Dr Eckart Gottschalk
CMS Hasche Sigle, Hamburg
eckart.gottschalk@cms-hs.com

Introduction

Given the ever-increasing focus on sustainability, businesses would be well advised to take environmental, social and governance (ESG) factors into account in today's M&A transactions.

ESG in M&A

Since the 2015 Paris Agreement on climate change, there has been certainty about the direction: the global economy will be transformed. Around the world, economies and states
are implementing the binding Paris Agreement with national determined contributions (NDCs) to phase out fossil-based industries by 2040–2060 (China as the last one by 2060). As short-term consequences, major shifts in investments can be seen towards low-emission production, qualifying any further investments in fossil-based technologies as stranded assets.

Overall, five interlinked forces in the global economy can be identified that are driving the climate and sustainability agenda forward: (1) regulators, to enforce behaviour and influence business models; (2) investors, as they reroute capital and influence returns; (3) employees, as they shift sides in the war on talent; (4) activists, as they put the spotlight on non-transparent issues; and (5) customers, as they shift market share.

Reasons for considering ESG factors in general

ESG is a set of standards that measure a business's impact on society (eg, human rights, health and safety at work, and diversity and inclusion), the environment (climate, biodiversity and CO2 reduction etc), with governance (eg, risk management, executive compensation and compliance) as its connector.

The driving factors in this regard are, first, regulations such as the 2015 Paris Agreement and the action plans at a national and European level, as well as supply chain legislation. Second, civil society and consumers play a major role, as evidenced by their ever-increasing demand for sustainability and observance of human rights, as well as the growing number of social movements and non-governmental organisations (NGOs). The financial markets and their standards are also seen as drivers, with increasing ESG requirements in accounting standards (eg, the International Accounting Standards Board (IASB), Deutsches Rechnungslegungs Standards Committee (DRSC), International Federation of Accountants (IFAC) and Institut der Wirtschaftsprufer (IDW), as well as the stricter financial market regulations like the Insurance Distribution Directive (IDD) and Markets in Financial Instruments Direction (MiFID)), the issuance of green bonds (with an average annual growth of 50 per cent per year since 2016), the establishment of the TCFD (Task Force on Climate Related Financial Disclosures) by the G20 Financial Stability Board calling for the transparent management of climate risks, and also the inflow into ESG integrated equity funds, with an overall increase of 200 per cent from 2018 to 2019 in the European Union and US.

There are already some external guidelines: since the United Nations 2030 Agenda for Sustainable Development, the EU has increasingly sought to initiate the redirection of private capital into so-called sustainable investments, notably through the adoption of the Sustainable Finance Disclosure Regulation in 2019 and the Taxonomy Regulation in 2020. Moreover, in the US the Inflation Reduction Act of 2022 is considered the most significant climate legislation in the country's history, offering funding, programmes and incentives to accelerate the transition to clean energy.^[1] This highlights another benefit of focusing on ESG factors, which is that companies may additionally be eligible for financial support from the public sector, such as the European Fund for Strategic Investments (EFSI) in the EU.

From an operational perspective, there are many areas of a business which are affected by ESG such as: (1) sales, as customers demand sustainable products; (2) operations, as a key enabler to achieve carbon footprint reduction; (3) tax, to manage sustainability-related tax matters, as well as grants and incentives; (4) legal, for general compliance and governance, as well as observation of gender quota laws for company boards and supply chain due diligence laws; and (5) finally, finance, to coordinate ESG reporting and key performance indicator (KPI) monitoring, green finance and sustainable finance. These five key functions are also considered as part of M&A activities.

The importance of ESG as part of a transaction

ESG matters in M&A transactions: recent research by Deloitte found that exactly three-quarters of all German companies believe that placing purpose alongside profit will be important. ESG analysis has already played an important role for institutional investors: such analysis resulted in a 30 per cent change in investment decisions and a 54 per cent reduction in the bid price. A significant majority of 94 per cent used this approach as part of the acquisition diligence process.^[2]

The consideration of ESG factors in M&A transactions is particularly relevant for those stakeholders who already (have to) increasingly incorporate sustainability aspects into their decision-making processes (eg, banks and insurance companies). Furthermore, ESG factors are already taken into account by private equity funds like KKR and Blackstone.^[3]

Certain areas are particularly relevant when it comes to ESG in M&A: principally, close attention should be paid to the avoidance of assuming sustainability risks that may have a negative impact on the targets company's economic valuation and, thus, indirectly on the buyer, such as bad publicity due to child labour abroad. Moreover, compliance with specific sustainability criteria is of great importance in sustainability industries, as adherence to these criteria is more likely to create added value for the target company and, thus, indirectly for the buyer. It is also relevant for the internal presentation and perception of the management board (eg, bonuses). Furthermore, ESG can serve as a means to mitigate risk factors, for example, in the case of a reorientation of a group of companies.

Prospective sellers, on the one hand, would be well advised to identify the ESG risks at an early stage of potential transactions that might have a negative impact on the enterprise value and the sale and purchase agreement (SPA) negotiations through a risk assessment and ‘bridal makeover’. In general, the target's implemented and sustainable corporate governance measures should be described alongside a list of all the sustainability standards applied. In terms of reporting, it is essential to get clarity on how sustainability issues are communicated internally and externally, and whether the company/group undergoes external sustainability audits. Additionally, it should be identified whether there are any requirements for suppliers/service providers in the supply chain and how their verification process is designed. Environmental policies and measures implemented to reduce energy consumption, if any, should be described. Finally, the seller should list all the loans and other financial resources in which the company is involved as a borrower that are linked to compliance with sustainability criteria.

Buyers, on the other hand, should define the importance of ESG in M&A transactions, which depends on the company's own ESG policy. An exclusion list of sectors, industries and specific economic activities in which investments may not be made should be determined, as well as reasons for transactions, for example, added value through sustainability considerations or ‘only’ avoidance of ESG risks.

ESG due diligence

As ESG factors are more commonly being taken into account nowadays, ESG due diligence is becoming more popular alongside legal and compliance due diligence, resulting in a review of the target company's awareness of the relevant sustainability legislation, the alignment of its internal and external processes with sustainability aspects, the ESG measures implemented or planned, and alignment with the prospective buyer's ESG policy. This represents a broad field of application that may be limited by the respective needs of buyers.

ESG factors in SPA negotiations and beyond

ESG factors can become relevant at any stage of the negotiation process. For example, meeting a certain sustainability standard can be either a signing or closing condition. ESG factors can also be included as a representation for which an indemnity is agreed on. In addition, the consolidation of ESG-related issues is an integral part of the post-merger integration process.

Conclusion

Businesses are facing a flood of new and future regulatory activity, often related to ESG aspects. To avoid assuming unknown ESG risks, legal/compliance due diligence should be extended to include the ESG risks of the target company, as ESG can play a role in every step of an M&A transaction.