ESG Essentials in M&A: What You Need to Know

In the contemporary corporate arena, the incorporation of Environmental, Social and Governance (ESG) factors into Mergers and Acquisitions (M&A) is evolving from a mere trend to an indispensable practice. With the crescendo of regulatory demands and the rise of consumer consciousness, corporate development teams have no choice but to acknowledge the importance of ESG in sculpting their M&A blueprints.

ESG Credentials: A Compass in Acquisition Attractiveness

The ESG performance of a company is emerging as a pivotal compass, guiding the attractiveness of a company for acquisition. Companies able to demonstrate robust ESG credentials are set to command elevated valuations, regarded as being adept at steering through future regulatory, environmental and societal challenges. The addition of ESG considerations is not just reshaping the landscape of M&A activities but is becoming a cornerstone in determining a company's value and potential for sustainable growth.

Due Diligence: The ESG Lens

The due diligence process is witnessing the inclusion of new ESG risks, with acquirers examining the ESG performance of targets to circumvent reputational risk, regulatory impacts and future litigation. Furthermore, the post-merger integration landscape is set to demand stringent ESG alignment, with acquirers motivated to align their targets’ ESG policies and practices with their own, in hope of fostering stakeholder trust and protecting value. This shift signifies a marked transformation in the evaluation of potential acquisitions, underscoring the significance of ESG elements in assessing a company's long-term viability and resilience.

The Perils of ESG-Toxic Acquisitions

Companies, in crafting their M&A strategies, stand at a juncture where the acquisition of “ESG-toxic” businesses – entities marred by subpar ESG standards or records – is fraught with substantial risks and challenges. These companies, potentially engaged in activities detrimental to the environment, exhibiting poor treatment of workers, or having a history of unethical conduct, etc. present a mixed bag of problems including financial, reputational, regulatory, integration challenges and human capital risks. The acquisition of an EGS-toxic company requires a thorough examination of the potential implications and a tactical approach to mitigate the associated risks. Buyer beware.

ESG: A Paradigm Shift in Due Diligence Review

The incorporation of ESG factors into the due diligence process marks a transformative shift in the evaluation of potential deals. Corporate development teams are increasingly recognising the substantial impacts ESG risks and opportunities can wield on a company’s financial trajectory, reputation and enduring sustainability. Accordingly, the due diligence process is now an amalgam of environmental analysis, social analysis, governance analysis, risk assessment and opportunity identification. Each aspect of this multifaceted approach plays a crucial role in determining the overall attractiveness and viability of a potential acquisition and should not be overlooked.

Example ESG Due Diligence Checklist

Environmental Compliance and Impact:

   - Assess compliance with environmental regulations.

   - Evaluate the target’s environmental footprint, waste management, and resource usage.

   - Identify potential environmental liabilities (e.g., contamination).

Social Responsibility and Relationships:

   - Review labour practices, human rights policies, and employee relations.

   - Examine relationships with communities, customers, and suppliers.

   - Assess data protection measures and customer satisfaction.

Governance Structure and Practices:

   - Analyse corporate governance structure, including board composition and diversity.

   - Review executive compensation, shareholder rights, and ethical conduct policies.

   - Evaluate any history of regulatory fines, penalties, or legal issues.

Reputational Risks:

   - Investigate any past ESG-related controversies or scandals.

   - Assess the potential impact of the target’s ESG performance on brand reputation.

Regulatory Landscape and Compliance:

   - Consider the current and future regulatory environment related to ESG.

   - Evaluate the target’s compliance with relevant local, national, and international regulations.

Integration Challenges:

   - Assess the alignment of ESG policies and practices between the acquiring and target companies.

   - Estimate the cost and effort required to align the target with the acquirer’s ESG standards.

Human Capital:

   - Evaluate the target’s ability to attract and retain talent based on its ESG performance.

   - Consider the impact of ESG issues on employee morale and productivity.

Financial Implications:

   - Identify any financial risks or liabilities related to ESG issues.

   - Assess the potential impact of ESG factors on the target’s valuation.

Opportunity Identification:

   - Identify opportunities for value creation through improved ESG performance.

   - Explore potential for revenue generation from sustainable products or services.

IFC and International Standards:

    - Consider the target’s categorisation according to IFC’s ESG risk categorisation.

    - Evaluate compliance with international standards such as IFC Performance Standards and International Labour Organisation (ILO) Core Labour Standards.

By thoroughly considering these factors, deal makers can gain a better understanding of the ESG risks and opportunities associated with an M&A target, aiding in informed decision-making.

IFC’s ESG Risk Categorisation

The International Finance Corporation (IFC) employs a categorisation process to describe the magnitude of risks and impacts associated with investment transactions. The categorisation spans from Category A, representing significant adverse impacts, to Category C, indicative of minimal or no adverse impacts (see below).  

