ESG sits firmly on the private M&A decision-making agenda

Posted: 30/06/2023

Introduction

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:

• the UK Corporate Governance Code 2018 (UKCGC);
• the directors’ duties in the Companies Act 2006;
• the Listing Rules;
• the FCA’s disclosure guidance and transparency rules (DTRs);
• the UK Stewardship Code 2020 (UKSC);
• the Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008;
• the Climate Change Act 2008; and
• the Bribery Act. 

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.

Due diligence

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:

• environmental issues (management of emissions, waste disposal, climate change, consumption of resources);
• health and safety (working conditions, compliance with health, safety);
• commitments to employees (retention, incentives, diversity, equal opportunities, anti-discrimination, worker rights);
• supply chain activity (responsible purchasing policy, supply chain code of conduct, risk assessment);
• security and risk management (security regulation compliance, cyber security administration, IT and data protection);
• operations (crisis management framework);
• board structure (composition, remuneration, decision-making process);
• disclosure and reporting standards and commitments; and
• compliance with anti-corruption regulations.

Seller preparation

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:

• progress made with its operations, such as reductions in energy use, recycling initiatives, efficient waste disposal, sustainable resources etc;
• improvements to governance and guidelines showing positive outcomes where processes and direction have been implemented and followed;
• retention of employees and the ability to attract new talent;
• customer satisfaction (product sustainability);
• sustainable practices within its supply chain (employment rights, health and safety, modern slavery); and
• prospects and opportunities arising from the implementation of its ESG strategies.

Acquiror preparation

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:

• its supply chain agreements to ascertain any specific ESG obligations it has in place with its suppliers (and liabilities for a failure to comply);
• the customer contracts it has in place to identify any ESG duties or responsibilities it has committed to its customers;
• its existing finance arrangements to identify any ESG specific reporting, disclosure and compliance requirements it may be subject to (and any ESG covenants proposed for deal related acquisition finance);
• whether its own ESG profile aligns with that of the target to avoid falling foul of ‘greenwashing’ claims (arising where statements issued by the acquiror regarding sustainability conflict with, or are undermined by, a target’s activities);
• whether a target’s initiatives around diversity and inclusion are on a par with its own (to allow positive integration and to avoid post acquisition issues with misaligned corporate culture); and
• its mandatory and/or voluntary ESG disclosure commitments to ascertain how the target’s processes will be integrated or expanded to fit with these.

How to deal with ESG risk

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:

• indemnification (although depending on the risk note these may prove difficult to insure);
• material adverse change/material adverse event clauses;
• ESG specific W&I insurance (subject to the usual diligence and carve out requirements);
• acquiring only the parts of the business carrying no ESG liability or risk;
• conditions precedent (where the risks relate to compliance and can be cured before completion);
• interim period operating covenants (where there is a split exchange and completion);
• completion conditions (where the risks are lower and a cure is necessary but not required immediately) potentially coupled with ESG related liquidated damages, and a reduction in management earn out remuneration where certain ESG ‘performance related targets’/conditions are not met within agreed post completion timeframes.

The materiality of the ESG risk will inevitably steer the negotiations and ultimately determine the course of action and approach in the transaction documentation.

Conclusion

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.

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