with risk and impact considerations they can create a “green” or “rainbow” premium while positively impacting the planet and people.
This will, without any doubt, increase the capital value thanks to a strategy based on sustainable transition and will answer the main objective of the European Union to push capital towards sustainable investments. Strong due diligence processes will be critical for firms to achieve this objective.
