Sarah Turner and Stephen O’Reilly consider the issues the ‘S’ in ESG will have on M&A transactions
Globally, ESG (environmental, social and governance) continues to be a focus for governments and regulators. In the context of M&A transactions, acquirers may typically have regard to the ‘E’ and the ‘G’ elements, such as the net-zero transition and sustainability, when assessing M&A targets, against a backdrop of companies having to provide more extensive climate-related disclosures to their stakeholders.
While climate and sustainability remain a core focus, the attention of business leaders and others is increasingly turning to both supply chain due diligence and how companies respond to the needs of the workforce. There is an increased focus on diversity and inclusion, and we have seen an increasing emphasis placed on how corporates support their workforce, including through the current cost of living pressures.
These areas, often seen as being key components of the ‘S’ in ESG, equally raise issues on M&A transactions, increasing the need to expand due diligence to cover key-ESG related concerns.
Key drivers of ESG due diligence
One key area driving the scoping and reporting of ESG due diligence on M&A transactions relates to the supply chain. New and proposed legislation, such as the EU proposal for a Corporate Sustainability Due Diligence Directive, which will have an operational impact for businesses in scope, will indirectly impact the due diligence that needs to be undertaken on a target and its supply chain.
Aside from the increasing amount of ESG-related operational regulation, other factors influencing the need for ESG due diligence on M&A transactions, include:
- Contractual obligations: buyers will have to be mindful of their own ESG contractual commitments with suppliers and customers. This may directly or indirectly require the buyer to ensure that any target business it acquires is able to comply with these obligations, requiring it to carry out specific ESG diligence on the target.
- Financing and investors: buyers will have to be mindful of obligations in financing documents that require the buyer (and its enlarged group via acquisitions) to be ESG compliant, and again have regard to the target’s compliance. This may be seen specifically in relation to acquisition finance. Listed company acquirers and their groups will be particularly conscious of the ESG-related reporting and disclosure obligations that they and their investors are subject to (and those that they will become subject to over the medium term).
- ESG profile of the buyer: a buyer which has carefully cultivated its ESG profile with its customers, suppliers, employees and other stakeholders will not want this to be tarnished by acquiring a business with a poor ESG compliance profile. If the buyer has put ESG policies in place in areas such as business human rights and made public statements or commitments, it will be examined against these and will not want to face claims of ‘greenwashing.’
Focus on the ‘S’ in ESG
Whilst regulatory requirements around board diversity and inclusion on boards in the UK and EU are currently limited to listed companies, voluntary initiatives (eg, the UK FTSE Women Leaders Review and the Parker Review on board ethnicity) are expanding their remits to the largest private companies. This puts the target’s wider diversity and inclusion strategy into the spotlight.
Starting with the Covid-19 pandemic and continuing with the current cost of living crisis, we have seen that many businesses want to be seen as good corporate citizens. A number of corporates have been looking to support their employees and/or customers directly, including through one-off and targeted payments. For the workforce, this ties into the quest for talent retention, which has itself been a key driver for M&A transactions.
Another development in this area has been the increase in corporates adopting ‘B Corp’ status. This movement was founded in the United States and is now picking up pace in the UK and globally and is achieving greater brand recognition, focusing on factors from employee benefits and charitable giving to supply chain practices.
As a result, due diligence on M&A transactions is expanding horizontally into these new areas, for example to address diversity at senior levels of the workforce and equal pay, as well as matters that are less tangible, including the corporate culture, whether the target is a good corporate citizen, and the quality of the target’s relationships with its business partners.
Some of these areas may be difficult to assess in the context of traditional legal due diligence as they encompass best practice or voluntary standards in addition to legal requirements. Further, whilst it is still not commonplace to see ESG specific warranties on UK deals, these areas will not always translate easily into warranties in the acquisition agreement. There may be difficulties in defining the criteria/standard to be warranted and quantifying any damage incurred, particularly if this is reputational or brand related. However, as the purpose of warranties is not solely to allow a buyer to bring a damages claim, disclosure against any specific ESG warranties may still be helpful to the buyer in understanding the ESG profile of the target.
Ultimately, if a buyer acquires a target with a corporate culture that is significantly different to its own, this could make post-acquisition integration very difficult. This provides an incentive for buyers to consider factors relevant to the ‘S’ in ESG as part of their M&A due diligence scoping.
Increased regulation and disclosure
Notwithstanding the focus on the ‘S,’ we cannot forget about climate change. As ESG regulation continues to increase in this area, reporting obligations remain front of mind for corporates. As highlighted in the recently published updated Green Finance Strategy from the UK government, 2023-24 will see a new raft of regulation in the UK, including development of a UK green taxonomy, requirements to publish net zero transition plans and the introduction of new Sustainability Disclosure Requirements. The International Sustainability Standards Board (ISSB) are expected to finalise their international sustainability disclosure standards later in 2023 to introduce harmonised sustainability reporting globally. At an EU level, another area of focus for many companies, including those headquartered outside the EU, is going to be the Corporate Sustainability Reporting Directive (CSRD). CSRD requires enhanced non-financial reporting on a variety of sustainability issues – such as environmental rights, social rights, human rights, and governance factors. As the scope of ESG-related reporting expands, it becomes increasingly important for acquirers to understand the ESG profile of the target.
The increased emphasis on ESG also brings with it significant developing risks. The last year has seen a continued rise in litigation around the world against governments and companies alike, seeking to hold them to account for climate commitments it is alleged they should have made – or ones they have made but are not seen to be demonstrating they can deliver. Regulatory enforcement action is also on the rise, as regulators focus on ‘greenwashing.’ Acquirers, therefore, need to factor in these potential financial and reputational impacts when assessing acquisition targets.
In 2023 we are likely to see three key areas where ESG will have impacts for M&A transactions – the cost of living, climate change (with associated additional regulatory and reporting requirements) and the impact of a company’s operations on its workers and society (including supply chain). The challenge for acquirers will be getting to grips with often intangible and reputational issues as part of their diligence on the target. All companies face the challenge of an increased volume and complexity of ESG-related regulation. Buyers will also increasingly need to have regard to their own ESG commitments and profile when assessing targets.
Legal Director Professional Support Lawyer