In private equity, environmental, social and governance (ESG) factors are often overlooked and undervalued. Due diligence is usually more focused on the financial and quantitative aspects of the target. However, in recent years, ESG has proven to be a powerful underlying factor for business successes and failures. As evidence by the #MeToo movement, and the various human resource scandals that have made headlines in recent months, an unhealthy corporate culture can have serious consequences for even the biggest of enterprises. A study that looked at 231 mergers and acquisitions between 2001 and 2016 found that ESG compatible deals performed better than those with disparate positions on ESG, by an average of 21%.

This figure should be considered alongside the fact that in 2016, more than 15,000 deals were terminated or withdrawn. The face value of these terminated deals totals USD three trillion. One can appreciate the time, effort, and costs incurred in relation to these proposed transactions, which is why investors need to look beyond the bottom line, and see how a target is achieving its results early on in the evaluation process.

The first challenge is in recognizing how ESG translates into financial success. Perhaps the most prominent link comes from employee management. Employees working within a healthy ESG environment are more focused on teamwork and productivity. There are also cost benefits to be realized from having a stable workforce and better employee retention. Studies have shown that companies with the best corporate culture generate three times the total returns to shareholders.

Another major link is sales. Consumers are paying more attention to environmentally friendly and ethically sourced products. In this highly connected global market, reputation is emerging as a key consideration. Consumers do not shy away from endorsing their favorite products or quite literally burning them on social media for millions to see. There is also a rational connection between ESG and a company's overall maturity. A company that has sustainability measures and solid governance policies is likely to have optimized its operations to reduce costs. It will likely also have better community, and governmental relations to bolster its reputation. Therefore, identifying a target's ESG becomes a valuable tool and a risk management strategy for an acquirer.

This can be a challenge because ESG is not readily apparent or quantifiable, and it's often beyond the scope of the standard legal due diligence process. Recognizing the importance of these factors in the context of risk management, companies have harnessed the power of big data, to provide non-financial insights to businesses looking to make an acquisition. Such tools can not only provide a historical report card, but can also forecast risks and opportunities. While still at the early stages, higher demand will inevitably lead to better reporting and analysis. Investors looking to protect their capital should carve out ESG as a standard component of every deal, and the data will follow.

The author would like to thank Maha Mansour, articling student, for her assistance in preparing this legal update.

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