the new driver of
corporate decision making
Corporate strategic decision making has always focused on financial outcomes. But non-financial, sustainability-related considerations are increasingly becoming as important in the minds of companies’ many stakeholders. In our experience, sustainability is now a top tier criterion by which more and more companies measure success and assess risk. As a result, it is determining strategic decision making at board level. For many, sustainability is the reason why capital is being raised and assets bought and sold. It also influences:
- how capital is being raised, and M&A being conducted; and
- who corporates interact with, and the nature of these interactions, with lenders, investors, buyers or sellers.
We examine in this briefing why the transformation is taking place, before exploring two practical aspects of corporate strategic decision making: access to capital (both debt and equity) and M&A (buy-side, sell-side and joint ventures).
EXPLAINING THE RISE OF SUSTAINABILITY ON THE BOARD AGENDA
In this video, Samantha Brady, Head of Environmental Law at Slaughter and May, guides us through the following:
- government policy and legislative change;
- the growing appreciation of business leaders of climate-related risks and opportunities;
- shareholder expectations and behaviour;
- potential litigation risk.
ACCESS TO CAPITAL
The rise of sustainability as a strategic issue is having two main impacts in the world of corporate borrowing.
The first is on the demand for capital: corporates transitioning their businesses, and new ventures forming with the express intention of addressing the world’s sustainability problems, need capital, and lots of it. In response, borrowers may need more debt and can increasingly look to source this through finance that is in some way ‘green’.
The second impact is on lenders. Mainstream banks are coming under pressure to transition their own financing activities to make their loan portfolios more sustainable. As a result, just as with established equity investors, financial institutions are increasingly focusing on non-financial characteristics alongside financial considerations. This is manifesting itself in an increasingly commonplace model of sustainable lending, linking loan terms to a borrower’s performance in relation to pre-determined Key Performance Indicators (KPIs). These may relate to, for example, energy efficiency or reduction in greenhouse gas emissions, diversity and inclusion targets or corporate governance transparency. Typically the margin for the loan will decrease where those KPIs are satisfied and increase if they are not. Sustainability-linked pricing is also now routinely included in working capital facilities and is becoming more prevalent in event-driven financings, both in the investment grade and cross-over or leveraged markets.
The regulatory environment relating to corporate debt is developing rapidly in parallel: this year sees the FCA publish feedback on ESG integration in UK capital markets, the EU Green Bond Standard take further shape, and the EU green taxonomy help provide a common language and a clearer definition of what is ‘sustainable’, with the UK’s taxonomy and Sustainability Disclosure Requirements to follow in the short term. Together, these developments are expected to limit room for potential bond greenwashing and harmonise expectations over the meaning of sustainable lending in the debt markets. Borrowers therefore increasingly have to consider non-financial considerations and present a positive carbon transition trajectory if they are to avoid rising costs of capital and tightening liquidity.
"These developments are expected to limit room for potential bond greenwashing and harmonise expectations over the meaning of sustainable lending in the debt markets."
Public equity markets
Public equity markets have been comparatively slower to adapt. There is no accepted model for a “sustainable IPO” or a “green rights issue” in the way that there is for a sustainable loan or green bond. There is also no received wisdom over the types of non-financial KPIs or reporting metrics that issuers are expected to include in equity prospectuses or investor presentations.
This lag in adaptation is partly structural. Equity capital has always had far fewer strings attached than debt capital, where a borrower may be forced to run its business in a particular way through KPIs and covenants (or suffer drastic consequences such as potential coupon adjustment, drawstops, repayment demands and security enforcement).
The power of equity investors comes instead from the ability to use engagement to put pressure on boards to change course or vote a certain way at shareholder meetings. Many of these levers, such as requisitioning shareholder meetings, voting against directors’ reappointment or ultimately selling down are, however, quite extreme and typically used where engagement and influence fail to deliver results.
Added to this, debt finance is typically provided by a collection of banks and other financial institutions. These are subject to intense regulatory scrutiny and where market norms, once developed, spread quickly amongst the lending community. This is demonstrated powerfully by the emergence of various sustainability-related lending principles, such as the ICMA Green Bond Principles, the LMA Sustainability Linked Loan Principles and the LMA Social Loan Principles.
In equity markets, despite the not insignificant take-up of the 2020 UK Stewardship Code and the arrival of multi-manager engagement platforms like Climate Action 100+, institutional shareholders tend to act more independently when selecting, managing and documenting their investments. Market norms in executing and managing those investments, particularly in public equity, are therefore perhaps a little slower to develop and harder to decipher.
