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The growing value of environmental, social & governance programs

The past decade has seen a steady process of consolidation in the engineering and construction industry (E&C). Despite some modest pauses and the adverse effects of the COVID-19 pandemic, merger activity has generally increased year over year, with 2021 posting a record 641 E&C transactions. Furthermore, the first half of 2022 largely kept pace with the prior year’s record levels, which is remarkable given the slowdown in the larger deal market.

Many industry veterans expect the trend to continue, despite macroeconomic data that suggest a deceleration in deal activity in 2023. According to a report published this past summer by the consulting and investment banking firm FMI, two-thirds of E&C leaders believed their companies were more likely to engage in mergers and acquisitions (M&A) in 2022 than in the previous year. The most popular rationale for M&A among those surveyed was the desire to enter new markets and new geographies. By necessity, this will lead many potential acquirors to assess companies with which they have limited experience or knowledge, and this in turn puts a great deal of importance on the due diligence process. When asked what factors are at play hindering an acquisition strategy, roughly one in four respondents to the FMI survey mentioned a lack of attractive targets. For companies that are prospectively on the sell side, this is both good and bad news. On the positive side, this means there are a significant number of suitors that have not found their match (or matches) in the marketplace and are still looking to acquire; however, this also suggests that the recent frenzy of deals has removed the most attractive targets from the market, leaving companies that might not have the qualities acquirors are seeking.

In order to command buy-side interest and top-of-the-market premiums, E&C companies eyeing an exit need to differentiate themselves in a manner that illustrates the value of the underlying operation. Most obviously, this translates into strong, profitable books of business in complementary geographies, but not all companies seeking to merge can stand out in this way.

 

There are still some approaches, however, that E&C companies can take to enhance their attractiveness to potential suitors. Chief among these is developing and implementing an environmental, social and governance (ESG) program.

 

ESG & Corporate Value

ESG has quickly risen to the top tier of boardroom concerns throughout corporate America because of its discernable impact on valuations and capital raising. In the first quarter of 2022, for instance, ESG-themed funds accounted for 26% of all newly launched passive exchange-traded funds. Similarly, ESG-themed funds counted over $300 billion in assets, a more than tenfold increase since 2011.

It is difficult to ignore ESG when so much capital is being funneled into ESG-friendly enterprises, but ESG is exerting an impact on the E&C industry beyond attracting potential capital investment — it can also have a positive role to play in recruiting new talent. ESG rates as a topic of high interest among younger professionals; numerous recent surveys and studies have revealed that Generation Z and millennials routinely rank social issues and sustainability more highly than previous generations. After all, it was these younger cohorts that powered the rise of ESG investing noted above. Relatedly, E&C companies are struggling to recruit and retain employees. A recent Deloitte report listed workforce and talent issues as being a headwind for the industry, noting: “The impact of not filling job openings can negatively affect E&C firms in more ways than one, including project delays and cancellations, projects being scaled back, inability to respond to market needs, losing project bids, and failing to innovate, among others.”

For E&C companies, ESG becomes a means to address several issues related to corporate value at once. Implementing a well-resourced program can differentiate a firm, potentially adding value in the deal market, as it also positions the firm to recruit the young talent needed to power future growth.

 

 

ESG in the Due Diligence Setting

E&C companies looking to launch ESG efforts could benefit greatly from examining how ESG is evaluated in the deal context via due diligence and ensuring their programs account for those areas of concern. Typically, these include:

Environmental/Sustainability — Does the target track and report on its consumption of paper, plastic, water, electricity and natural gas? Does it have plans to reduce consumption of these items over time? If so, has it achieved any specified goals to minimize its impact on the environment and to use recyclables as much as possible?

  • Does the target focus on the selection of eco-friendly materials, smart technology, product design, construction methods and recycling opportunities in order to reduce their sizable carbon footprints?
  • Does the target outsource emissions to subcontractors or third parties to ensure overall carbon footprints of projects are reduced?
  • Does the target seek to manage water efficiency in project design and delivery?

Occupational health, safety and welfare — Investment in training, safety management and auditing is crucial to maintaining proper working conditions. In general, companies should seek to properly train employees and focus on building a strong culture emphasizing safety, spanning from jobsites to the corporate office.

Community engagement and impact — Maximizing positive impacts on communities is an important metric in analyzing ESG in the E&C industry. An ESG plan that is part of the essential corporate strategy includes:

  • Participation in the design-build aspects of projects that enhance community viability and economic development, particularly in less affluent census tracts.
  • A track record of supporting and implementing items contained in community benefits agreements (CBAs) in the design-build of major developments.

 

Diversity, equity and inclusion (DEI) — Who comprises the executive and senior management of the target? Has the company implemented a DEI program? Is it complying with that program? Have there been efforts to diversify its management or its employee base? Does the company have programs, targets, and/or systems to track hiring practices? If there is an incentive compensation plan, are awards or payouts tied to the achievement of ESG goals or targets?

  • Has the target ever entered a “teaming agreement” with a minority-owned firm to win new business or delivery on existing projects?
  • Does the target have a minority supplier program that seeks to identify and utilize a network of minority-owned businesses when possible?
  • All operating companies listed on the Nasdaq stock exchange must use the Board Diversity Matrix provided by the Nasdaq or use a format substantially similar to that to annually disclose board-level diversity data in their proxy statements, their Forms 10-K or 20-F, or on their respective websites. With certain exceptions and permutations (and subject to phase-in or transition periods), Nasdaq-listed companies will have to have or explain why they do not have “diverse” directors as that term is defined in the Nasdaq’s corporate governance requirements. The explanation for not having done so must be provided in advance of those companies’ next annual meetings in their proxy statements or on their respective websites. There are also certain states that have adopted legislation or in which legislation is pending regarding board diversity objectives applicable primarily to publicly traded companies. Details on board of director diversity is well beyond the scope of this article. For additional information, however, see Husch Blackwell’s “Diversity on Public Company Boards of Directors.” Knowledge of and achieving these board diversity objectives will be
  • of great importance to publicly traded companies.

Engineering and construction companies that effectively implement ESG-related initiatives could enhance their attractiveness to larger industry players looking for growth via mergers and acquisitions. In short, ESG programming should be viewed as an investment — not a cost center — that can add to corporate value, either in the form of an exit transaction for existing shareholders or as a means to attract talent amid the labor scarcities with which the industry currently struggles.