ESG due diligence should be focused on various aspects including IFC Performance Standards for Environmental and Social Sustainability and International Labour Organisation (ILO) Core Labour Standards, among others. This categorisation process serves as a comprehensive framework for assessing the environmental and social risks and impacts of investment transactions, providing a structured approach to ESG risk management.

• Category A activities are likely to cause significant, diverse, or unprecedented adverse impacts, considered "significant" if irreversible, affecting vulnerable groups, posing major health risks, involving displacement, or impacting cultural heritage sites.
  
  
• Category B activities may cause specific, mostly reversible impacts, with predetermined mitigation measures in place, and are less adverse than Category A.
  
  
• Category C activities have minimal or no adverse impacts.

Considering the acquisition of an M&A target characterised by suboptimal ESG practices presents a range of risks and challenges:

Financial Risks

Companies with deficient ESG practices are often perceived as harbouring elevated risk, presenting an argument for in lower valuations. Such companies may face liabilities stemming from environmental contraventions or litigation around labour disputes, etc. These liabilities (which might be off-balance sheet at the time of due diligence) have the capacity to directly impact upon the financial trajectory of the acquiring company in the post-acquisition phase and even to fully de-rail a deal.

Reputational Risks

Acquiring a company tarnished by a compromised ESG track record can inflict adverse consequences on the acquirer’s reputation across customers, investors and wider stakeholders. Indeed, association with an “ESG-negligent” company could damage customer and investor relationships and ultimately, an erosion of shareholder value. In this respect, acquirers need to think long and hard about the reputation of the target company and whether any trade-off around introducing reputational risk can be justified.

Regulatory Risks

Companies labelled as ESG-toxic are susceptible to intensified scrutiny from regulatory entities, potentially resulting in fines or sanctions. The regulatory landscape is becoming stricter in relation to ESG considerations, thereby, the acquisition of a company beset by inferior ESG performance could bring about significant complications in regulatory compliance across subsequent stages of the deal process.

Integration Challenges

The integration of a company burdened by poor ESG standards into a company well-known by robust ESG standards can create an up-hill battle for the integration team and functional workstreams. Additionally, the acquirer may find itself duty-bound to channel significant investment towards aligning the acquired company with its own ESG benchmarks. In this respect, it’s imperative to model any such integration costs into the deal.

Human Capital Risks

Companies with tarnished ESG records may encounter challenges in attracting and retaining talent. Empirical studies show a preference, particularly amongst millennials and the younger workforce, for working with companies that consider ESG fundamentals as part of their mission statement and general working practices.

ESG’s Influence on Deal Fundamentals and Structure

ESG considerations are emerging as potential deal-breakers and influencers on business plans, valuations, deal structures and financing. Non-compliance with environmental regulations, reputational risks, ethical concerns, cost of remediation, revenue and growth opportunities, risk assessment, earn-out provisions and financing terms are key considerations in this evolving landscape. The influence of ESG on deal fundamentals and structure underscores the need for organisations to integrate ESG considerations into their strategic planning and financial projections, ensuring alignment with regulatory requirements and industry standards.

Navigating ESG Risks: Warranties and Indemnities

In an era of heightened awareness of ESG risks, warranties and indemnities are becoming instrumental in managing these risks in transaction agreements. ESG-related representations, warranties and indemnities are integral components of a transaction agreement, serving as conduits for the allocation of ESG risks and liabilities between the seller and the buyer. The utilisation of warranties and indemnities to manage ESG risk in M&A transactions reflects the growing recognition of the potential financial and reputational implications of ESG issues, requiring proactive risk management strategies.

Takeaway

Incorporating Environmental, Social, and Governance (ESG) factors into Mergers and Acquisitions (M&A) is shifting from a supplementary trend to an imperative necessity, propelled by escalating regulatory standards and heightened consumer consciousness. ESG credentials are now a crucial barometer of a company’s acquisition appeal and intrinsic value, reshaping the terrain of M&A activities and due diligence processes. The navigation through the acquisition of “ESG-toxic” entities demands a careful and strategic approach, given the range of associated risks including financial, reputational, regulatory and human capital.

Key considerations for M&A deal makers include assessing the target’s ESG performance, anticipating integration challenges and evaluating potential impacts on reputation and regulatory compliance. The IFC’s categorisation process and the increasing reliance on warranties and indemnities underscore the significance of a comprehensive and proactive approach to ESG risk management.

Ultimately, as the ESG landscape continues to evolve, deal makers must remain vigilant, adapt to emerging trends and integrate ESG considerations into their strategic planning to ensure the long-term viability and sustainability of their acquisitions.