To understand the effect of climate change on M&A, Datasite surveyed 400 dealmakers globally and produced a report with the findings.

ESG and climate trends are changing the investment landscape

Climate change concerns are having an effect on mergers and acquisitions, 400 dealmakers told Datasite in a global survey.

Environmental issues are transforming markets and driving capital allocation, cutting to the core of M&A, investments and growth strategies.

Focus on climate impact is now the norm as investors and consumers exert more pressure than ever before.

The results are wide ranging.

Oil and gas companies are proactively discussing how they will play in the energy transition. Shippers talk about carbon impact and manufacturers examine their vendor and supplier relationships.

Whole industries have grown up to focus on clean tech in sectors as varied as semiconductors, vehicle charging infrastructure, landfill gas, concrete and building materials, and home technology, to name a few.

Attention to climate change, once a distraction, is no longer optional for M&A professionals and investors. Datasite survey respondents ranked the “environmental” segment of environmental, social and governance (ESG) considerations as their top priority.

More than half of respondents - 65% - have seen ESG risks kill a deal, and most viewed climate change as a significant personal risk as well as an M&A risk.

Of course, risk and opportunity are two sides of the same coin. BlackRock CEO Larry Fink wrote in this year’s letter to investors that while “the reallocation of capital accelerated even faster than I anticipated,” the transition represents “a historic investment opportunity.” The more proactively dealmakers redesign their M&A process to address climate issues, the better they will be able to help clients turn risk into opportunity.

Sustainability a concern in due diligence

Climate change issues are present in every industry, and dealmakers have realized that all due diligence needs to have an ESG component. Datasite respondents expect climate change to be the biggest dealbreaker over the next 12 months, slightly ahead of COVID and well ahead of inflation.

Changing physical footprints, supply chain disruptions and government regulations will disrupt business operations over the coming years, meaning that M&A professionals should be proactive when they evaluate deals.

Only 2% of respondents said they did not believe the physical risks of climate such as floods, hurricanes and rising sea levels would impact M&A strategies in the next 5 years, and only 4% said ESG concerns are not currently part of their diligence process.

It is no surprise that in this context, three quarters of respondents said they expected their focus on environmental due diligence to increase “Extremely” or “Very much” over the next two years.

What types of risks should dealmakers consider during the diligence phase? Datasite respondents considered regulatory, litigation risk, supply chain disruption, consumer demands, and risks to physical assets roughly equally important.

Regulatory angle

Regulatory risks related to business jurisdiction should be a “key driver” of ESG due diligence, says Holland & Knight Partner Jennifer Hernandez, who leads the firm’s West Coast Land Use and Environmental Group. Subsidies, tax benefits, or outright bans on certain technologies or activities may be subject to political whims, she noted.

Dealmakers may find a deal works when viewing it by the numbers but should not ignore the critical regulatory angle. “A really common issue we have with clients is thinking the straight math matters and not keeping an eye on the regulatory winds,” she says.

One recent example from California is a 2018 regulation mandating specific percentages of gender diversity on the boards of publicly traded corporations by 2022. Policy regimes can be unpredictable, and should be  a “first tier” consideration for dealmakers, she says.

Closing and post-merger integration are also areas to watch. During closing, clauses may be added specifying ESG requirements for parties financing the deal, supplier and vendor requirements, and specific climate or governance-related representations and warranties such as the “Weinstein clause” requiring the disclosure of any misconduct allegations. Post-merger integration must also plan to align targets with the buyer’s policies and reporting standards.

ESG Activisim

Global oil giant ExxonMobil and other oil and gas industry names have long been targets of activist investors. The strategy was embraced by hedge funds over the last decade as a way to improve returns and edge out entrenched management, but recently, “impact investors” have used these same tactics to push climate-focused strategies for fossil fuel players.

In the past, activists needed significant holdings to make waves. Now, it is possible for investors holding tiny percentages to harness ESG and sustainability concerns and bring other shareholders along with them.

This year, tiny fund Engine No. 1, owning less than 1% of shares, managed to sway enough shareholders with its “Reenergize Exxon” campaign to get three of its nominees elected to the board. The newly formed fund succeeded by capitalizing on a groundswell of public sentiment, pressure on other global oil companies, and Exxon’s disappointing returns in recent years.

The campaign argued that a push away from fossil fuels and toward cleaner forms of energy will not only benefit the planet, it will also directly benefit shareholders.

Engine No. 1 said the company needed a “more disciplined and forward-thinking approach to capital allocation strategy,” saying that it showed a history of spending “unproductive capex” and funding low-return projects.

Repositioning is important not only to avoid the long term business risks of climate change, but also to profit from the energy transition.

