As environmental, social and governance (ESG) factors have become a growing focus for companies and their shareholders, financiers, employees and other stakeholders, they have also become increasingly important to the success of M&A transactions.
ESG factors are now seen as important value drivers for dealmakers, as well as being essential to corporate values and reputational expectations. Effective diligence, evaluation and management of ESG considerations are critical steps for parties to take to mitigate risk, achieve beneficial outcomes and synergies, and successfully execute transactions. This article explores key ESG factors that are increasingly influencing M&A transactions, as well as actions parties can take to effectively identify and address ESG risks—and how buyers can capitalize on ESG opportunities presented by a target company.
Identifying and understanding the material ESG factors at play is a critical aspect of evaluating the potential risks and benefits of a transaction. The wide range of ESG factors means risks and opportunities may arise from many areas. For example, buyers will want to assess whether a target company: engages in appropriate environmental practices; has proactive climate change adaptation and greenhouse gas reduction plans; operates without unsafe or abusive labour practices; has a satisfactory human rights and community engagement record; has sufficient data protection, privacy and anti-corruption practices in place; and has a reputation of satisfactory legal and regulatory compliance generally. Overseas operations and supply chains can often heighten transaction risk, particularly in developing countries. Many human rights, social and environmental advocacy groups are well-organized and well-funded to draw attention to ESG deficiencies and initiate campaigns that can result in significant reputational damage.
In addition to commercial and reputational consequences, there are increasingly direct and indirect legal, regulatory and governmental risks for transaction parties that may arise from:
Many ESG factors work to serve as direct reflections of core corporate culture and values, which means that failure to take appropriate steps to address ESG factors can have a disproportionately negative reputational impact on organizations. For this and other reasons, consideration of ESG factors is also coming into greater focus for corporate directors in discharging their fiduciary duties and exercising their governance responsibilities. In evaluating and approving a transaction, boards should seek to understand the ESG risks associated with the transaction, the mitigants that management is proposing to adopt, and ensure that management implements reporting processes so that the organization’s approach can be effectively monitored.
Companies are investing heavily in their ESG frameworks and implementation of improved ESG standards. M&A transactions will be evaluated for consistency with those expectations and criteria. Corporate codes of conduct and integrity guidelines have become increasingly ESG-focused and many expressly reference the UN Guiding Principles on Business and Human Rights, which principles include human rights due diligence, steps for prevention and remedial action, and a reliable forum for complaints. Accountability for meeting ESG priorities is being reflected in companies’ corporate performance scorecards and executive compensation decisions.
The cost of and access to capital for businesses is increasingly being linked to their ESG ratings and performance. This is becoming a consideration of increasing importance for M&A transactions—both in terms of the availability of acquisition financing necessary to complete the transaction, as well as the ongoing financing post-closing for the combined business. Large institutional asset managers such as BlackRock and State Street have announced that their investment decisions will be driven by ESG performance. In addition, 113 financial institutions in 37 countries have now adopted the Equator Principles1.
The Equator Principles offer a risk management framework for determining, assessing and managing environmental and social risk in projects2. On October 1, 2020, the latest version of the Equator Principles, EP4, came into effect. EP4 expands the application of the Equator Principles and reflects the growing importance of ESG factors through strengthening the requirements for Indigenous stakeholder consultation and climate change risk analysis and biodiversity reporting, among other things. Similarly, lenders such as the International Finance Corporation (IFC) and export credit agencies incorporate ESG-related performance standards into their assessment of potential investments3. Commercial lenders are also increasingly considering ESG factors part of the process for making their lending decisions.
ESG issues are now more important than ever for public shareholders and activists in the context of M&A transactions. Unaddressed ESG risks and resulting reputational damage can cause failure of a buyer and/or target to obtain required shareholder approvals for a transaction and serve as a catalyst for activist campaigns (and potentially even litigation) that may impact a company long after a proposed transaction is abandoned or completed. Conversely, companies with a strong ESG reputation and who are seen to take proactive steps to manage ESG risks are more likely to be given greater support and latitude to engage in M&A transactions by their shareholders.
