Posted: 30/06/2023
The focus on environmental, social, and corporate governance (ESG) continues in 2023, with ESG considerations firmly on the decision-making agenda for investors, particularly those contemplating cross-border M&A transactions.
Most of the mandatory ESG regulations currently apply to listed companies, large corporates, LLP’s, private equity funds and financial institutions. Reporting obligations are set out in various legislation and industry requirements, but there is no single body or framework in the UK that covers all aspects of ESG. The main sources of legislation in the UK[1] are:
However, reporting requirements will likely shift toward smaller companies also adopting ESG reporting standards at some level in the future. The long-term ESG and sustainability goals of a target are therefore increasingly featuring as a value driver impacting its prospects, which is being reflected in target valuation. Those targets which can credibly prove they are at the forefront of ESG developments appear to be attracting more market interest and securing higher valuations from acquirors who are looking to raise their own ESG credentials.
Given the potential value proposition, many private companies are electing to report voluntarily to prepare for future initiatives and to ensure any long-term disposal strategies are not impacted by poor ESG governance – a wise move in this climate it seems.
In particular, voluntary ESG reporting frameworks, such as the Global Reporting Initiative (GRI), the Sustainability Accounting Standards Board (SASB), the International Sustainability Standards Board (ISSB), the United Nations’ Sustainable Development Goals (SDGs), and the Taskforce on Climate Related Financial Disclosures (TCFD) are proving popular with private companies.
Whilst ESG is not part of traditional due diligence, it has become increasingly important for investors when making investment decisions. In the context of M&A due diligence, a clear focus is being placed on ESG in document review, evaluation of target companies’ ESG policies and initiatives, and on the assessment of target companies’ compliance models. Input from legal and non-legal advisors is necessary and advisable to ensure robust expert analysis, which allows acquirors to address and evaluate the position thoroughly.
These are some, but not all, key recommended ESG diligence areas:
Pre-sale planning is key for sellers, and they should be prepared for ESG queries likely to arise. Sellers who have committed to ESG initiatives can use the diligence process to show case specific achievements which will undoubtedly positively impact valuation. They should aim to highlight to the acquiror:
It is important to review and identify early on any ESG issues or concerns. Early review will allow an acquiror to appoint appropriate specialists during the due diligence phase to further assess and pinpoint material risks which may require ESG focused warranties, covenants, or indemnification and/or insurance, and to ascertain any opportunities and prospects which could influence pricing or earn out arrangements.
Key to this is acquirors being aware of their own commitments and obligations to ensure that any target it acquires does not adversely impact its own ESG compliance requirements. This will also assist the acquiror with the ESG due diligence and review process.
Specifically, an acquiror should consider:
Whilst many general ESG risks can be covered by the standard set of warranties, eg the compliance with law and the no-litigation warranty, this is not always appropriate or adequate and acquirors may therefore consider more tailored representations and warranties. However, determining the criteria for these and quantifying financially the damages that could be incurred from such breaches makes traditional and even tailored warranties unworkable for certain risks.
So whilst such warranties may be useful for disclosure purposes, buyers might consider additional protective measures such as:
The materiality of the ESG risk will inevitably steer the negotiations and ultimately determine the course of action and approach in the transaction documentation.
For investors future proofing is key. The focus is always on what the target will look like in the future and whether the acquisition documents reflect this.
A target company’s ability to comply with current, proposed and even voluntary requirements around climate, sustainable supply chains, workforce conditions and energy usage is becoming imperative. With further developments in reporting on the way in the UK, such as the new sustainability disclosure requirements (SDRs) - expected to come into force in Q3 2023 - which aim to set metrics, goals, and provide a framework that companies can use to assess sustainability risks, there is no doubt that ESG considerations are certainly going to continue to impact M&A transactions going forward.
[1] Note that European sustainability reporting obligations can also impact UK companies if they have significant operations or activities in the EU.