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From criminal case to data breach, ESG risks increasingly moving the dial in Aussie M&A

Australia was shocked when news broke earlier this month about a former Queensland childcare worker being charged with 1,623 child abuse offences against 91 children. Few would expect that to impact M&A, unless you are preparing to sell or buy childcare assets.

At least two large childcare businesses are expected to hit the market this year – Partner Group’s Guardian Childcare and Education and Quadrant Private Equity’s Affinity Education. The two would attract both strategic players and financial sponsors, as reported, with local media previously suggesting core-plus infrastructure investors could look at Affinity.

In light of the recent news, however, core-plus investors especially Australian super funds are not likely to touch childcare assets now, as they would try to avoid any potential exposure to such reputational risk, said a banker familiar with the situation.

Not just reducing the buyer pool, environmental, social and governance (ESG) risks are increasingly moving the dial in the dealmaking process in Australia and, if not sink a deal, could affect deal structure and valuation, M&A practitioners told this news service. They suggest a bespoke approach is needed to address such risks.

ESG matters must be addressed at a very early stage in the deal process, said Corrs Chambers Westgarth’s Head of Corporate and M&A Sandy Mak. “It (ESG) has been accelerated to stage one of due diligence, along with commercial due diligence and valuation, just showing how important it is to the potential success of a deal,” she said.

Make or break the deal  

A recent study by KPMG shows that 74% of the M&A practitioners surveyed have ESG considerations as part of their M&A agenda. Deal cancellation was the most common consequence of a material finding during ESG due diligence, 53% of US and 66% of investors in Europe, Middle East and Africa said.

Meanwhile, a separate global report “M&A Risk in Review 1H 2023” by Aon in collaboration with Mergermarket found that almost all, except 2%, of the survey group said that they have turned down one or more deals due to ESG concerns in the last 12 months.

Australia-specific statistics are not available, but the country witnessed a high-profile case of investors applying ESG lens to influence the outcome of an M&A transaction last year.

AGL Energy [ASX:AGL] (AGL) abandoned a proposal to split into AGL Australia and Accel Energy via a demerger in response to shareholder pressure, including from tech billionaire Mike Cannon-Brookes’ private investment firm Grok Ventures that urged the company to retire coal assets earlier and move faster to renewables.

An ESG-focused lawyer said he suspects that the rate of deals being cancelled for ESG reasons would be “in the order of 5-10% at most”, while most deals still get called off due to typical reasons, such as strategic fit, price, conditionality, timing etc. Having said that, “there’s no doubt that ESG due diligence is becoming more and more a standard part of every deal,” the lawyer said.

Indeed, a variety of stakeholders, including regulators, investors, and employees, are paying greater attention to how ESG factors have been considered in the investment lifecycle, said Laurence Heselden, Aon’s Director M&A and Transaction Solutions based in Sydney.

“Regulators are demanding disclosures at much greater granularity, investors are demanding greater transparency and employees also want to see commitments matched by actions,” he said.

Risk vs opportunity 

With the evaluation of a company’s ESG profile increasingly included in M&A due diligence, ESG due diligence is much more than “a box ticking exercise” and must be designed to both understand the risks and to identify value opportunities, according to Corrs Partner Andrew Lumsden.

“Some buyers use ESG due diligence as a tool to protect existing ESG portfolios that require certain ESG thresholds to be met in any new deal. Others see ESG as an opportunity for value add and value creation,” he noted.

Aon’s Heselden agrees that there is no “one-size-fits-all” approach to ESG due diligence as it needs to be tailored to the specifics of the project, the sector, geography and ESG maturity. “For one target, this may be the carbon footprint and the credibility of net zero targets; for another, it may be the labour standards and human rights in the supply chain that may pose a more material risk,” he said.

In the case of private equity (PE) investors, they are now more likely to conduct an ESG screening in the investment lifecycle and to carry out a more in-depth ESG assessment at the point of due diligence, Heselden continued. 

A Sydney-based PE dealmaker said ESG is being discussed in about one-quarter of his current portfolio companies, and “it is definitely easier for companies to raise capital if they tick ESG criteria”.

Some Australian PEs are more actively building out their internal ESG capabilities to assist portfolio companies in addressing ESG vulnerabilities during the holding period and also to use a company’s ESG practices as a lever for value creation and growth, Heselden said.

For example, Quadrant Private Equity earlier this year hired Adrian Cullen from Woolworths Group [ASX:WOW], where he was Head of Sustainability, to a newly created role as Head of ESG. Curren will further develop the PE firm’s ESG strategy as well as to manage ESG risks and implement initiative across its portfolio, Quadrant said at that time.

In the listed space, companies are paying more attention to ESG considerations and those failing to do so risk seeing investors walk away, said Ali Ukani, who is responsible for corporate and ESG advisory at Melbourne-based fund manager Peak Investment Partners. Sydney-based fund manager Alium Capital has gone so far as to create a due diligence questionnaire (DDQ), "with lots of questions around Scope 3 emissions", which it sends to companies as part of its initial analysis, Partner Rajeev Gupta said.

Cyber included?

While ESG traditionally refers to environmental, social and governance issues, there has been a global call to integrate ESG and cybersecurity, including a policy brief published on the Harvard Law School Forum on Corporate Governance in September 2022 discussing how Nasdaq can implement cybersecurity into its ESG Reporting Guide.

Cybersecurity is an easy “fit” into governance, often dictated by legislation and regulatory requirements. Moreover, the advent of technology that allows asset owners and operators to remotely control and extract performance data from operational sites has created the ability for cybersecurity to have an environmental impact as well, such as remotely turning on/off of valves and pumps or changing chemical dosages, according to Heselden.

Cyber risks must be assessed diligently during the M&A due diligence process, as the failure to identify a cyberattack will put the buyer’s own systems at risk when completion of the transaction occurs, Corrs’ Lumsden noted. 

According to statistics by the Office of the Australian Information Commissioner (OAIC), five data breaches that occurred in the back half of 2022 impacted at least one million people. In March, Latitude Financial [ASX:LFS] was hit by a major cyberattack that affected 7.9 million individuals in Australia and New Zealand.

Challenges in ESG assessment 

When it comes to assessment of ESG matters, M&A dealmakers say they are still facing significant challenges in ESG assessment, especially as Australia is still catching up with more established practices in overseas markets such as EU.

Peak’s Ukani said ESG is still an opaque area, relying on voluntary compliance. The main issue is that, even at the macro level with countries setting targets for net zero emissions, for example, there are no repercussions if countries miss those targets, he said.

The PE dealmaker also said ESG is still a complex area in dealmaking because criteria are still being defined and there is still a lack of skills and measurement tools. The ESG-focused lawyer agreed that ESG due diligence is always a challenge due to the breadth of the subject matter while issues will differ substantially depending on considerations like the sector, relative ESG positioning of the buyer and target, and nature of the deal.

The lawyer acknowledged that Australia is moving ahead with ESG practice, especially with the Treasury consultations around climate-related financial disclosures ongoing and ASIC, the corporate regulator, taking actions against greenwashing.

ESG will have a more material impact on dealmaking once there are universal standards and more transparency, Ukani said. “It's still an area of continuous development and we are learning as we go,” he said.