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The impact of ESG criteria on M&A transactions
Wolf Theiss, Vienna
The fast-evolving area of environmental, social and governance (ESG) criteria has and will continue to have a critical impact on M&A transactions. Takeovers and lending depend on compliance, and the growing importance of ESG factors is inducing companies to take the implementation of these criteria seriously. These concern not only environmental issues, but also social issues such as compliance with labour law standards and observance of human rights (including the same requirements for businesses in the supply chain), and measures to prevent corruption.
An appropriate ESG strategy and approach may result in an essential competitive advantage, which is one of the reasons why ESG is rising to the top of the priority list of many companies.
Non-compliance with ESG criteria
Risk arises if ESG criteria are neglected. ESG factors can influence the valuation of companies and have a negative impact on their asset, financial and earnings positions. There is also reputational risk in the absence of sustainable activities or at least efforts to achieve them. Even doing business with a company with ESG risks can have negative effects on investors and other companies. At the international level, some mergers and acquisitions have already been abandoned due to (high) ESG risks involving one or more of the businesses. Therefore, investors are increasingly taking ESG factors into account during their due diligence, not only checking whether the current legal requirements and market standards have been met, but also whether they correspond to general expectations and risks that could arise in the future.
In Austria, there have been numerous regulations issued concerning the disclosure of ESG criteria. For example, since 2017 certain companies must prepare a sustainability report on how they deal with environmental, social and employment issues, corruption, bribery and human rights. Generally, the relevant companies are required to comply with timely disclosure of the non-financial report and the corporate governance report, whereby non-compliance may, inter alia, result in fines. The transparency requirements regarding ESG factors have recently been tightened. For example, institutional investors and asset managers are required to monitor the companies in which they have invested about certain ESG criteria and to publish a corresponding participation policy.
Due diligence as a tool for ESG risk analysis
The consequences of ESG non-compliance increases the importance of a comprehensive evaluation of a target company. Without a thorough risk assessment, buyers may acquire a non-compliant company that brings with it the risk of significant reputational damages, fines and lawsuits.
An essential part of ESG-related risks can be assessed during legal due diligence. Such ESG-focused due diligence may encompass:
- compliance with anti-corruption regulations;
- public law regulations and permits that are relevant to ESG;
- data protection regulations;
- disclosure and reporting obligations; and
- liability risks with respect to environmental issues, (eg in connection with historical groundwater contaminations).
Furthermore, clients increasingly conduct a specific environmental, social and governance review of the relevant target which goes beyond the usual commercial and environmental due diligence exercise. Such ESG due diligence may, inter alia, encompass a review of standards developed by the Sustainability Accounting Standards Board (SASB) to determine ESG risks associated with the activities of the relevant target. These specific ESG reviews include ESG elements which are of importance with respect to the specific target and may encompass the following areas:
- the supply chain;
- human rights;
- human capital/employee welfare;
- employee health and safety;
- data security;
- environmental management systems;
- energy and greenhouse gas management;
- water use and impact;
- biodiversity and ecosystems;
- climate risk and resilience;
- waste and materials use; and
- environmental and social aspects of product stewardship.
Reflecting ESG risks in transaction documents
Following the assessment of ESG compliance risks, any identified instances of non-compliance should ideally be rectified by the completion of the M&A transaction. The remediation of (high) risks based on non-compliance with ESG-related standards and regulations may be a condition precedent to completion of the transaction. To the extent that remediation is not possible:
- the relevant risks can either be reflected in the valuation of the target company;
- certain risks can be reflected in the transaction documents (eg as an indemnity);
- a carve-out of the relevant business part may be considered; or
- the relevant risk may be remedied in the course of a post-completion transformation process.
Lastly, in the current M&A environment, a specific and broad ESG warranty is often considered as too buyer-friendly. They are rather uncommon in Austria, whereby transaction documents commonly cover an essential part of ESG risks within the scope of the common warranties, such as employment, environmental, compliance and data protection warranties. It remains to be seen how the Austrian M&A market will evolve in this regard.
The importance of ESG (in M&A) will only continue to grow
The importance of ESG aspects is growing rapidly in Austrian M&A transactions. The opportunities and risks based on ESG will take on an even more important role during M&A transactions, as target companies are increasingly selected based on ESG considerations.
Therefore, buyers will increasingly focus on the assessment of ESG compliance risks when examining the business models of target companies, and on the potential transformation process of target companies by integrating such targets in the existing ESG compliance system of the buyer group.