Most organisations are well aware of the kind of compliance risks that can jeopardise their bottom line, such as money laundering, bribery, and other types of corruption. But focusing on these risks exclusively when conducting pre-transactional or third-party due diligence can leave an organisation caught off guard by other non-financial risks that have the potential to compromise a healthy balance sheet. In this article Sarah Hennessey, Senior Associate, looks at the importance of these ‘alternative’ non-financial risks across environmental, social, and governance issues – often referred to as ‘ESG’.
ESG risks have been on the corporate and investor radar for some years now. Therefore it is surprising they are still too often considered in the context of branding, reputation management or meeting disclosure requirements, rather than in terms of a direct threat to profitability. ESG due diligence is still sometimes side-lined as a ‘nice to have’, an issue to deal with in the future, or treated as a box-ticking exercise to conduct as quickly and inexpensively as possible, particularly in comparison to financial or legal due diligence. Some stakeholders may believe that addressing ESG concerns is a form of virtue-signalling. But these assumptions ignore the true underlying risks and rewards associated with ESG issues.
There is already plenty of empirical evidence that good ESG practices embedded in a company can increase its profitability, as well as preventing costly problems. According to a longitudinal analysis published by McKinsey & Company in November 2019, based on 2,000 academic studies on the relationship between a company’s investment in mitigating ESG risks, around 70 percent of the studies revealed a positive correlation relationship between ESG scores on the one hand and financial returns on the other, whether measured by equity returns, profitability or valuation multiples. This is supported by more recent research by the Boston Consulting Group in April 2022, which found that companies with strong ESG reputations enjoyed higher customer satisfaction, and better access to markets, investment capital and talent. And finally, a study published by Moore Global in September 2022 found that companies across eight major economies that adopted ESG as part of their strategic planning sustained faster profit growth, better customer retention and brand impact, as well as fewer hiring issues than non-ESG adopters.
On the other hand, deprioritising ESG concerns can leave organisations exposed to serious financial and legal consequences that come from places they do not expect. S-RM's senior practitioners have encountered scenarios in which companies initially ignored or minimised ESG risks, resulting in serious financial losses down the line. The three examples highlighted below show why ESG due diligence really is worth the time and cost.
Thorny environmental regulations throttle a Colombian construction project
Everything seemed to be falling into place for the multinational investment firm that had purchased a controlling stake in a Colombian infrastructure project. The firm had signed contracts with local partners, purchased equipment, and hired contractual workers. But just as construction was getting underway, the project encountered a setback. A Colombian environmental regulator ordered an immediate halt to construction over environmental impact concerns that had been raised by organised community groups living nearby.
What initially was a temporary delay soon ballooned into much greater disruption. The firm, that had completed all its requisite financial and legal due diligence, had never imagined that construction would remain suspended for several years as negotiations with the environmental regulator and community organisers dragged on. While construction was eventually allowed to resume, the firm had to write the entire project off as a loss, which amounted to tens of millions of US dollars.
What would have helped
Knowledge of local and federal environmental regulations in Colombia, as well as considering responsible land use and community relations, could have better informed the company at the point of investment, including on key stakeholders to engage and a consideration of the terms of the deal. Instead, the firm was caught on the back foot and had to scramble to understand the regulatory environment in Columbia only after running afoul of the environmental regulator. Ignoring the risk presented by the environmental impact of the construction project caused a direct financial loss and resulted in years of administrative and legal costs in handling the protracted negotiations with the environmental regulator.
European retail customers reject products that displace indigenous people
In just a few short years, a European beauty and cosmetics brand had expanded from a small, homegrown start-up into a mid-sized company, with distribution deals in major pharmacies and supermarkets. The brand had built its customer base by promising sustainable and ethical business practices at every step of the way in the production and distribution of its products. Marketing surveys revealed that the majority of the brand’s customers had been convinced to switch from competing products out of a desire to support these ethical and sustainable business practices.