Three out of its four board nominees were elected by shareholders. All four nominees reflect the various types of management experience that are needed for an effective transformation:

• A CEO who turned around a refining company to improve profitability
• An executive who added renewable products to the product mix of a traditional fossil fuel company
• A former wind executive; and
• An energy policy and regulatory expert

Exxon’s story leaves no doubt that climate and ESG trends will eventually transform all companies, and provides a blueprint for future activists. Those companies not eager to become targets are working even harder to change.

This is clear from Datasite’s survey, which showed more than 50% of respondents’ companies are preparing for climate-related activist intervention. More US dealmakers than those in the UK are preparing for activist board interventions - 61.5% vs. 44.5% - potentially reflecting the popularity of the strategy in the US.

Other global jurisdictions have forced change through regulations or courts. For example, in spring this year, around the same time as Engine No. 1’s victory over Exxon, the Hague District Court ordered Royal Dutch Shell to reduce its worldwide CO2 emissions by 45% by 2030.

Energy transition in small scale

Smaller companies can often move more quickly. Xebec Adsorption has used M&A over the last few years to transform itself from a compressed air provider for pneumatic machines into a renewable natural gas (RNG), hydrogen, nitrogen and oxygen company. Its RNG technology captures methane from industrial sites, landfills and dairy farms and turns it into natural gas - an activity that will become more and more prevalent as global methane emission reduction targets gain ground.

Capturing waste gas is one angle to address climate change, but on-site production of a variety of gases can eliminate the costs as well as the environmental impact of shipping. Local, small scale hydrogen and medical oxygen production is more economical and sustainable, and “in the future there will be no purpose to having centralized facilities and transporting over distances” gas that can be produced on-site, says Xebec CEO Kurt Sorschak.

During COVID this became clear as the increased hospital demand for oxygen created supply and logistics bottlenecks. Xebec subsidiary Inmatec  delivered 224 on-site oxygen generators in 2020, up from 118 in the previous year, according to the company. The company says its generators can decrease costs and carbon emissions by 60% versus traditional supply options.

One feature of on-site gas production may prove to be both a barrier and a benefit: it is small-scale and can be used to retrofit existing facilities. This makes it feasible for adoption by dairy producers, individual landfills, industrial facilities and small businesses. However, these projects don’t grab as much attention as megadeals such as, for example, Vineyard Wind, an 800 Megawatt offshore wind project that recently raised USD 2.3bn in senior debt.

Both types of projects are important for the energy transition. But only 10% of Datasite respondents said that repairing and building infrastructure would create M&A opportunities, with about three quarters of respondents saying that new technologies and new regulations would create most of the opportunities.

Transportation electrification

Electricity, along with alternatives to fossil fuels, is critical to the climate change program. Whether it is smart grid, electric vehicles and charging stations, or producing electrons through wind and solar, electrification will be a focus for dealmakers.

Half of dealmakers located in the US told Datasite that they expect the most growth in electric vehicles and charging stations. UK dealmakers were more likely to tag smart grid - the other side of the electricity coin - as the largest growth opportunity.

In the electric vehicle space, M&A has been driven by legacy automotive manufacturers and OEMs using deals to transition into electrification. Manufacturers have also used organic strategies, announcing new models and products, investments and operational changes. For example, BMW has said that by 2030, electric vehicles will account for at least half of its worldwide sales, and has also pledged to reduce its own CO2 emissions and work with more recycled materials.

Overall automotive sector deal value reached USD 123.5bn in the first nine months of 2021, the highest level in 15 years, according to a White & Case report. Even legacy automotive companies are chasing the expected EV megatrend.

The October 2020 USD 3bn merger of auto parts makers BorgWarner and Delphi is a case in point: the combined company expects to drive growth of products for hybrid and electric vehicles, particularly in electrified propulsion systems, while maintaining some of its still-profitable legacy automotive lines.

Charging station infrastructure has seen a run of deals in tandem with EV growth. ChargePoint recently announced its second acquisition in Europe after going public via SPAC earlier this year. Biden’s infrastructure bill has USD 7.5bn in grants to boost national charging station buildout.

Cars and charging stations are only one piece of the automotive puzzle. M&A trends show huge growth in ancillary automotive technologies, also known as connected, autonomous, sharing and electric (CASE). These technologies cross a wide span of OEMs and their suppliers and vendors including semiconductors, power supplies, sensing technologies and software. Amazon’s USD 1.2bn acquisition of Zoox and Traton’s USD 3.7bn acquisition of Navistar are just two examples.

SPAC frenzy

SPACs have been important to green industries, particularly in automotive and CASE sectors. Velodyne Lidar, which develops autonomous driving technology, started the trend when it went public in a USD 1.8bn SPAC in 2020. Many similar companies have followed suit, including the highest-valued auto deal in Q1 this year, a USD 28.5bn merger between EV producer Lucid Motor and SPAC Churchill Capital Corp.

