What is ESG?

ESG stands for Environmental, Social, and Governance. It’s a set of standards for a company’s operations that socially conscious investors use to screen potential investments.

Environmental criteria consider how a company performs as a steward of the natural environment. It includes factors such as a company’s energy use, waste, pollution, natural resource conservation, and treatment of animals.

Social criteria examine how a company manages relationships with its employees, suppliers, customers, and the communities where it operates. It may involve aspects like worker health and safety, labour standards, diversity, human rights, consumer protection, and contributions to the local community.

Governance deals with a company’s leadership, internal controls, and shareholder rights. It covers aspects like corporate structure, executive compensation, audits, internal controls, and shareholder rights.

These criteria help to measure the sustainability and ethical impact of an investment in a company or business and are increasingly used by investors to guide their investment strategies.

How can MSPs Leverage the ESG Framework?

ESG is intended to be incorporated into a business’ operations and long-term strategy and encompasses a wide range of factors. ESG can be a significant value driver and a crucial indicator among investors for the sustainability and long-term prospects of a firm.

It is increasingly becoming a major motivating factor behind entire strategies, a central method of securing acquisition financing, a key driver of valuations, and a core consideration when choosing target businesses.

In addition to being superior long-term investments, companies with high ESG credentials are increasingly regarded as more profitable and less risky acquisitions.

Managed Service Providers (MSPs) can leverage the ESG framework in several key ways to improve their business operations, enhance customer relationships, and gain a competitive edge. Here’s how:

·       Risk Management: ESG factors help MSPs in better risk management. For instance, adhering to good governance practices can help mitigate the risk of legal or regulatory actions, while considering environmental factors can reduce the potential for damaging incidents such as data centre energy inefficiencies or waste management issues.

·       Business Growth and Client Acquisition: Businesses are becoming increasingly conscious of the ESG performance of their partners and suppliers. An MSP that can demonstrate strong ESG credentials can have a competitive advantage when bidding for contracts or attracting new clients.

·       Financing and Investment Opportunities: As mentioned, ESG factors have become critical in securing investment and financing. Investors are increasingly factoring ESG performance into their investment decisions. MSPs that have integrated ESG into their operations could find it easier to attract investors or secure favourable financing terms.

·       Attracting and Retaining Talent: In the tech industry, where the competition for talent is fierce, being an organisation that values and prioritises ESG can make MSPs more appealing to prospective employees. For example fostering a diverse and inclusive workplace where employees are treated fairly and are encouraged to contribute can help retain existing employees and attract a wide range of new applicants.

·       Business Longevity and Sustainability: Incorporating ESG considerations into their strategies can help MSPs future-proof their businesses. This might include considering the environmental impact of their operations and seeking to minimise it, or it could involve ensuring their governance structures are robust and transparent.

·       Innovation: An MSP that is conscious of ESG considerations can be driven to innovate in ways that reduce environmental impact, improve social conditions, or enhance governance. This could lead to the development of new services or solutions that provide a competitive advantage.

·       Reputation and Brand Value: By integrating ESG principles, MSPs can enhance their brand image and reputation among customers, investors, and the public.

·       Client Satisfaction and Loyalty: As more companies focus on their own ESG efforts, they would appreciate working with an MSP that aligns with their values. This can lead to increased client satisfaction and loyalty.

Things to Consider When Implementing ESG Into Your M&A Strategy

Companies implementing it into their M&A strategy will need to consider their own ESG objectives rather than just focusing on businesses with solid reputations. MSPs should look for targets that fit with their own strategic objectives and have excellent ESG credentials.

They should examine a company’s ESG policies, regulatory compliance, and pertinent performance measures to evaluate the ESG performance of possible targets. They must look closely at the values, culture, and social responsibility of a target organisation to ensure that the associated risks are highlighted.

