Insights / 08-12-2021 / London

In this Q&A we consider the impact of environmental, social and governance (ESG) issues on M&A transactions. Examples of what might typically fall within the scope of ESG factors are outlined in our recent article ESG: Corporate Decision Making.

How is ESG affecting the M&A market?

• Companies that have developed a robust ESG policy are looking to acquire target companies aligned with their own interests.
   
• Businesses are also looking more closely at their own operations with such introspection leading to the disposal of its own business assets and interests that are not in line with its contemplated ESG strategy and goals.

Why are ESG Factors becoming more important in M&A transactions?

ESG issues, including human rights, have increasingly become a board level concern as ESG regulation, legislation and shareholder expectation continues to grow.  A failure to engage with ESG matters is increasingly being seen as a risk to a company’s long term value from a regulatory, reputational and shareholder perspective. As a result boards and management are paying considerably more attention to ESG factors in M&A transactions. Management and boards are looking closely at the ESG strategy and culture of a target and considering whether it will be in line with its own ESG policies and whether ESG factors will have a positive or negative impact on the valuation of a target.

What is the perceived value of ESG?

Whilst ESG has been a focus for investors for some time, ESG is likely to become a key value component for many companies over the coming years.  Although it might take time, diligence and commitment on the part of a company to execute a broad company-wide ESG strategy, if implemented well, can prove enormously fruitful. 

A good ESG strategy can potentially promote value in the following ways:

• positive shareholder engagement;
   
• retention of employees;
   
• enticing new hires (with metrics such as diversity, inclusion and sustainability now playing an important part in employment decision making);
   
• attracting the attention of ESG focused investors providing potential new finance lines for a company;
   
• customer engagement and loyalty;
   
• potential cost reduction; and
   
• reduced regulatory intervention.

These elements will undoubtedly be attractive to buyers and add to the deal value where a buyer is looking to align its own ESG strategy with that of a target and maximise profitability.

What might a buyer consider when undertaking ESG due diligence?

Since we have established that ESG factors can play a part in company value and future earnings, a simple review by a buyer of a target’s mission statements, policies and public communications is no longer enough.

Whilst certain ESG issues will generally be addressed as part of customary environmental, employment practices and human rights due diligence, buyers may now also wish to consider more carefully the following (not exhaustive):

• diversity of the workforce, C-suite and board;
   
• board involvement in developing and implementing ESG strategy;
   
• retention and productivity of employees;
   
• ESG KPIs in place for management (e.g. in relation to compensation);
   
• sector and location risks both operations and supply chain (e.g. sector has high environmental risk, hazardous working conditions or employs vulnerable workers, has limited employment rights etc.);
   
• long term ESG risks and opportunities;
   
• delivery of ESG disclosure, performance indicators and industry specific metrics;
   
• the personnel involved in handling ESG matters;
   
• the target’s performance on carbon emissions, sustainability, diversity and inclusion and health and safety; and
   
• the target’s activities in the community within which it functions.

Such diligence will be crucial for identifying ESG risks, the protections required in the acquisition agreement and the financial impact of any integration costs/ synergies post-closing. 

A buyer might also consider tasking a dedicated ESG officer or ESG team to lead this aspect of due diligence.

What protections might a buyer seek on identifying ESG risk?

Where due diligence highlights ESG risk, the buyer may seek to negotiate in the following ways:

• a downward valuation of the target company;
   
• transactional insurance against the risk;
   
• a carve-out of the relevant business part affected;
   
• certain risks addressed in the transaction documents (e.g. as an indemnity or through warranty protection); or
   
• remedy the relevant risk in the course of a post-completion integration process.

 How can the buyer prepare for integration post-closing?

The ESG due diligence outcomes will assist the buyer in considering the impact of the acquisition on its own reputation, culture and the integration of the target into the buyer’s group.

The buyer should plan ahead and consider the strategies and actions it will implement post-closing to:

• address any material risks identified during due diligence;
   
• align the target’s ESG policies with those of the buyer; and
   
• ensure the target’s ESG compliance meets that of the buyer.

With the processes already considered the buyer will be better positioned to ensure a more seamless integration of the target.

Final thoughts

The consideration and management of ESG factors is increasingly important in M&A transactions.

Sellers whom actively prepare and engage in ESG diligence improve their business valuation and competitive market pricing whilst allowing buyers to better evaluate their targets. ESG need not be perceived as solely risk-based but rather a metric from which both buyers and sellers stand to gain value.

This Q&A does not constitute legal advice. Should you have any queries, or youwould like our assistance in considering the issues raised in this Q&A then please do not hesitate to contact the author of this article or your usual contact at Ince.