Evaluating Opportunities in ESG Due Diligence

To kick off our series of ESG insight and guidance, former Anthesis Executive Director Don Reed explores ESG opportunities in the diligence phase.

Risks Vs Opportunities

A significant proportion of private equity financial due diligence involves identifying the risks associated with a target company, so acquirers know what they’re getting into. Environmental, social and governance (ESG) due diligence typically focuses on risks in the same vein, but what about ESG opportunities?

It’s easy to say opportunities are just the flip side of risks but this truth can also lead to laziness in ESG due diligence.  The risks are easier to identify and assessing the degree to which they are mitigated is done by comparing existing and best practices in risk management techniques.

Opportunities are mirror image, but they require something more.

A Hypothetical Case Study

Let’s take the example of a packaging company that specializes in serving the health and beauty segment.  Packaging is a big part of the impact of their customers’ products, and most leading health and beauty consumer goods companies have public commitments on reducing their impact. Even more of these companies want their consumers to believe that they’re on the same side.

The ESG risks include; chemicals of concern in packaging, product safety, end-of-life disposal, recycled content, recyclability, supply chain, worker dignity, and more.  What are the companies’ practices for identifying and managing these risks? Do they have policies in place? Governance to ensure that the policies are followed?  A track record of compliance and beyond?

Evaluating opportunities requires a somewhat different lens.

This starts with improving the operational efficiency of the company’s buildings, processes and practices based on a thorough analysis of energy, water and material use as well as waste.  In our example, we’d expect to find energy efficiency improvements in the industrial processes the company has control over, with attractive rates of return as well as options to improve material efficiency, turn some waste into product, and reduce waste costs.  There are, however, potentially more strategic options with greater financial implications.

What are the packaging company’s capabilities to develop and bring to market solutions that lower the overall footprint of its customers’ products, including consumer end-of-life? Do they know where key customers are heading in terms of customer sustainability commitments with which they could help, through packaging that delivers life cycle benefits?  Have they sold these attributes before? Do their key clients put a value on such lifecycle benefits?  Do they innovate on sustainability attributes?  What about capabilities to use sustainability product attributes to create consideration among prospective clients and win them over?

3 Points of Assessment

To fully assess the ability of a target company to capitalize on opportunities like this, one has to:

• Formulate a point of view about how the company’s markets, key customers and key prospects will change on their desire for ESG attributes over the investment horizon.
• Evaluate the target’s current capabilities and readiness to capitalize on these changes.
• Assess the potential for the target as-is and with improvements to grow, based on the successful execution of sustainable product strategy.