Whilst the brand was comfortable guaranteeing these high operating standards in its European operations, it became more challenging once there was a need to outsource ingredient production to local third parties elsewhere in the world. It was one of these third-party relationships with an agricultural producer in South America that would spell troubled waters for the brand. Just as the brand was launching a new product line with a flashy marketing campaign in Europe, local South American newspapers were breaking the story that the brand’s local partner was forcibly displacing hundreds of indigenous people in order to ramp up agricultural production on legally contested land.
The brand’s first reaction was that the controversy would be a blip on the radar – after all, how many European retail customers closely follow South American newspapers? But within a couple of weeks, European publications began picking up on the story. Suddenly, the brand’s social media accounts were flooded with complaints by customers, calling the brand “hypocritical” and even “fraudulent”. Soon enough, what had started as a reputational issue became a serious financial blow. Within a month of the story breaking in Europe, the brand saw a 40 percent reduction in sales across all product lines. Layoffs and scaling back of operations soon followed. The brand has survived the public backlash, but it is yet to regain the market share that it had prior to this supply chain controversy.
What would have helped
Anticipating social risks and mitigating them is essential to safeguarding the bottom line, but especially so when sustainable and ethical standards are part of the reason for the growth of the business in the first place. These risks, which include alleged human rights violations, inhumane or unsafe labour practices, and systemic discrimination, if not appropriately identified and managed, can drive away the very ethically minded customers an organisation has worked hard to attract. They also present potential legal exposure should a company come under investigation for unlawful treatment of workers or other involved parties. Ultimately, whether driven internally by a company, or the raft of regulation that is emerging in this area, supply chain due diligence going further than just tier one is absolutely imperative for any company, but especially one with a complex and international supply chain.
Undetected rogue employee sabotages a promising US tech start-up
In the US, a tech start-up had assembled a strong executive team with diverse skill sets and proven track records for scaling companies and driving new sales. Larger corporations had taken notice of the start-up's success and had begun making inquiries to consider a potential acquisition.
However, a recent external audit of the start-up's finances had revealed a startling disparity: hundreds of thousands of US dollars from the start-up's operating budget for the previous year were unaccounted for. Around the time the results of this audit came in, the executives were starting to notice strong performing entry and mid-level employees were resigning with little notice or explanation, and new corporate customers who had been onboarded by the legal team were not putting in any product orders.
An internal investigation eventually revealed that an employee within the finance department had been siphoning the start-up's revenue into launching his own direct competitor. He was using the siphoned funds to poach talent from the start-up with generous salaries and signing bonuses. To cover his tracks, he had paid off members of the sales team to create fake contracts with new customers, even inventing false purchase orders to deliberately sow confusion about the start-up's financials.
What would have helped
While the employee in question and his co-conspirators eventually faced criminal charges, their actions seriously derailed the start-up's promising trajectory. After industry publications picked up on the story, corporations who had been interested in acquiring the start-up began to ask how such intentional sabotage had gone unnoticed for so long. By failing to establish firm internal controls and prioritise a robust internal monitoring programme, the start-up not only lost the revenue stolen by the corrupt employee, but also credibility within the industry. While the start-up has since improved its internal governance protocols, its growth trajectory has stagnated, and it has failed to attract any further serious investment.
Safeguarding from all angles: why ESG due diligence is worth the cost
The losses in revenue, customers, credibility, and time and legal costs faced by the examples shared here were entirely avoidable. Had they assessed the material ESG risks to each of their organisations and conducted ESG due diligence, they would have been much better prepared to identify and mitigate these threats. Or at least the organisations would have the credible information needed to make different decisions at critical junctures that would have allowed them to prevent these threats from materialising.
It may be tempting to put off ESG programme building and due diligence until forced to by legislation, to write it off as too nebulous to tackle properly, or to mistakenly believe it is an ideology rather than a risk management and value creation framework. But ESG due diligence is absolutely vital, not just to protect an organisation’s long-term reputation, but to protect your bottom line, here and now. Forward-thinking and proactive leaders understand that safeguarding an organisation requires anticipating risks from all angles and investing in mitigating their potential harms. As the global business climate continues to become more complex and the risks that can derail the bottom line have never been more diverse, organisations underestimate ESG risks at their own peril.