Environmental, social and governance (ESG) considerations are not new, but their importance has increased dramatically in recent years with movements such as #MeToo and Black Lives Matter putting various social issues in the limelight and events such as last year’s COP26 summit and the global Net Zero targets drawing attention to the need to tackle environmental and energy issues. Against this backdrop, businesses are being scrutinised by a range of stakeholders including consumers, employees, and investors. As a result, ESG considerations have become a key agenda item for shareholders and boards and they are now playing a significant role during mergers and acquisitions, from target selection and due diligence through to post-merger integration.
In this article we consider where ESG factors are relevant in private company M&A transactions, how to approach such factors and what can be done in advance of a deal, from the perspective of both a seller and a buyer.
Preparation for the sale for a company
One of the key elements to ensuring a sale proceeds is to ensure buy-side due diligence is well handled by the selling shareholders and their advisers with any business risk issues pre-empted well before they are raised by the buyer’s advisers. Sellers should therefore consider carrying out their own pre-sale due diligence process. This may include reviewing contracts to ensure they are up to date and ensuring a company’s assets are documented and recorded carefully. This is particularly important in seller led sale processes.
As ESG considerations increase in priority, sell-side due diligence can also be an opportunity to demonstrate and build upon a company’s ESG successes by giving the company a chance to emphasise improvements made to its operating model (for example, reductions in energy use), demonstrate effective management structures (such as well constructed board governance guidelines) and highlight the future opportunities available from its ESG strategies. By critically assessing the company’s ESG approach as part of pre-sale planning, it could positively impact the deal value and sale process.
Target selection from the buyer’s perspective
Corporates are increasingly seeking transactions to improve their ESG credentials to create greater long-term value for their business, shareholders and other stakeholders. Buyers are interested in how simple the process of integrating an acquisition into their existing business will be (and key to this is how well it measures against their existing business’ internal ESG standards). If, for example, a company acquires a target with a corporate culture significantly different from its own, this can make integration difficult, and the deal may then be at risk of falling through. Various ESG research and ratings providers have now developed quantitative measures for aspects such as corporate culture, which can be used to assess the likelihood of long-term success from the acquisition.
ESG’s contribution to valuation
A good ESG strategy could potentially increase a company’s value as a result of:
- Positive shareholder and wider stakeholder engagement.
- Retention of employees and attracting new hires.
- Attracting ESG focused investors.
- Customer engagement and loyalty.
- Potential cost reduction.
- Reduced regulatory interference.
By framing the assessment of ESG around value and risk management across a company’s business and evidencing how these have a positive impact on the company’s performance, this should minimise negative impact on the valuation of a deal (and could be used in negotiating the sale agreement).
Due diligence by a bidder
Some ESG factors have long been a feature of a buyer’s customary due diligence processes, such as a target’s governance structure or its approach to health and safety. However, such due diligence analysis has not explicitly sought to assess ESG adoption by a target company. Adding a dedicated environmental and social focus provides the opportunity to identify and quantify different types of risks and opportunities.
Appropriate ESG diligence largely depends on the nature and type of business, however, as ESG is becoming a more integral part of a company’s or bidder’s operating model, areas of increasing focus include:
- The target’s policies and programmes aimed to track its ESG progress, compliance with its ESG objectives and to address risks.
- The detection and prevention of abuses and maintaining labour standards in a company’s supply chain.
- Employee engagement and workforce culture and diversity.
- How a target interacts with its wider stakeholders.
- Environmental and energy use.
- Whether a target complies with the ESG disclosure and reporting obligations that it has voluntarily chosen to follow (as a result of most private companies not yet being subject to mandatory ESG reporting requirements).
Such diligence is crucial for identifying ESG risks and the consequent protections that will be required in the sale agreement or to be adopted in the post-closing integration. Furthermore, as not all ESG matters can be financially quantifiable, it may be challenging for a buyer to be fully compensated in the event of non-compliance by way of contractual provisions such as warranties and indemnities (however see further below). Detailed ESG due diligence therefore ensures that issues are dealt with at an early stage prior to the acquisition completing.
ESG in transaction documents
Where due diligence highlights ESG risk, buyers may seek to negotiate the acquisition terms in the following ways:
- A downward valuation of the target company.
- Transactional insurance against the risk.
- A carve-out of the relevant part of the business that is affected, remaining with the sellers.
- Certain risks addressed in the transaction documents (as an indemnity or a pre or post closing condition); or
- Remedy the relevant risk during the post-completion integration process.
Buyers should consider the materiality of any ESG risks identified through the due diligence process and whether they can be mitigated through contractual protections. Many of the typical warranties and representations included in M&A transactions cover standard matters such as legal, regulatory and environmental compliance. Although buyers may consider more specific ESG-focused representations and warranties, for example, regarding compliance with specific codes or principles that the target has undertaken to voluntarily comply with, or to cover specific climate change matters, such specific warranties are generally limited due to the difficulties in determining the losses flowing from such breaches. Other contractual provisions that may be considered include pre-closing covenants requiring the target to disclose any new ESG risks between signing and closing the deal, or otherwise indemnity arrangements for known ESG issues (although see comments above).
After the completion of an acquisition, ESG often remains a key focus of the buyer’s integration process. Buyers tend to develop and implement action plans to address material ESG risks of target companies and monitor remedial efforts and future compliance. To ensure a company’s ESG compliance meets the buyer’s expectations, buyers will require the target to sign-up to their group’s ESG policies, communicate these to relevant stakeholders e.g. shareholders and employees, and ensure these are enforced by management through, for example, their bonus KPIs.
What could a future ESG led M&A transaction look like?
Over time, it is likely that private company M&A transactions will see more ESG-linked performance metrics being used in both management remuneration and earn-outs for exiting shareholders as effective tools to help foster stakeholder alignment by basing such rewards and returns off a combination of financial as well as ESG performance related targets.
The successful execution of mergers and acquisitions is therefore becoming more reliant on the effective diligence, evaluation and management of ESG considerations as these are critical steps for both parties to take before and throughout the M&A process in order to mitigate risk and achieve beneficial and long-term synergies for both the buyer and acquired business.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, August 2022