In recent years, environmental, social and governance (ESG) issues have become increasingly important to shareholders and boards, as the regulatory landscape has developed quickly in multiple jurisdictions, and the financial and reputational risks of non-compliance with ESG regulation and best practice have increased. Listed companies, large corporates, private equity funds and financial institutions are all now subject to increased ESG-related reporting and disclosure obligations, and are demanding greater transparency and standards from investee companies in ESG matters. ESG factors are also increasingly relevant to acquisition finance, with the growth of the sustainable finance market.
Whilst the environmental aspect of ESG was put into the spotlight due to the increased emphasis placed on climate change in recent years, the Covid-19 pandemic has seen an increased focus on the ‘social’ element, such as how companies have supported their employees and wider society through the crisis. There is significant pressure on governments and regulators to focus on a green Covid-19 recovery. With this in mind, key stakeholders, such as investors, customers, business partners and employees expect to see a defined ESG strategy from the companies they engage with in order to satisfy their own agenda in relation to matters such as climate risk, decarbonisation and ‘S’ factors such as diversity and inclusion.
Against this backdrop, boards and management teams are more conscious of ESG considerations in M&A transactions. M&A transactions are inevitably impacted by broader global impacts and trends, whether that be the Covid-19 pandemic or the situation in Ukraine and Russia, and ESG factors are no exception to this. Buyers are increasingly looking at whether the ESG strategy and culture of an acquisition target is compatible with and aligned to their own and any ESG goals that the buyer has set out. Acquirers are starting to think more about the ESG benefits and opportunities that may arise though M&A, as well as mitigating potential risks. Factors such as the availability of ‘green’ financing options and the focus on ESG reporting are also having an impact on M&A transactions.
M&A as part of ESG strategy
As part of their ESG strategy, companies should be considering how M&A can assist them to achieve their ESG-related objectives, and looking at how the right acquisitions can be used to improve their own ESG credentials.
One current area of ESG focus in the UK is net zero transition plans, which will be required to be published, initially by UK financial institutions and listed companies, from as early as 2023 with earlier adoption being encouraged, detailing how they will adapt and decarbonise as the UK moves towards a net zero economy by 2050. Companies in traditional industrial sectors, for example, that are looking to reduce their emissions and decarbonise by adapting new technologies may look to do this through the acquisition of companies specialising in these new technologies or which are able to deliver their decarbonisation plans.
M&A transactions are inevitably impacted by broader global impacts and trends, whether that be the Covid-19 pandemic or the situation in Ukraine and Russia, and ESG factors are no exception to this.
Whilst much of the focus on ESG factors is in relation to acquisitions, in addition, groups may take the decision to divest of certain business lines that are no longer consistent with their overall ESG strategy.
Corporates are also considering in the current climate, where there are challenges with recruitment, whether their current workforce have the necessary skills to execute their ESG related plans, such as decarbonisation. M&A transactions can, therefore, allow them to benefit from particular skills and expertise in the workforce of the target group to drive these initiatives forward.
ESG risk on M&A transactions: the need for diligence
Buyers are becoming increasingly aware that poor ESG credentials in the target can impact its long term performance, and the value of their investment. Due diligence has always considered legal and regulatory risk, but reputational risk and non-compliance with ESG best practice is becoming equally important.
ESG due diligence is, therefore, becoming increasingly relevant to all M&A transactions. One of the challenges with ESG legal due diligence is the nature of the information to be reviewed, and who is best placed to review it, for example, is it in substance financial, technical or commercial information rather than covering legal matters? In some areas, it may be preferable to engage external consultants, particularly in areas such as industry-specific metrics and carbon emissions.
Areas of focus for ESG due diligence may include:
- Supply chain – including the detection and prevention of supply chain ‘abuses’ and maintaining labour standards (see further below).
- Employee engagement and the culture and diversity of the workforce.
- How does the target engage with its wider stakeholders, such as the communities within which it operates?
- Does the target comply with the ESG disclosure and reporting obligations that it is subject to?
- The source of the target’s energy, how it reports on it, what regulations apply and what it needs to do next.
- How does the target transport products (and people) and how do those in the supply chain move their products and what is the impact of that on the target’s commitments and emissions?
- What technology the target invests in and what opportunities there are for using technology, for example to monitor its energy usage or where energy comes from.
- Does the target envisage any changes in its business model to deal with climate risk?
