Milena Prisco
Pavia e Ansaldo, Milan
milena.prisco@pavia-ansaldo.it

Introduction

Globally, environmental, social and governance (ESG) considerations continue to have increasing relevance in M&A transactions for several reasons: the gradual and progressive changing of the investors’ mind set, the attention of the banking system towards focusing on sustainability ratings in addition to credit ratings, the integration of ESG factors into an initial public offering’s (IPO) use of proceeds and, last but not least, the mandatory European Union regulations that involve the private equity (PE) and venture capital (VC) sector.

The paper ‘ESG Disclosures in the Private Equity Industry’^[1] by the London Business School remarked that ‘an increased focus on ESG issues in private equity companies' investment strategies pays off for PEs and its investors in the form of successful exits and, thus, superior fund performance’.

The EU’s Action Plan on Sustainable Finance has been disruptive considering the shift from soft to hard law. Before this shift, investors such as PE and VC funds only adopted responsible investment policies on a voluntary basis (eg, the Principles for Responsible Investment).

There is no doubt that the sustainable finance governed by EU legislation has impacted PE and VC transactions more and more, both on the investor and target company sides.

ESG and M&A

Starting from the company portfolio, ESG factors have become key drivers in PE and also in VC deals because a good target’s ESG performance can increase its long-term value and send positive signals to shareholders. On the other hand, a target’s poor ESG performance can also create reputational and financial risks for the buyer. Because of this, it is crucial for companies to assess ESG factors and the target company’s alignment with them. Considering the wide range of implications caused by ESG factors in PE and VC transactions, this legal analysis is focused only on non-listed companies.

The EU’s legislation, the Sustainable Finance Disclosure Regulation (Regulation (EU) 2019/2088) (the 'SFDR') and the Taxonomy Regulation (Regulation (EU) 2020/852), requires financial sector participants, including European PE and VC fund managers subject to the European Venture Capital Fund Regulation (EuVECA), to comply with a whole range of transparency and disclosure obligations on ESG factors, ranging from the publication of certain information on websites, and in both pre-contractual and periodic documentation related to their financial products and their relevant investments. The SFDR defines ‘sustainable investment’^[2] and ‘sustainability risk’ as an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment; therefore, for the first time, such a definition has set forth the correlation between financial risks and ESG risks in a hard law provision. In line with these regulations, the integration of sustainability risks into the investment processes of asset managers (alternative investment fund managers (AIFMs) and undertakings for the collective investment in transferable securities (UCITS)) were introduced by Commission Delegated Regulation (EU) 2021/1255 and Commission Delegated Directive (EU) 2021/1270, respectively.

In order to implement ESG disclosures, PE and VC firms must assess the sustainability risks in their investments (eg, M&A transactions and equity investments). Moreover, these investors can consider the principal adverse impact (PAI) of their investments on the ESG factors specific to the target company on a voluntary basis, provided that they do not exceed on their balance sheet the criterion for the average number of (500) employees during the financial year; in a case where they exceed this limit, the company is obliged to make a statement on its website about its due diligence policies with respect to the adverse impacts, taking due account of the company’s size, the nature and scale of its activities and the types of financial products the company makes available. Irrespective of the PAI, PE and VC firms must supplement their investment policies with policies aimed at continuously assessing and measuring the status of the sustainability factors in the target companies underlying their investments in order to be able to monitor compliance with ESG factors and intervene (directly or indirectly) where necessary.

Impact on transactions

The impact on transactions varies depending on whether the investment is a majority or minority investment, the industry of the target company, its nature (listed or unlisted) and its geographical location. Furthermore, PE and VC funds have a deeper ESG approach depending on: whether they consider the PAI on the sustainability factors; whether they invest in companies ‘promoting, among other characteristics, environmental or social characteristics, or a combination of those characteristics’, according to Article 8 of the SFDR; and whether they invest in companies ‘contributing to an environmental objective, as measured, for example, by key resource efficiency indicators on the use of energy, renewable energy, raw materials, water and land, on the production of waste, and greenhouse gas emissions, or on its impact on biodiversity and the circular economy, or an investment in an economic activity that contributes to a social objective’, according to Article 9 of the SFDR.

During the investment scouting phase, it is advisable to carry out an initial screening, for example, by applying exclusion lists indicative of non-ESG compliant sectors or types of business. Moreover, ESG factors may determine whether and how sustainable finance structures are required for the acquisition, considering the increasing use of sustainable linked loans to finance sustainable acquisition projects.

The implementation of these EU regulations affects PE and VC transactions from the due diligence perspective to the negotiation of investment contracts and shareholders' agreements governing the investment cycle until the fund's exit. Indeed, in order to even carry out investment screening, investors must, therefore, collect and analyse a range of data and information from the target companies that also pertains to the non-financial sphere and, thus, to ESG factors, which is conducted through various methodologies and increasingly also with the support of qualified data providers.