Failure to properly integrate ESG objectives into the M&A strategy can lead to a range of negative outcomes for MSPs. Here are some potential detrimental effects:

• Loss of Client Trust: MSPs that don’t consider ESG factors may lose client trust, especially as more businesses become environmentally and socially conscious. Clients may switch to providers that align better with their own values.
• Regulatory Sanctions: Ignoring ESG considerations, particularly in areas with strict environmental or social regulations, could result in regulatory sanctions, fines, and legal actions. This could severely impact the financial health and reputation of the MSP.
• Investor Relations: A lack of focus on ESG can negatively impact investor relations. Investors may be more reluctant to invest or might divest from companies that do not consider ESG factors, as they are perceived as riskier and less sustainable in the long term.
• Reduced Market Value: Poor ESG performance can result in a reduced market value, as investors, clients, and the wider market may view the MSP as less sustainable and therefore less valuable.
• Difficulty in Talent Acquisition and Retention: A lack of ESG commitment can make it harder for an MSP to attract and retain top talent. Many professionals prefer to work with companies that have strong ESG commitments.
• Integration Issues: If the target company’s ESG credentials are poor or their values do not align with the acquiring MSP, it could lead to integration issues post-acquisition. This could include cultural clashes, low morale, high turnover, and operational inefficiencies.
• Reputational Damage: MSPs that fail to consider ESG factors risk damaging their reputation, which can have a lasting impact on their brand and their ability to secure future business.
• Operational Risks: Inadequate attention to ESG issues can lead to operational risks. For example, neglecting environmental factors could lead to inefficiencies, increased costs, or disruptions to the MSP’s operations.

To avoid these outcomes, MSPs should ensure that their M&A strategy includes a thorough evaluation of potential target’s ESG credentials, and the alignment of these credentials with their own strategic objectives.

Impact of ESG on Valuations

Incorporating ESG into the due diligence process is an essential part of a buyer’s M&A strategy, and it holds particular relevance for MSPs given the nature of their business.

In order to raise a company’s valuation, buyers must consider how it intends to improve its ESG credentials. This can be accomplished by highlighting a company’s ESG strengths throughout the due diligence phase while simultaneously identifying areas for growth. In order to lower the acquisition price and pinpoint areas where a target’s value can be increased, buyers should also insist that a target improve its ESG performance.

Here are a few ways MSPs can add value:

• Improved Service Delivery: By examining a target company’s ESG practices, MSPs can identify opportunities to streamline operations, reduce waste, and optimise energy use. These improvements can lead to cost savings and improved service delivery, increasing the overall value of the company.
• Innovative Services: Understanding a target’s ESG strengths can help MSPs identify new, innovative services that could be offered. For example, if a target company has strong practices around energy management, the MSP might consider developing a new service offering around energy efficiency for its clients.
• Risk Mitigation: By identifying areas where a target’s ESG performance is lacking, MSPs can take proactive steps to mitigate potential risks. This could involve working with the target to improve its practices, thus enhancing its value and attractiveness to clients and investors.
• Client and Investor Appeal: Demonstrating commitment to improving a target’s ESG credentials can make the acquisition more appealing to both clients and investors. They are more likely to trust and invest in an MSP that is committed to sustainable and responsible practices.
• Cultural Integration: Understanding a target’s values, culture, and social responsibilities can help MSPs determine how well the target will integrate into their existing operations. This can help to smooth the transition and prevent potential issues down the line.
• Value Creation: When MSPs insist on targets improving their ESG performance, it not only lowers the acquisition price but also creates value in the long run. A company with better ESG performance is more likely to be sustainable, resilient, and successful, ultimately increasing its value.
• Regulatory Compliance: By including ESG objectives and metrics in the agreements, MSPs can ensure that the target company complies with any relevant environmental and social regulations. This can help avoid potential fines or legal issues down the line.

It not only helps to identify potential risks but also reveals opportunities for innovation, cost savings, and value creation. This approach can enhance the attractiveness of the acquisition to clients, investors, and regulators, ultimately contributing to the MSP’s success.

Post-Deal Integration

The integration of ESG objectives post-acquisition is a crucial aspect of an M&A strategy with a focus on sustainability for MSPs. This involves ensuring that the acquired company’s ESG goals and values align with those of the MSP, which may necessitate changes to policies, reporting practices, or internal processes.

