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Laying the cornerstone for sustainability.
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At the start of the 2000s, private equity outfits discovered the concept of operational value creation for themselves. After buying a business, the temptation to increase its value by carefully tweaking its operational value chain and generating fat profits was simply too great. Nearly 20 years later, a new lever for increasing business value appears to be establishing itself – the ability of companies to successfully implement the required ESG processes.
Is ESG implementation measurable?
The concept of ability to implement a process indicates how well a process corresponds to the requirements placed upon it. With reference to ESG factors, this means that metrics have to be collected that make an increase in value measurable in a firm way. These metrics must meet various criteria. Firstly, they must be clearly defined to allow an accurate view. At the same time, they have to be sufficiently universal to be comparable as well as have a clear connection to the income statement, balance sheet or cash position, and thus to company value.
What complicates the matter is that ESG factors are split into a variety of aspects which affect business entities in completely different ways. While many ESG criteria are important from the transaction or valuation perspective, they are also relatively soft criteria that are hard to quantify. To transform them into measurable and trackable metrics is a great challenge for all the parties to a transaction.
Is the creation of value by ESG quantifiable?
A low level of ESG process capability predictably leads to a burden on earnings and liquidity. For example, production costs increase due to a rise in costs of fuel and emissions or because better packaging standards have to be observed for waste avoidance reasons. If these standards are not kept, this in turn leads to increased legal and consulting costs or costs that may be expected from the risk of legal action. On the other hand, planned expansion suffers because suppliers and customers move their business to competitors who conform more with ESG, or it suffers because it is more difficult to recruit skilled staff, for whom the employer’s ESG conformity has become highly relevant when looking for a job.
In the M&A process, it is precisely the opportunities that ESG brings, however, that highlight its potential for increasing value in the target business and that direct focus onto future improvements in earnings, which results in the business becoming the best in the relevant areas or even in all ESG areas. In this way, businesses that get to grips with this development early can be first movers and bring about an appreciation in value. In simple terms, quantification in the M&A process is conducted by deducting as costs the expenses that the company has to make in order to become the best in its class and thereby reducing future earnings until the status as best in class has been achieved. It is therefore indisputable that ESG factors have a growing influence on the value of the business. Whether this means that they are perceived as being a risk or an opportunity with respect to value depends on the maturity of the company’s ESG process capability and on the expected chances for improvement. One thing is for certain: ESG factors should be taken into account in investment decisions and in setting the purchase price. This involves identifying and evaluating the relevant ESG criteria for the target acquisition and for businesses comparable to it. The company’s relative process capability is to be assessed referring to these criteria.
Conclusion: Are there boundaries to ESG value growth?
The challenges regarding transformation that have to be overcome in some sectors due to the increasing significance of ESG criteria are massive. In many cases, there will be no alternative than to follow the new regulatory rules of play. Established business models are often under such pressure that companies have to play along if they do not want to be pushed out of the market in the medium term. At the same time, there is the opportunity to shake up entrenched structures and for them to find a new and better position in their industry. Current key topics in particular such as climate neutrality, digitalisation and cyber security as well as supply chain management harbour great risks to the value of businesses that remain inactive. But the good news is also that we all profit in the long term from improvements in these issues and that they open real opportunities for sustainable value appreciation in the M&A process.