Co-authored by Lee Dehihns & Jack Cox
Welcome back. In our most recent post, we looked into Hester Peirce’s recent comments about IOSCO’s call to action for more ESG reporting. This ‘Part 2’ blog will dive deep into some evidence about this topic.
A study from Sustainalytics took a sample of 231 M&As; within that sample “ESG compatible deals” outperformed “ESG incompatible deals” by an average of 21% on a five-year cumulative return basis. This suggests that ESG compatibility may have a positive contribution to the overall financial success of M&A deals. This information can be incredibly useful for investment banks that are supporting M&A deals. It is possible that ESG factors can be used to weigh risk in M&A deals moving forward. The cumulative returns of the study suggest that returns in ESG compatible deals could outweigh returns from ESG incompatible if a longer amount of time has elapsed since the original deal.
A collaborative survey from Principles for Responsible Investment (PRI) and PricewaterhouseCoopers (PWC) suggests that strong ESG factors can increase the likelihood of an M&A deal getting done. Furthermore, poor performance on ESG factors can impact the valuation of an M&A deal, whereas strong performance on ESG factors does not usually facilitate a premium for valuation. PWC believes based on their survey that ESG due diligence will continue to develop in scope and in importance. This can be illustrated by the fact that 63% of surveyed companies think that there has been a large increase in the influence of ESG factors in transactions in the last three years, and that 75% of surveyed companies believe that there will be an immense increase in the influence of ESG factors over the next three years. This information is relevant as it shows an increased need for due diligence in order to quantify the financial performance of ESG factors.
ESG factors could be relevant in brokerage activities. A report from J.P. Morgan took a quantitative approach to see if ESG can enhance an investment portfolio. There takeaway was that present ESG factors in a portfolio can reduce volatility, increase Sharpe ratios, and prevent large losses during times of market stress. This was concluded from various regression analyses comparing ESG indices to regional MSCI indices around the world. In fact, J.P. Morgan ran regressions with ESG combinations from ACWI (quality, dividend yield, PMOM, and low volatility); the results were excess returns of 1.7%-3.4% from the years 2007-2016. This could be incredibly useful information for custodians and brokerage firms offering products, particularly to institutional investors.
Barclays investigated the impact of ESG factors on bond performance. Barclays gathered data from both Sustainalytics and MSCI. High-ESG portfolios have outperformed low-ESG portfolios on average by 0.29% per year and by 0.42% per year over the past seven year for Sustainalytics and for MSCI respectively. Positive governance factors had the greatest impact on returns from both Sustainalytics and MSCI. Although, ESG score providers may use different methodologies, this data suggests that management quality and a long horizon can benefit bondholders.
Besides being informative in the investment decision-making process, some ESG criteria and related risks could have a material impact elsewhere and should be disclosed. For example, picture a retail filer that has a single supplier that supplies all the inventory for said retailer’s stores. Imagine if that supplier is subject to a worker health and safety issue at its only factory in Bangladesh (for example, explosions or a building collapse), or if there were a substantial cost increase in shipping due to compliance with greenhouse gas regulations or severe delays from extreme weather. These are specific ESG criteria/risks that should be disclosed, and are more than just “nice to have.”
In short, ESG criteria is incredibly relevant. Both issuers and investors can get a better grip for their financial making decisions with this information. It appears that Hester Peirce does not understand the current landscape of ESG reporting criteria; she should not shy away from IOSCO’s suggestions.
Thank you for reading! Moving forward, we will have some posts on specific deals that have been impacted by ESG factors.
 “ESG Compatibility: a Hidden Success Factor in M&A Transactions.” Sustainalytics, 29 June 2017, marketing.sustainalytics.com/acton/attachment/5105/f-09a7/1/-/-/-/-/ESG%20Spotlight%20Series_MAs
 “The Integration of Environmental, Social and Governance Issues in Mergers and Acquisitions Transactions.” PWC, PRI, www.pwc.com/gx/en/sustainability/publications/assets/pwc-the-integration-of-environmental-social-and-governance-issues-in-mergers-and-acquisitions-transactions
 ESG – Environmental, Social & Governance Investing. J.P. Morgan, 14 Dec. 2016, yoursri.com/media-new/download/jpm-esg-how-esg-can-enhance-your-portfolio
 “The Positive Impact of ESG Investing on Bond Performance.” Barclays Investment Bank, 31 Oct. 2016, www.investmentbank.barclays.com/our-insights/esg-sustainable-investing-and-bond-returns.html?trid=%5B%25tp_AdID%25%5D&cid=disp_sc01e00v00m04GLpa11pv29#tab3