Fintech M&A has consistently been in the news, even during the last 18 months. CB Insights reported in April 2021 that there had been 67 M&A deals globally (including announced, but not yet completed deals) for venture capital-backed fintech companies in Q1 2021, in addition to a number of significant funding rounds.
As we've noted in our recent overview of trends from the 2021 proxy season, investors are demonstrating an increased willingness to vote against proposals if companies do not conform to expectations. Among those expectations are environmental, social and governance (ESG) matters. This trend is echoed in the private equity and venture capital communities where an increasing number of limited partners have published ESG policies which they will consider when deciding where to allocate capital.
It does not need a huge leap of faith to predict that stakeholders are likely to take an increasing interest in ESG factors when voting on acquisitions of (or investments in) fintech companies, or decisions on where to allocate capital. Even if an acquirer is not experiencing pressure from its own stakeholders, ESG factors are still likely to play a role in its thought process: if it is looking at an eventual exit, either through an IPO or through a sale, the acquirer should be keen to make sure that the target company has a compelling story from an ESG perspective to make it as attractive as possible in the long-term.
In this post, we look at some of the difficulties in assessing ESG factors as part of due diligence and consider what steps can, and are, being taken to improve the reliability of ESG diligence so that potential purchasers can accurately assess the ESG credentials of target businesses, including in the fintech space.
Moving on from the checklist?
Historically, ESG related diligence has predominantly focused on risk factors that could impact the public image of the purchaser or the target (e.g., have there been any historical negative ESG allegations made against the target? Is the target involved in certain red flag industries from an ESG perspective?), often in the form of standardised checklists for ticking-off ESG related risk factors before an acquisition is completed.
This defensive view of ESG diligence is useful in some respects as it reduces the risk of an ESG-related scandal and enables purchasers to tell their stakeholders that they have considered ESG factors in making their investments. But what it lacks is the consideration of the potential benefits that a stronger ESG focus can create in investee companies.
One of the main drivers behind this risk-based approach to ESG is that it is far easier to gauge losses caused by ESG-related risk factors (e.g. fines for failing to uphold working standards/a poor reputation causing customers to abandon a business) than it is to assess the benefit arising from an ESG focus. With ESG risks, there is a clear causal link between the ESG issue and the negative impact on the value of the business which justifies spending time and money to diligence these areas pre-acquisition.
We are however increasingly seeing that those businesses with a greater focus on ESG are able to gain a competitive advantage over their peers by doing things differently or having a story to tell which appeals to customers, a statement that is particularly relevant in the ESG-focused fintech world – whether that’s MPesa providing payment services to the unbanked in Kenya, digital banks targeting specific sectors of society or retail platforms which allow investors to invest sustainably.
The challenge for a prospective purchaser is ensuring there are ways to accurately verify statements made by target companies, compare businesses and measure growth on defined ESG metrics. The lack of standardised measures of assessment for ESG (as there is for financial performance, for example) means it is harder for prospective purchasers to effectively diligence the ESG credentials of businesses and ultimately demonstrate a causation between high-performance from an ESG perspective and improved financial performance.
Why is accurately measuring ESG factors important?
Potential acquirers of ESG-focused fintechs need to ensure that the target is doing what it says it's doing. Looking at environmental factors as an example, the term "greenwashing" is not new, nor is it strictly defined, but could broadly be described as "an attempt by a company to make its products appear environmentally friendly when, in reality, they are not" (Chueca Vergara and Ferruz Agado). A company may not be intentionally deceptive, but greenwashing (or overly promoting other ESG characteristics) could arise entirely accidentally, given the current lack of clarity on taxonomy and globally-consistent measures of ESG factors.
Being able to accurately measure ESG factors is also important for purchasers both in terms of minimising ESG-related risks but also in order to assess businesses on their ESG credentials and determine potential growth strategies linked to ESG development. Being able to identify potential opportunities for ESG development (or even ESG turnaround strategies) and empirically measure this against financial growth will enable purchasers to drive further ESG development in investee companies and assist in the growth of the industry.
The challenge here is that without consistent metrics to measure against (and with varying approaches and outcomes by different ESG rating providers), it can be challenging for purchasers to accurately gauge claims made by promising fintechs or to measure development following an acquisition. The lack of a standardised approach means that diligencing ESG targets, and measuring ESG growth, becomes subjective and inconsistent.
What is being done to address this?
There are already moves towards ensuring that businesses can be assessed on a consistent basis, at least based on environmental factors. In the EU, the Taxonomy Regulation establishes an EU-wide taxonomy intended to provide businesses and investors with a common language to identify to what degree economic activities can be considered environmentally sustainable. Part of the intention behind such harmonisation is to facilitate cross-border sustainable investment in the EU. As a result of harmonised disclosures, EU businesses should find it easier to raise funding for their environmentally sustainable activities, as these could be compared against uniform criteria.
We have also seen an increasing focus from the UK's FCA on ESG matters - ESG formed part of the FCA's business plan for 2020/2021 and one of the outcomes that the FCA was seeking in relation to innovation in sustainable finance was making use of technology to bring about change and overcome industry-wide challenges (we posted about one recent development, the FCA's sustainability sandbox, here, so the FCA is really cracking on). By way of example, the FCA recently published a letter to the chairs of authorised fund managers setting out the FCA's expectations on the design, delivery and disclosure of ESG and sustainable investment funds. When diligencing a fintech company that purportedly invests in ESG or sustainable investment funds, it might be worth checking whether the target considers similar factors when choosing ESG funds.
Taking it a step further, even if the guiding principles are not directly applicable to the target, a fintech holding itself out as making sustainable investments should consider some of the principles as they set out good practice that the FCA would expect to see. For example, firms should ensure that any ESG/sustainability focus is represented in marketing materials in a clear, fair and not misleading way and that there is appropriate application of the firm's resources (including skills, experience, technology, research, data and analytical tools) in pursuit of its stated ESG objectives.
But what more is needed?
There are clearly moves towards standardising metrics for certain categories of ESG factors but more work is needed to enable consistent assessment of, and reporting by, businesses across the spectrum of ESG factors.
The proposed International Sustainability Standards Board (ISSB) is set to be launched by the IFRS Foundation Trustees in time for COP26 in November 2021. The ISSB will be tasked with delivering baseline reporting standards for sustainability in line with the IFRS’s work on financial reporting. If successful in its aims, this would be a very significant step towards the aim of setting reliable and comparable metrics for comparing businesses on sustainability matters.
The guidelines to be issued by the ISSB, and measures such as the Taxonomy Regulation (at least in relation to certain types of EU entity), should help purchasers to accurately and consistently compare and diligence certain target businesses from a sustainability standpoint. Once this happens, it can hopefully demonstrate empirically the causal link between sustainability and financial performance. This will lead to even greater focus on, and investment in, businesses that can demonstrate greater levels of sustainability. We may even see the rise of sustainability turnaround investors (in much the same way as we have seen financial turnaround investors) that will help drive further growth in this area.
There is still a way to go to get consistent comparison metrics that can be used to diligence ESG focused businesses, but recent developments such as the Taxonomy Regulation, the FCA’s focus on sustainable investment funds and the formation of the ISSB, are all steps in the right direction. What is clear now though is that the historic checklist-based approach to ESG diligence is not fit for purpose when diligencing ESG-focused fintechs and work is needed (and quickly) to establish objective ESG comparison metrics for businesses.