Focus on value and supply chains
One particular area that merits a specific mention is the need to factor in ESG considerations in relation to the supply chain. Recent events such as the Covid-19 pandemic and events in Ukraine and Russia have put global supply chains under increasing pressure. However, corporates are also increasingly at risk from dangerous working conditions, slave labour, deforestation, pollution and environmental degradation in their supply chains. The supply of component parts, especially those sourced from either suppliers with a monopoly or those in challenging geographical areas, will increase the pressure on supply chains from an ESG perspective. In response to this the EU have proposed legislation for mandatory value chain due diligence to combat this that will also impact non-EU companies that access EU markets.
Corporates are increasingly at risk from dangerous working conditions, slave labour, deforestation, pollution and environmental degradation in their supply chains.
ESG-related issues in the supply chain can cause significant reputational damage. As such, on acquisitions, the supply chain is likely to require careful analysis to understand its resilience and areas of risk.
Harnessing the upside through M&A
As well as being mindful of the need to mitigate ESG risks arising from M&A transactions, companies are also looking at where ESG synergies can be achieved that will enhance the value of an acquisition.
Having a favourable ESG profile can benefit companies financially in a number of ways, including attracting capital from ESG-focused investors, promoting positive stakeholder engagement, including with customers and suppliers, and assisting with the recruitment and retention of employees. When considered in an M&A context, all of these areas have the potential to create synergies for a buyer that will enhance deal value.
The other reason that ESG diligence is important is to identify any specific ESG contractual protections that may be required in the acquisition documents. Many of the typical warranty areas on M&A transactions will cover ESG-related matters, including general and specific compliance with laws, environmental, anti-bribery and modern slavery warranties. ESG specific warranties are generally limited. This is for a number of reasons, for example there may be difficulty in establishing a breach of voluntary standards or requirements, as well as determining the losses flowing from such breaches. Warranty protection may also be negated by disclosure of ESG information and policies by sellers on the data site. Warranties may rely on subjective judgements from the sellers, who would be reluctant to give them and, as such, they are not a feature of competitive processes, and may also not be acceptable to W&I insurers.
An understanding of the ESG risks and opportunities facing the target is also important to buyers when it comes to post-completion integration, and assessing how those risks and opportunities will be managed in the ownership of the buyer.
Private equity transactions
ESG may be relevant at all stages of the investment process. Increasingly PE houses are establishing dedicated ‘impact’ funds which only invest with an ESG agenda. ESG-linked performance metrics are already a feature of executive remuneration in a number of listed companies, and we expect to see this with remuneration for management teams on private equity deals over time.
In the financing market, the availability of ESG-linked finance has grown in recent years, providing an opportunity for purchasers to obtain favourable terms if certain ESG conditions are met. Investor demand for green bonds has benefited acquirers with strong ESG credentials, with cheaper pricing and more attractive terms available.
Many of the typical warranty areas on M&A transactions will cover ESG-related matters, including general & specific compliance with laws, environmental, anti-bribery and modern slavery warranties.
Initiatives such as the UK government roadmap to sustainable investing and the European green deal have further identified the need for more capital to be deployed in sustainable financing as the EU aims to become climate neutral by 2050, and the UK government aims to ‘green’ the UK financial system and make climate and environmental considerations central to decision making. Accordingly, we expect sustainability-linked bonds, green bonds and social bonds to remain in focus.
There has been a focus from governments and regulators in recent years on mandatory ESG-related reporting, as listed and large companies and financial institutions in the UK are required to report in line with the Task Force on Climate-related Financial Disclosures (TCFD) recommendations. At an EU level, there are moves towards the proposed Corporate Sustainability Reporting Directive, and in the US, proposals for climate-related disclosures for publicly reporting companies have been published by the Securities and Exchange Commission. For listed companies, ESG-driven shareholder activism, including the Say on Climate initiative, was a feature of the 2021 AGM season, and this looks set to be the case again in 2022.
This landscape increases the importance of factoring in the impact of ESG matters on M&A transactions. This will be further enhanced by recent moves by the International Sustainability Standards Board to create a set of ESG reporting standards for corporates.
The impact of global events and trends on M&A transactions has been particularly apparent in recent times, and ESG-related factors such as climate, sustainability, energy transition and diversity and inclusion are no different. In addition to an increased focus on the legal and reputational risks and acquirers complying with their ESG-related obligations, we believe that M&A transactions will increasingly be considered in the context of whether they are consistent with the buyer’s ESG strategy and further their ESG goals, and the synergies that can be achieved.