PwC: Quantifying the factors that drive value creation
The process of creating value from M&A transactions starts well before a purchase agreement is signed.
By PwC
By Nicolas Bourdier, US Deals Sustainability Leader, Principal, PwC United States
For dealmakers, the process of creating value from M&A transactions starts well before a purchase agreement is signed. It begins at the screening and valuation processes and continues during due diligence, when deal teams hunt for risks and opportunities by assessing the commercial, financial and other operational aspects of a target company. Today’s savvy deal teams also make sure to include sustainability matters in their assessments – and identify the corresponding financial value that’s at stake.
Why? Because they know that the financial returns from a deal can be protected or enhanced by careful management of matters such as energy efficiency, physical climate risk, supply chain resilience, waste reduction and carbon emissions. And they understand that assigning value to these business issues during the diligence phase helps them determine the right purchase price and build a sound, detailed value-creation plan. Private equity (PE) firms in particular use this diligence approach to improve exit multiples within their relatively short holding periods.
In practice, analysing the financial implications of sustainability topics during the pre-deal phase involves certain challenges. Deal teams seldom have as much access as they’d like to the target company’s data – and the data they can obtain may be incomplete. What’s more, teams normally have just one or two weeks to determine which sustainability topics among many may be financially material and to estimate how much value the team might protect or create by addressing them. But if they persist through those challenges, M&A practitioners can gain an edge. Consider that one-third of PE executives surveyed by PwC said that sustainability factors were a primary driver of value creation in more than half of their organisation’s recent deals.
Successful dealmakers we know use a focused, pragmatic approach in estimating and assigning potential value to sustainability matters even within the constraints of pre-deal due diligence. Combining information on the target company with materiality frameworks and firsthand insights on customer preferences as well as peer companies’ practices and performance enables teams to rapidly identify those sustainability matters that are likely to have significant financial impacts. They also use industry benchmarks to fill gaps in the available target company data. The result: better financial estimates that inform their bids and their value-creation plans.
Finding deal value by focusing on sustainability
The business rationale for looking at sustainability topics during due diligence is consistent with traditional diligence approaches. One reason is to highlight business risks and opportunities that are specific to the target company. These should include risks and opportunities resulting from the shifts in industry structures, customer needs and regulations that could occur as climate change alters the way we live and work.
A second reason is to ensure that the financial forecast used to price the deal adequately considers costs and benefits – both those associated with the target’s planned initiatives and those arising from sustainability matters that the business has yet to address. These factors inform the decisions that acquirers must make about whether to pursue the deal and, if so, how much to pay for the target company. The following examples, all from companies we have worked with, illustrate just some of the material sustainability factors that due diligence has revealed in practice.
Cost-effective sourcing. Due diligence helped one PE firm assess a company that had set a goal for sourcing a certain portion of its energy from renewable sources – yet hadn’t established a clear plan for how it would achieve that goal. Knowing that stakeholders would expect the company to fulfil its energy pledge, the firm set out to gauge the financial impact of procuring renewable energy in the target’s main operating regions. The firm estimated the target company’s energy needs, greenhouse gas emissions and operational costs associated with renewable energy procurement. This analysis enabled the firm to develop a strategic energy plan for its holding period.
Physical climate risk. A second PE firm, in considering whether to acquire an electric vehicle charging business, observed that floods, storms or other physical climate hazards might hit the charging stations, damaging the equipment and interrupting service to customers. In order to estimate the financial impact of such incidents, the firm used climate models and GPS data to figure out the location-specific likelihood of harm to each charging station under multiple scenarios. It then tallied the potential repair costs and revenue losses for many years into the future. The firm concluded that climate hazards probably wouldn’t cause significant financial drag while it owned the charging business. But the analysis also anticipated that the hazards would impose a steeper financial cost in subsequent years – steep enough to reduce the selling price the firm could seek for the charging business at exit. This led the PE firm to adjust its bid accordingly.