Due to the growing investor focus on transparency and evolving regulatory requirements, public companies are increasingly finding it necessary to provide more detailed disclosure on their ESG practices and procedures, including in relation to acquired businesses. Therefore, acquirors are becoming more focused on their ability to comply with such disclosure requirements and the risk of liability for misstatements or omissions on ESG matters. Similarly, lenders are increasingly incorporating ESG disclosure obligations as conditions of their loan agreements. This, in turn, is likely to provide a further imperative for appropriate diligence, management and monitoring of ESG risks in M&A transactions.
The following are several concrete steps that parties can take to address ESG considerations in their M&A transactions and the issues noted above.
In addition to other customary diligence investigations, buyers should consider undertaking in-depth diligence specifically focused on sustainability and ESG issues relating to the target company. Appropriate ESG diligence will largely depend on the nature and type of business the target is conducting and the jurisdictions in which it is operating. Specific areas of focus may include:
While diligence in these areas often focuses on downside risks, upside value creation opportunities should also be considered and identified. Buyers should review a target’s areas of significant positive ESG performance, especially where this performance may enhance the ESG reputation of the combined entities and contribute to other valuation metrics. ESG diligence will also be a focus for other third parties involved in the transaction (investors, lenders, underwriters, insurers, partners and other stakeholders), and a thoughtful approach by the buyer will facilitate the diligence process for those parties.
When negotiating transaction agreements, buyers should consider whether material ESG risks identified through the diligence process can be mitigated through contractual protections. Standard representations and warranties broadly covering customary matters, including legal, regulatory and environmental compliance, may offer significant protection. Buyers may also consider more specific ESG-focused representations and warranties. For example, representations and warranties could be included regarding compliance with specific codes or principles that the target has undertaken to voluntarily comply with—such as in the case of precious metals miners, compliance with the Responsible Gold Mining Principles developed by the World Gold Council, or in the case of certain carbon intensive companies, compliance with the recommendations of the Task Force on Climate-related financial disclosures. Other special representations and warranties relating to environmental, human rights and climate change matters and/or specific ESG problems experienced by the target may also be considered. Other provisions to consider include special pre-closing covenants requiring detailed reporting and disclosure of any new ESG issues that may arise, and in the case of private company transactions, special indemnity arrangements for known ESG issues.
After the deal has closed, it is essential that ESG remains a strong focus of the acquiror’s integration plan. The acquiror will want to develop and implement an action plan to address material ESG risks of the target company and monitor remedial efforts and compliance going forward. Another key priority will be ensuring that the target’s culture of ESG compliance meets the expectations of the acquiror. The acquiror should ensure that appropriate ESG policies of an equivalent scope and standard are implemented by the target, communicated effectively to relevant employees, shareholders and stakeholders, and enforced by management. A merger or acquisition may also present the opportunity for the acquiror to leverage best practices from the target, if the target’s ESG policies and achievements are stronger in certain areas, or to seize on ESG-related opportunities presented by the target’s reputation and performance in the area.
Appropriate consideration and management of ESG issues has risen to be an area of critical importance to M&A transactions. Parties that can proactively identify, address and monitor ESG risks (as well as opportunities) are likely to have more success in completing transactions that will contribute to the value of their organizations in the long term.
1 Equator Principles Association Members and Reporting: https://equator-principles.com/members-reporting/
2 Equator Principles, July 2020, effective October 1, 2020: https://equator-principles.com/wp-content/uploads/2020/05/The-Equator-Principles-July-2020-v2.pdf
3 International Finance Corporation: https://www.ifc.org/wps/wcm/connect/topics_ext_content/ifc_external_corporate_site/sustainability-at-ifc/policies-standards/performance-standards/ps5