Quantifying ESG strengthens valuations in mergers and acquisitions
18/06/21
Responsible investment
The fact that improving ESG (environmental, social & governance) factors in companies can lead to risk reduction and value creation is hardly news. Recent mergers and acquisitions have shown that companies with a clear ESG label can count on a lot of interest and are sold at high multiples. But how can this value be substantiated and quantified, so that ESG can be a measurable factor in investments, mergers and acquisitions?
PwC's valuation expert Manoël de Goeij talks about the link between responsible investment and financial criteria such as cash flows and cost of capital, and PwC's research into this: 'In our view, ESG factors will in many cases have to be given a permanent place in company valuations. We have already started to quantify the often qualitative ESG factors and are constantly refining our models'.
ESG factors require attention
Societal topics, good corporate governance, CO2 reduction and circular entrepreneurship, Black Lives Matter and modern-day slavery resonate in the business world. ESG factors demand attention, influenced by more critical consumer behaviour and increasingly stringent laws and regulations. ‘In fact,' says Manoël de Goeij, 'since the corona pandemic, the call to speed up measures to improve the climate and social conditions has become louder. The transition to sustainability alone affects all sectors worldwide and will lead to value creation and destruction on a scale not seen before.'
Global Private Equity Responsible Investment Survey
De Goeij, who works as a valuation expert in mergers and acquisitions, particularly in the financial sector, has noticed that the importance of responsible investment is also increasingly recognised by investors such as banks and insurers, pension funds, private equity houses and corporates on the acquisition path. In PwC's Global Private Equity Responsible Investment Survey 2021, the trend is crystal clear, says De Goeij: 'Responsible investment based on ESG factors is becoming mainstream. And value creation, alongside risk management, is increasingly emerging as the main reason to start working with ESG.'
Creating value in six areas
De Goeij sees six areas where value is created under the influence of ESG:
1. Revenues can grow for companies that pay attention to ESG factors: they reinforce brand value, reduce the risk of future disruption and find access to new markets, customers and sources of income.
2. Costs can decrease, for example through lower energy consumption and water use, and productivity can increase, by attracting and retaining talent that cares about ESG and through resilient supply chains in which the risks of, for example, child labour and environmental damage have been reduced.
3. Continued compliance with changing legal and regulatory requirements provides strategic freedom to do business and potential access to subsidies and government support.
4. Capital expenditure in line with ESG goals can be made for the longer term and therefore may lead to a better result.
5. The cost of capital can decrease because the risks are reduced and also because there are more and more attractive financing options for sustainable activities, such as green bonds.
6. A strategic premium also seems to partly explain the high multiples paid in some sectors for companies with a strong ESG label. Through such an acquisition, a buyer can strengthen its position and reputation in the market, especially if the buyer itself still lags behind on ESG. The competitive pressure created by the strong interest in ESG companies also contributes to driving up the multiple.
Deliveroo
Asked where the link between ESG and value can lead, De Goeij points to the dramatic course of the recent IPO of meal delivery company Deliveroo. This company opened thirty per cent lower on the stock exchange after two British investment companies pulled out just before the IPO. The reason was said to be the poor working conditions of the delivery couriers and the negative publicity about this. Here we saw a badly judged social factor translated directly into loss of value.
Discounted cash flow method
In principle, the impact of ESG can be taken into account in the two classic valuation methods, namely the discounted cash flow method (DCF) and the multiples method. The DCF method, which is more often used by corporates, leads to a valuation after the future cash flows have been mapped and discounted with the cost of capital. PwC has started to consider the influence of ESG factors in the DCF valuation models. De Goeij: 'We can reflect the impact in the five areas - revenue, costs, compliance, investments and cost of capital. In order to provide insight into how much the specific ESG factors contribute, estimates are made depending on the sector and other specific business circumstances. Of course, this is not always easy, but in a growing number of situations, a valuation without including ESG will no longer give the right answer.'
'Responsible investment based on ESG factors is becoming mainstream. And value creation, alongside risk management, is increasingly emerging as the main reason to start working with ESG.'
Cash flows
De Goeij talks about the research carried out by PwC to substantiate the above: 'Our literature review of more than fifteen scientific studies shows that in almost ninety per cent of these studies there is a correlation between ESG measures and cash flows. A manufacturing company, for example, will probably face a discount on its valuation for the expected costs of CO2, while a comparable company that structurally reduces CO2 emissions can count on a premium. A clothing company with production facilities in Asia can count on a discount if working conditions are poor, or on a premium if the social conditions in the entire chain are well under control. And an international company that practices fair tax payments may eventually receive a higher valuation than a company that relies on tax avoidance routes, even though the latter will have a lower tax burden in the short run. With the increasing understanding of the links between ESG and financial value, valuation experts will be able to sharpen their models more and more.'
Cost of capital and risk
De Goeij says that PwC's literature research also shows that ESG factors have a clear impact on the cost of capital. In over 90 percent of the 30-plus studies we reviewed, the cost of capital falls when ESG measures improve. In another study we conducted ourselves, we see the same correlation in the majority of sectors, namely that strong ESG policies lead to a lower beta - a measure of risk - just as poor policies lead to a higher beta.'
'Since the corona pandemic, the call to speed up measures to improve the climate and social conditions has become louder. The transition to sustainability alone affects all sectors worldwide and will lead to value creation and destruction on a scale not seen before.'
Multiples method
In the multiples method, commonly used by PE, the valuation is determined by multiplying the earnings with a multiple based on prices observed in the stock market or in private transactions for comparable companies. De Goeij: 'We are seeing more and more market data indicating that the multiple increases with a higher ESG score. With each transaction in which ESG is explicitly reflected in the valuation, we can further refine our multiples method. We follow this development with great interest.’
Better price in transactions
Investors, such as private equity houses and corporates that make acquisitions or divestments, are looking for ways to include ESG in the financial valuation of transactions. De Goeij: 'A selling party who is able to make the positive value of ESG in the company explicit can ask a higher price. And buyers who identify the risk and opportunities of ESG in advance can pay a more competitive price. As noted earlier, ESG currently also seems to be a factor that can lead to strategic premiums. With the rising importance of ESG, we see that its value is also increasingly being incorporated into transactions. The recent acquisitions in, for example, the renewable energy segment are illustrating this.'
Combining financial and non-financial metrics
PwC worked with an aerospace and defence company to determine the business value impact of certain ESG initiatives. PwC also helped a large energy company to optimise its resource allocation by combining financial characteristics with ESG factors in a single value system. De Goeij: 'Combining financial metrics with non-financial factors is the route to a valuation that does more justice to the new reality of ESG. Now that ESG is increasingly being used to create value, it will be reflected more and more in the valuation of mergers and acquisitions.