Nevertheless, there are initial signs of sustainability having an impact on how public equity (both primary, through an IPO, and secondary, through placings, open offers and rights issues) is raised and for what purpose. For example:
- IPOs and other market debuts: a number of companies coming to the public equity markets for the first time are seeking to present sustainability as a key plank of their core strategy and investment proposition. For example, Made.com Group plc, which successfully completed its IPO in 2021, selected sustainability as one of its four key “strategic pillars”. Made.com has an extensive, board-approved, sustainability and responsible sourcing strategy, sustainability KPIs, a dedicated sustainability team which focuses on developing, implementing and tracking progress of the sustainability strategy, and a sustainability council made up of employees from different areas of the business which applies the sustainability strategy in real-life situations throughout the company.
- Secondary equity raises: Water company Severn Trent raised £250 million in 2021 by way of an institutional placing1 specifically to fund six new green projects endorsed by the watchdog Ofwat, building on their pledge to spend £1.2 billion on plans to help further sustainability and assist customers and communities across the Midlands.2
As sustainability takes on a more prominent role for investors, issuers and regulators alike, so it becomes subject to increased scrutiny. This scrutiny has the potential to impact a number of processes in the public equity markets. For example sustainability related statements in prospectuses will need to be subject to more robust verification, review and testing. So too with public disclosures more broadly, including those in annual reports and trading statements; assurance and verification processes will therefore have some catching up to do.
But implementing new processes may be challenging. The disclosures in question are often forward-looking and aspirational with some tied to distant future dates without a reliable means of assessing whether the goal, target or ambition in question is in fact realistic or not when judged according to the relevant issuer’s financial position, strategy and market standing. Indeed there is an opportunity for the development of both market and legal frameworks to provide assurance tailored to these new forms of disclosure, just as there is now a commonly used approach for competent person’s reports for mineral companies.
In the context of a prospectus in particular (with its associated personal liability for directors) boards, in-house legal teams and professional advisers will need to start applying the same level of rigour to sustainability-related statements as is applied to key financial-related sections such as the no significant change statement, working capital statement, synergy forecasts and profit forecasts.
There are also some signs of structural change from regulators and issuers which might aid in catching-up with debt markets. For example, the London Stock Exchange’s Green Economy Mark allows investors to identify “an investible universe of ‘green economy’ equities, enabling a broad exposure, rather than a focus on one area”3. It identifies London-listed companies and funds that generate 50% to 100% of their revenues from products and services that contribute to the global green economy. Approaches such as this could help open up a market in green-labelled equities similar to green bonds, and provide a complement to ESG ratings by giving additional insight into the issuer.
For the public equity markets, the simple point is this: if capital is searching for somewhere to go that has good ESG credentials, issuers who are able to provide those credentials will benefit through higher demand for equity. It may be that enhanced disclosure requirements and ESG-focused investment funds will accelerate this by helping companies that are genuinely aligned with sustainability to emerge more clearly. Corporates will want to be responsive to developments in public equity in order to maintain attractiveness.
Private equity markets
Trends are much harder to discern in the private equity markets but, in general, private companies face much less scrutiny than their public, listed counterparts. Indeed there is some evidence of sustainability-led disposals by listed companies generally which have resulted in target businesses, particularly in oil and gas, being owned by private equity firms and private operators, with some recent commentary4suggesting that this trend is increasing.
Predicting the future relationship between private markets and sustainability is difficult. Today private markets do in some sectors provide a ready-made home for businesses which have fallen foul of the sustainability agenda (and there are flows of private capital to suggest private investors are taking advantage of this), but that will change over time. More private investors, particularly private equity firms, will adjust their investment objectives to cater for an increasing number of more sustainability-conscious investors and to seek financial returns from the energy transition and other structural changes affected by the desire to be more sustainable.
This is evidenced by the number of new funds being created to invest in ‘green’, or otherwise sustainable, businesses: in Q3 2021, for example, flows into ESG funds totalled $54.7bn, beating the total record for 20205. But this transition will take some time, and considerably longer than in the public equity markets, because the levels of scrutiny, particularly from the media and shareholders, and the absence of other stakeholders like proxy associations, means that the impetus for change is notably less strong. That said, new reporting obligations such as those under the Sustainable Finance Disclosure Regulation, will drive change. There are already plenty of signs of private equity sponsors, particularly those which are listed or otherwise have the scale to face more significant scrutiny from investors, the media and others, shifting their activity towards investing in more “ESG-appropriate” assets and businesses. Blackstone being a notable example6.
"In Q3 2021, flows into ESG funds totalled $54.7bn, beating the total record for 2020."
