ESG and deals: 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.