Revenue growth. For a third PE firm, due diligence highlighted a revenue growth opportunity at a target company whose business was distributing specialty building materials and construction products. Some of the target company’s vendors offered products made fully or partly from recycled materials (e.g., 100% recycled paper, gypsum board with 10–20% recycled content). However, the target had yet to begin tracking which products offered specific sustainability attributes, highlighting these attributes to its customers, or educating customers and employees about the benefits of using sustainable products. During due diligence, the PE firm determined that the target could drive top-line growth if it conducted market research, identified products with sustainability attributes and marketed those products to sustainability-conscious customers.
As these examples suggest, there’s a third reason for looking at sustainability factors during due diligence, beyond assessing the risks and costs: It can help prioritise initiatives and associated investments for the post-close period. Improvements in energy efficiency and other post-close actions may require upfront investment before financial benefits can be realised. Similarly, retrofitting a factory to withstand heatwaves, storms and other climate hazards carries a cost – but it can more than pay for itself by preventing downtime. Buyers should therefore determine how to sequence sustainability-related actions to yield the greatest financial returns. Early assessment also helps potential investors identify sustainability matters that will benefit from further analysis after the deal closes.
Four enabling practices
Leading firms are finding that pre-deal analysis can help them do a better job of forecasting and managing the financial impacts of sustainability factors. Experience suggests that the following four practices, when conducted during due diligence, enable dealmakers to gain insight on the link between sustainability initiatives and value creation.
Build a storehouse of industry knowledge. Savvy practitioners don’t wait for a potential transaction to learn which sustainability issues they may need to consider as part of due diligence. They build up their knowledge ahead of time, paying particular attention to industry-specific standards, research (both academic and corporate) and databases. These sources can provide helpful estimates of the financial impacts of various sustainability factors. For example, dealmakers looking at a target that produces substantial volumes of solid waste may find it helpful to know typical waste-generation metrics by industry and typical waste-disposal fees in particular geographies, so they can assess whether the target’s waste generation creates a financial risk or an opportunity.
Focus on a small selection of factors. A deep storehouse of industry knowledge also helps dealmakers home in on the specific sustainability factors that will most likely have a material effect on each target company’s financial forecast. The sustainability agenda, after all, covers a wide range of topics. Only a subset of those topics might be considered financially material to a given company, based on the nature of its business, the locations where it operates, the extent and composition of its value chain, and other attributes. Leading practitioners therefore take a selective approach to their pre-deal analysis, considering a target company’s industry, geography, size and nature of operations to filter a long list of sustainability topics down to those with meaningful, measurable costs and benefits for the target.
Monitor sustainability-related regulations and incentives. The ever-changing regulatory landscape means companies may face unexpected compliance costs and have access to new incentives. Sustainability-related regulations may require a target company to measure and report more aspects of its own performance, or monitor the conduct of organisations in its supply chain – both of which involve understanding multiple obligations and coming up with efficient ways to address them. One PE firm we know found that because of such regulations, a target company would likely need to make substantial investments in new capabilities and assets. Many companies also stand to benefit from green incentives, such as tax credits; these too are worth estimating as part of due diligence.
Be pragmatic with financial estimates. M&A practitioners know that performing due diligence is an exercise in coping with scarcity of time and of information. After identifying the sustainability factors for which they wish to quantify financial impacts, leading practitioners ask the target company to supply relevant data, such as metrics on energy or water consumption, GHG emissions, waste generation, or risk exposure. At the same time, practitioners use their established storehouse of industry knowledge to fill gaps in the sustainability, operating and financial data provided by the target – for example, by taking an industry average for emissions per unit of revenue and using it to find the target’s approximate GHG emissions. A disciplined estimation of financial figures enables management to make informed decisions, while avoiding the false precision of pinpoint projections.
Successfully adopted, these four practices can help dealmakers round out their due diligence with well-grounded estimates of the financial impacts associated with sustainability topics. They can also lay a foundation for productive discussions in the post-close phase, helping buyers prioritise the sustainability investments that will create the most business value.