The SPAC momentum has led critics to call it a bubble with too many shell companies chasing too few targets, but the truth is the structure occupies a market niche that is well suited to the needs of green technologies. It allows retail investors to participate in earlier stage companies than would typically come to the IPO market, while providing a public capital markets venue for companies that don’t quite fit the standard process.

EV charging companies have fueled a renewed SPAC wave this year, most recently with Dutch company Allego planning an offering through an Apollo shell that values it at USD 3.14bn.

Renewables and grid tech

Investors and corporate acquirers are increasingly aware that simply replacing fossil fuels with “traditional” renewables like wind and solar is not sufficient. Corporations are developing integrated strategies that incorporate solutions for intermittent production, whether that is smart grid, fuel cells, batteries, or small-scale gas plants.

Recently, several hydrogen fuel cell companies have used public markets to raise capital for proposed M&A sprees. Fuel cell companies Plug Power, Ballard Power and Bloom Energy and battery makers FREYR Battery and Microvast have all outlined ambitious growth proposals.

Datasite respondents said they expected to see the most investment in green energy initiatives over the next five years, but they also gave equal weight to a range of corporate strategies to combat climate change. Expansion into new markets, vertical acquisitions, disposals or spinoffs, restructuring and partnerships or JVs all received votes in the survey.

Capital drives the M&A trend

Although Xebec is a small player, it has an agreement with a partner fund of Fonds de solidarité (FTQ), one of Canada’s largest capital providers. FTQ, with CAD 17.2bn in net assets, like virtually all large firms, has announced several ESG initiatives in recent years.

For example, Apollo Global Management named its first Chief Sustainability Officer last month; CVC Capital Partners says it “fully integrates” ESG into every investment decision; and TPG announced USD 5.4bn in commitments to a climate focused fund, to name a few. These are driven in large part by their LPs, who increasingly want to know their capital is going to align with their philosophy in addition to providing returns.

BlackRock said in 2020 it helped its clients put USD 39bn into sustainable investments, and these are expected to grow. The firm’s 2020 Global Sustainable Investing Survey found that 18% of respondents’ assets were invested “sustainably” in 2020 and the share will almost double to 35% by 2035.

Respondents included 425 investors in 27 countries representing USD 25tn in assets under management, according to the survey.

On the smaller end, many new boutique “impact” firms have sprouted up. Prequin estimates 132 such funds were initiated this year alone, with trillions of dollars under management. These funds can have an outsized effect on corporate priorities, board composition, and acquisition strategies.

The increased attention to climate change will be enough to impact valuations, with around 50% of Datasite respondents ranking increased public attention as the most important driver of cleantech valuations in the next year.

Interestingly, respondents diverged by age in their second-ranked valuation driver: while 32% of people over 40 (vs. 16% of the under-40s) viewed the benefits of the underlying tech as the second-ranked driver, 27% of the younger group (vs. 8% of the over-40s) saw government policy and incentives as second-ranked. It seems the older generation goes by the “straight math” while the younger generation looks to the “regulatory winds.”

Asset managers and PE firms are also concerned with equity, diversity and inclusion as part of their ESG strategy. Carlyle in February announced a USD 4.1bn ESG-linked credit facility to support its portfolio companies, with the price of debt “directly tied to the firm’s previously set goal of having 30% diverse directors” on the boards of Carlyle controlled companies, according to a press release. It also said that companies with diverse board members enjoyed 12% greater annual earnings growth than those without board diversity.

Final thoughts

Climate has been on the radar for decades. Now, the intersection between environmental impact and a demand for returns is translating into real-world capital availability for profitable ESG-focused companies. Ultimately, capital availability, or lack thereof, will drive M&A in countless industries as the heat is turned up on company after company. Exxon was only the beginning.

“People are saying this is real, how can I do something about it,” says Xebec’s Sorschak. Individuals are talking to investment advisors about how they can put their money into climate-friendly investments that are also attractive investments on their own. A critical mass occurs at the confluence of profitable companies and investors with capital - both retail and institutional.

Datasite’s survey bears this out as respondents say they are making individual capital allocation decisions with these factors in mind. Around 82% of respondents said they look at a company’s ESG policies when they evaluate job opportunities, and the same percentage said climate [RA1] change is “Very important” or “important” in their personal real estate investment decisions. Most respondents, almost three quarters, expect climate change to impact their future quality of life.

Individual characteristics matter, with women versus men tending to be more concerned about COVID-19 than they are about climate, according to the survey. The under-40 age group was more likely than the older generation to say that environmental issues would be top due diligence concerns in the coming years. 

In spite of demographic differences, more than 70% of Datasite respondents globally said that climate has moved up in priority just this year. The overwhelming message is that ESG has emerged as an inescapable M&A driver for the foreseeable future.