M&A (AND ORGANIC ALTERNATIVES)
Academic literature abounds in studies looking at the effectiveness of M&A strategies in delivering financial returns for shareholders. The literature is a little less fulsome when it comes to the effectiveness of M&A strategies in delivering more sustainable outcomes but this is expected to be a key driver of M&A over coming years as many commercial organisations look to the acquisition of new technologies and new ventures as a means of quickly pivoting their existing business to a more sustainable future. Many of the points that M&A functions in large corporates worry about, however, apply just as much to these types of ESG-led transaction as they do to any other M&A transaction:
How should target businesses be integrated into the purchasing group?
To what extent should the current management team be retained to achieve the purchaser’s vision for the newly acquired business?
How will the target business dilute or enhance the (sustainability) profile of the acquiring business?
What level of investment is required in order to achieve the purchaser’s vision, and can it in fact be achieved on the expected time horizons or at all?
In that sense, running an acquisitive ESG-influenced M&A growth strategy isn’t all that different from more traditional M&A strategies, although the focus of diligence and other aspects of the process will inevitably be skewed, at times, to different considerations. There is, however, an often overlooked alternative to M&A as a means of transforming a business: hold and improve by making changes organically.
Organic change might mean developing new technologies (like electronic cars, direct air capture of CO2, and low carbon versions of products) or looking at how to make existing processes more energy and resource efficient, for example, switching to low carbon data processing solutions, or adopting lower waste and water-use manufacturing methods.
But in practice, these sorts of strategies tend to require careful thought about how to spend capital in a way that supports carbon reduction, promotes energy and resource efficiency, and avoids it being locked into inefficient technology for the next capital replacement cycle, such that decarbonising the business in question and improving its energy and resource efficiency is still possible.
These sorts of strategies are also far from being quick fixes. When judged against sometimes ambitious emission reduction targets it is not clear whether shareholders and other stakeholders will necessarily give businesses that take these courses of action sufficient credit for their efforts, or be content to wait long periods of time before results manifest themselves.
It will be interesting to see whether the short-termism that is widespread amongst many institutional shareholders in respect of financial expectations also applies to those around sustainability. A hold-and-improve strategy will involve detailed, methodical changes to the value chain, often with investment in innovation, married closely to overall strategy.
Even products like cement, steel, shipping and air travel, often cited as being hard – or impossible – to abate, are looking to become greener:
- In October 2021, the Global Cement and Concrete Association announced its roadmap to achieve net zero by 2050 and a number of start-ups claim to have low carbon cements.
- In the last few years, BHP has signed Memoranda of Understanding with Korean steel giant POSCO, Japan’s JFE Steel, and China’s Baowu and HBIS Group to look at ways to “green” steel production through optimising coke quality and assessing carbon capture options. Similarly steel producer SSAB’s “HYBRIT” (hydrogen breakthrough ironmaking technology) collaboration with mining company LKAB and Vattenfall aims to achieve fossil free steel.
- The EU launched dual FuelEU Maritime to promote sustainable shipping, whilst leading shipping companies like Maersk have committed to spending the extra 10-15% capex required to put dual fuel ships in the water as well as securing commitments from more than half of its largest customers that they will actively use and scale zero carbon solutions for their ocean transport.
- The EU has also launched ReFuelEU Aviation to support sustainable air travel development, as Airbus has announced its intention to build the world’s first hydrogen power zero emissions commercial aeroplane by 2035.
OTHER STRATEGIC DECISIONS AND ACTIONS
Sustainability also has the potential to impact a range of other areas of corporate decision making, like capital return policies, share buybacks, dividend policies and capital expenditure.
In many of these areas, there is a tension between on the one hand the “E” and “S” drivers (which emphasise the importance of stakeholder protection) and, on the other hand, the objective at the heart of capital return strategies such as dividends and buybacks (which emphasise returning value to shareholders). Some businesses, like BNP Paribas, BIC, Campari and Enel7 have tried to square this circle through so-called “ESG buybacks” that allocate part of the outperformance8 of the buyback to funding an ESG project.
More broadly, decisions by corporates to do things like invest in new technology, pivot asset portfolios so that they are more appropriate for the energy transition, change manufacturing processes or alter supply chains all have a financial impact. It will be interesting to see to what extent shareholder expectations around leverage ratios, levels of capital expenditure and dividend policies change to allow for this upheaval.
The growing influence of sustainability across the full spectrum of corporate decisions means that most sophisticated businesses will need to be ready to deploy a range of corporate strategies in order to achieve their strategic objectives: whether this is green finance, M&A, technological and operational change (including in relations with third parties like suppliers) or other organic growth.
The deployment of such a wide range of corporate strategies and the growing influence of sustainability on all of them makes it an exciting time to be a corporate practitioner.
At Slaughter and May, we would be delighted to assist you as you implement your sustainability strategy.
If you would like to discuss further please get in touch with your usual Slaughter and May partner or alternatively contact:
Head of Environmental Law