In light of THE above, ESG due diligence becomes fundamental not only to remain compliant with EU regulation and the applicable local legislation, but also as it must highlight: in terms of materiality, the sustainability risks present in the target firm; in qualitative terms, the status and compliance with primary and secondary regulations; certifications and industry standards, in addition to commonly adopted standards, such as those specified by the Global Reporting Initiative (GRI), the European Financial Reporting Advisory Group (EFRAG) and, for the workforce, the International Labour Organization (ILO) principles; as well as the legal safeguards to frame ESG factors (eg, corporate governance, supply chain and personnel contracts, and environmental management). ESG due diligence should be carried out not only from the legal perspective but also from the technical angle of the ‘E’ in the case of a target with a material climate/environmental impact and the ‘S’ in terms of the social implications for local communities.

The outcome of due diligence is crucial: to negotiate prodromal investment ‘fulfilments’ to reduce or eliminate any ESG risks, for example, conditions at closing; to construct ad hoc declarations and warranties; to impose the post-closing ‘ESG actions’ to be kept in mind when allocating the investment and any additional costs; to regulate the reporting obligations to monitor ESG risk management; and to implement management governance policies and active voting.

The representations and warranties should ensure not only compliance with the law and the absence of any litigation, which is already essential for more sensitive areas such as labour, environment and supplier contracts, but also compliance with industry certifications and international standards. For example, to protect the ‘S’ factor and in light of the #MeToo movement, there has been some use of the so-called ‘Weinstein clause’, which is a representation that, to the knowledge of the company, no claims of sexual harassment have been made against any current or former executive officer. If an ESG issue has been identified during the due diligence process, the buyer can allocate the risk associated with that issue through special indemnities in the share purchase agreement.

The ESG priority list to be achieved after closing may depend on the industry, the size of the company and the allocation of the investment in relation to the sustainability goals. Depending on the case, it may also be necessary to indicate covenants concerning the achievement or maintenance of certain levels of ESG compliance, measurable on the basis of indicators or evaluation rankings. Covenants (eg, net zero requirements for the entire supply chain and improvement of workplace safety), if not respected, could be functional in operations that envisage progressive investments to justify the non-payment of tranches subsequent to the entry tranche, or even way-out mechanisms in the worst scenario.

With reference to the ‘life cycle’ of the investment, the collection of ESG data and the periodic reporting essential to guarantee the monitoring and management of sustainability factors and possibly ESG risks must be contractually regulated. The monitoring shall be ensured through constant controls, represented by board members and/or committees and/or managers appointed ad hoc to supervise the ESG factors in the target company. Clear policies with precise allocations of responsibility and ways of sharing information flows are a crucial tool to provide the manager with a constant overview of the sustainability issues and problems. According to Article 10 of the SFDR, PE and VC firms with sustainable investments in their portfolio must publish and maintain on their websites:

‘(a) a description of the environmental or social characteristics or the sustainable investment objective; (b) information on the methodologies used to assess, measure and monitor the environmental or social characteristics or the impact of the sustainable investments selected for the financial product, including its data sources, screening criteria for the underlying assets and the relevant sustainability indicators used to measure the environmental or social characteristics or the overall sustainable impact of the financial product’. Most of this information must also be included by the PE and VC firms in their periodic reports, according to Article 11 of the SFDR.

The structure of post-acquisition corporate governance should be ESG based, including the engagement of experts skilled in sustainability matters and a clear system of powers and tasks for responsibility and accountability both at board and management level. With regard to risk management, depending on the type of investment, governance policies must be envisaged that can make use of veto rights at board level concerning non-ESG compliant issues (eg, in minority takeovers), a change of directors at board level and/or corrective action to be taken at board level (eg, in majority takeovers), always bearing in mind the issue of management and coordination and with due distinction in listed companies, where ‘activism’ is subject to more complex mechanisms with less representation. In relation to the target company, governance and the achievement of sustainable goals are becoming very common such that prior or post-acquisition buyers require that board members and/or managers should have part of their remuneration linked to the achievement of sustainability targets integrating ESG key performance indicators (KPIs) into corporate management. Moreover, among the requirements on sustainable investments and eco-sustainable investments the SFDR and the Taxonomy Regulation set forth the so-called ‘good governance practices’, which not only include sound management structures, employee relations and the remuneration of staff, but also tax compliance. As a consequence, PE and VC firms should examine the tax structures across their portfolio companies, including how much and where they pay taxes.

Conclusion

Given the progressive entry into force of the EU regulations on sustainable finance and the relevant disclosure duties, the growth in ESG disclosures is stronger for PE firms based in Europe, larger PE firms, listed PE firms and PE firms investing in industries with material ESG risks, such as those concerning the environment. However, the lack of uniform standards and indicators on harmonised indices and reporting methodologies is currently a real obstacle to the creation of ESG best practice in M&A transactions. Moreover, the PE and VC market trends and the literature suggests that ‘PE firms’ management of ESG risks and the pursuit of ESG opportunities have potentially become increasingly relevant to their value creation potentially by reducing investment risks, identifying new sources of growth for portfolio companies, and increasing the resilience to long-term changes in the political and regulatory environment’.^[3]