ESG: Turnaround opportunities

The message is clear: ESG is going to have transformational effects on businesses. 'Bad' ESG businesses will have three choices: either fix, split or die. And either they do it themselves. Or eventually the capital markets will do it for them. 

All three of 'E', 'S' and 'G' will present seismic challenges for a variety of businesses. But after COP26, 'E' has grabbed the recent headlines as the world moves towards net-zero targets. Take the discussion around the global miners as a well-known example playing out in the public markets. But the same principles apply in the private sphere too.

Two scenarios come to mind:

First, how should distressed and special situations investors approach bad ESG companies which go into distress not because of ESG, but for other underlying business reasons?

So far, the message from investors is that they cannot invest in bad ESG companies. That’s an immediate and upfront problem and applies equally to buying into the debt as it does to the equity. Many investors may have to pass on what otherwise could be an opportunity, if the underlying business doesn’t fit within their ESG strategy – whether it’s on an 'investment-by-investment' basis or whether it’s an 'across-the-portfolio' basis.

Of course, not all distressed or stressed situations lead to a full blown restructuring – the pandemic has reminded us of that. But could investors be missing out if a restructuring and the accompanying legal mechanisms can be used to fix both the business and the ESG issues together?

Second, how should investors consider bad ESG companies that will go into distress directly because of ESG issues?

The commentary is that bad ESG companies will eventually have to fix their underlying issues (if they can), restructure by spinning out the bad ESG business or face financial starvation as access to the private and capital markets eventually dries up.

Public businesses falling into this second scenario become attractive to activist investors. 'Bad-but-reforming' ESG companies can outperform the S&P index by more than 5%. Similar opportunities exist in emerging markets.

Private businesses could become attractive to collaborative special situations investors as they face the same issues. What levers can be pulled to implement an ESG turnaround? Could the business be split into 'good ESGco' and 'bad ESGco'? The best example at the moment in this second scenario are the so-called transition bonds, but there will be situations which call for far more extreme interventionist measures as time goes by.

Distressed and special situations investors have been looking at goodco and badco structures for years. Investors have the expertise and experience to make them a success for all stakeholders.

But two questions remain. Will investors have the specific skills and advisers to implement an ESG turnaround? And will they have the mandate and buy-in from their LPs to do so?