For MSPs, it’s vital to effectively communicate the merged ESG objectives to all stakeholders, including employees, clients, and investors. This is particularly important in the tech industry where reputation and perception can greatly impact a company’s success. Clear communication of ESG initiatives can enhance the MSP’s brand image, encourage client loyalty, and attract potential new clients who value corporate responsibility.

Equally important is the implementation of a rigorous monitoring and reporting system by the MSP to evaluate the impact of the acquisition on its own ESG goals. This can track progress on ESG initiatives, providing a tangible way to measure improvement and identify areas for further growth. For MSPs, this kind of transparency not only supports internal decision-making but can also enhance relationships with investors and clients who value accountability in ESG matters.

ESG & Financing

Making ESG a central part of the M&A strategy can have significant benefits for MSPs in terms of financing. In the current climate, where investment for M&A can be challenging to secure, an MSP that demonstrates a robust ESG-focused strategy can differentiate itself and attract more investment opportunities. Investors are increasingly looking to support companies with sustainable practices, so this approach can give MSPs a competitive advantage in securing the necessary funding for acquisitions.

According to a PwC report from 2021, 72% of private equity firms pre-screen prospective targets for ESG possibilities and hazards. ESG was covered on the board agenda by 56% of the PE firms surveyed more than once a year, with 15% reporting that it was covered at every board meeting. Banks are incorporating ESG more and more into their M&A financing, and some are even giving purchasers with excellent ESG credentials better financing terms. TRXimpact is a digital transformation consulting firm that works with customers ranging from large corporations to not-for-profit organisations and public institutions. The business obtained a £30 million sustainability linked loan (SLL) from HSBC UK in September 2022, with the money designated for its UK acquisition strategy.

For MSPs looking for M&A financing, this trend offers several key insights:

1. Pre-screening Targets: With a significant number of private equity firms pre-screening potential targets for ESG opportunities and risks, MSPs looking to be acquired or seeking investment need to ensure they have a robust ESG strategy in place. MSPs also need to carry out their own due diligence in the M&A process, considering ESG credentials of potential targets as part of their evaluation.
2. Increased Board-Level Consideration: The fact that more than half of the private equity firms surveyed cover ESG on the board agenda more than once a year indicates that ESG is becoming a core strategic consideration. For MSPs, this implies that they should anticipate and prepare for in-depth discussions around ESG during M&A negotiations.
3. Attractive Financing Terms: Banks are increasingly incorporating ESG into their M&A financing decisions, with some even offering better terms to buyers with strong ESG credentials. This could mean that MSPs with a clear ESG strategy and performance could secure more favorable financing terms for their M&A activities.
4. Sustainability-Linked Loans: The example of TRXimpact shows that businesses can secure substantial sustainability-linked loans (SLLs) to fund their M&A strategies. For MSPs, this could present an alternative financing avenue. By aligning their strategies with sustainability goals, MSPs may access new forms of financing that directly support their growth and acquisition plans.

MSPs should recognise the increasing importance of ESG in M&A financing and consider how they can leverage this trend. By prioritising ESG in their own operations and in their evaluation of potential M&A targets, they can improve their chances of securing favourable financing and potentially access new forms of funding like SLLs.

How Can MSPs Capitalise on ESG Linked Financing

The financing is tied to three sustainability objectives: lowering business CO2 emissions, enhancing gender and racial diversity, and facilitating staff volunteerism in the community.

The rising prominence of sustainability-linked loans and green bond issuance provides MSPs with valuable opportunities to finance their growth and M&A activities, while simultaneously promoting their commitment to ESG objectives. Here’s how MSPs can capitalise on this trend:

