ESG and acquisitions - Vice and virtue increasingly shape M&A

Beyond a mounting execution and DD risk for deals, ESG factors are now driving some transactions outright

Why is ESG important?

Environmental, social and governance (ESG) issues have risen up the agenda of investors, governments and the public at large all over the globe. This has seen ESG become a driver for transactions – in the form of both disposals of risky assets (eg, fossil fuels) and acquisitions of sustainable assets or assets that will help a company achieve its ESG goals (eg, renewables, recycling, waste management, tech and aquaculture). At the same time, ESG factors are receiving more attention in due diligence and deal terms as their materiality increases.

There is also greater regulatory focus on ESG – reflected in the introduction of reporting requirements across the globe (including in the UK, Japan, Hong Kong and China) and moves in Europe to impose new corporate governance and risk management obligations on companies relating to ESG.

Whilst reporting requirements have to date largely been targeted at listed companies, they are expected to be extended to large private companies in some jurisdictions. It is important in the context of private M&A to consider how ESG risks and regulations may affect a company's reporting obligations, or any plans to exit an investment in future, through a subsequent disposal or an IPO. The focus on ESG is not just driven by legislation: a ground-breaking judgement in Milieudefensie et al. v Royal Dutch Shell in May 2021 saw a Dutch court order a company to reduce its CO2 emissions.

How does it impact M&A?

Businesses need to pay attention to ESG issues not only because they – or the businesses they seek to acquire – could be in breach of hard law but also because such issues may impact on their reputation or degrade their future performance. In M&A, negative ESG issues – whether related to environmental impact, board diversity, supply chain management, or other factors – may affect deal certainty by impacting target valuations in previously unexpected ways. They may also affect the availability of financing for a transaction as lenders and investors increase their focus on these issues.

ESG due diligence is becoming more important for corporate and private equity buyers in M&A transactions. Buyers and advisers should consider appropriate, sector-specific scopes for such diligence exercises, particularly as monetary or other traditional 'risk' thresholds in due diligence may prevent discovery of some ESG issues, such as a human rights breaches in the supply chain.

Deal protection provisions are another area in which ESG is impacting on M&A transactions. Buyers may request ESG-related warranties above and beyond the traditional scope of 'compliance with law' warranties. As ever, any ESG-specific warranties need careful drafting to ensure any breaches and resulting losses are objectively identifiable. This is especially important if the parties want to utilise warranty and indemnity (W&I) insurance for the transaction.

Sellers may also look to protect their reputation post-closing, for example, by conducting diligence on the buyer or seeking post-closing commitments as to how the business will be run by the buyer in future.

Source: Global dealmakers series 2021 – "Deal breakers and opportunity makers: The role of ESG in M&A" Baker Tilly International/Acuris thought leadership campaign (http://www.bakertilly.com/insights/deal-breakers-and-opportunity-makers)