1. Sustainability-Linked Loans (SLLs): As demonstrated by TPXimpact, SLLs are a viable option for financing that also helps promote and achieve ESG goals. MSPs can develop specific sustainability objectives related to their operations, such as reducing CO2 emissions, enhancing diversity in their workforce, or supporting community engagement initiatives. By tying these goals to their financing arrangements, MSPs can secure funding while demonstrating their commitment to sustainability.
2. Attracting ESG-Focused Investors: Many investors are specifically targeting companies with strong ESG credentials. MSPs can take advantage of this trend by integrating ESG considerations into their strategic planning and operations and communicating these efforts effectively. This can make them more attractive to these investors, potentially easing financing challenges for M&A activities.
3. Green Bond Issuance: Another innovative financing method MSPs can explore is issuing green bonds, which are designed to fund projects with positive environmental benefits. If an MSP has environmentally friendly initiatives or projects – such as efforts to reduce energy usage in data centres or deploy renewable energy – issuing green bonds can be a way to raise capital while furthering these initiatives.
4. Better Financing Terms: As more financial institutions recognise the value and reduced risk associated with ESG-focused companies, they’re offering more favourable terms to these businesses. MSPs that prioritise ESG factors can potentially secure better financing terms, making their M&A activities more financially viable and sustainable.
5. Broader Financing Options: Incorporating ESG factors can open a wider range of financing options for MSPs. This includes everything from green bonds and SLLs to ESG-focused venture capital and private equity funds.

In summary, MSPs can seize these financing opportunities by integrating ESG factors into their business strategy, thereby positioning themselves as sustainable, responsible, and forward-thinking businesses.

ESG Performance Linked to Higher Valuations

Recent research by Deloitte evaluated the market valuations attracted by companies with different ESG scores. The study made use of information from Refinitiv, which generates an ESG score for businesses based on more than 500 KPIs. According to Deloitte’s analysis, an increase in ESG of 10 points is related with a roughly 1.2x increase in EV/EBITDA multiple. Technology company prices examined by Janus Henderson in March 2022 revealed a positive association between ESG performance and valuations.

Additionally, a Harvard analysis found that stronger ESG performance drew higher prices, even after controlling for criteria like profitability, size, and industry. Other studies have also shown a correlation between ESG performance and valuations.

Businesses that do well in terms of ESG often have lower operating expenses, a stronger brand, and greater resilience to a wide range of threats. The term “ESG value premium” refers to the advantageous financial results that businesses realise from making ESG investments. It implies that companies that prioritise ESG are more likely than their competitors with less strong ESG credentials to produce long-term value and generate higher returns.

Fremman Capital-owned VPS is a global marine fuel testing advisory company that tests marine fuels and lubricating oils. Based on the results of these tests, VPS provides ship operators with quality, trustworthy analytical data, interpretation, and advice to help them operate more efficiently, cut emissions, and reduce fuel costs.

The company bought Manchester-based Emsys Maritime in February 2023. Emsys Maritime develops maritime emissions measurement equipment for a variety of international clients, including shipyards and ship operators. By enhancing its digital decarbonisation service, the acquisition will help VPS satisfy the demand from shipping customers, which is expanding quickly.

Emsys Maritime, a business with a strong technical reputation and capacity, was bought by VPS in order to offer a thorough understanding of greenhouse gas emissions in the maritime industry. Along the whole VPS digital client journey, the addition of real-time emissions monitoring to the company’s current portfolio of digital decarbonisation services would provide value. Simon Brown, the founder and managing director of Emsys Maritime stated –

“The acquisition by VPS allows Emsys Maritime to accelerate its already strong growth into new market areas and customer sectors. The integration of our real time data into the VPS digital decarbonisation platform will create an industry-leading portal which will help the wider shipping community on its journey towards net zero.”

This illustrates how acquiring businesses that perform well in ESG areas like environmental and societal change, supply chain disruption, geopolitical unrest, and customer expectations can lead to operational gains. By assisting buyers in identifying and implementing best practises in areas like labour management, diversity and inclusion, energy efficiency, and waste reduction, ESG-focused purchases can also help to enhance operational efficiency.

Conclusion

ESG should not just be viewed by buyers as a necessity to satisfy compliance requirements or protect their reputations. ESG is a significant driver of value and, as a key element in an ambitious M&A strategy, can assist buyers in generating long-term value, choosing acquisition targets with high growth potential, improving their financing options for subsequent acquisitions, and gaining access to the knowledge, skills, and credentials needed to enhance their own ESG performance.