ESG impact on M&A business

ESG impact on M&A business

Environmental, social and governance (ESG) factors or “sustainability” are criteria used to measure a company in a way that is not normally included in the company’s financial statements. For example, ESG may include examining (i) a company’s compliance with climate change mandates or carbon limits; (ii) attitude in relation to human rights, including in relation to its suppliers or distributors; or (iii) organizational and management structure.

Traditionally, ESG has been underutilized as a tool in M&A transactions, but recent general trends have brought these factors to the fore as a method of mitigating risk and increasing value. As we will see below, it is important to consider ESG in M&A – not just for potential buyers, but also for potential sellers and their owners.

Current Uses of ESG in M&A Transactions

The vast majority of M&A transactions already consider and are aware of some ESG factors. This is most common during the fact-finding due diligence process. The default in this process is the disclosure of material items that may cause future liability to the buyer, such as possession or disposal of hazardous materials that may violate environmental laws, or potential violations of labor laws. For buyers, this helps to mitigate risk as these potential sources of liability can be drafted, while for sellers, having this shallow-level ESG knowledge can help reduce negotiation costs and make a deal much more likely to be closed. closed.

The governance aspect of the ESG also plays a role in most M&A transactions today. Disclosure schedules generally include a list of shareholders, directors, managers and/or other interested parties. Understanding the dynamics of company management and the interaction between stakeholders can facilitate negotiations and make post-merger or acquisition integration smoother.

A critical aspect of the M&A process is the post-agreement integration of new leadership into the existing company. The higher a company’s score on the ESG governance factor, the greater the likelihood that this integration can be done successfully. This benefits buyers and sellers, especially with the common use of rollover capital in current M&A transactions.

Using ESG to mitigate risk

Effective use of ESG requires an expansion of the normal due diligence process, but in return it can offer advantages to both buyers and potential sellers. Companies that score higher on ESG metrics are often more aware of upcoming regulatory changes, contractual requirements, or other changing factors that could materially affect their business. A broader look at relevant ESG due diligence can identify potential liabilities such as lawsuits, shrinking customer base or supplier issues or shareholder challenges prior to signing or closing an M&A deal. Early detection and knowledge can allow both sides to negotiate these issues and deal with them with normal M&E tools. This may include listing certain excluded liabilities, providing for withholdings or collateral, or even changing the purchase price.

This ESG-enhanced risk mitigation follows the same lines of general risk mitigation practiced in normal trading; however, each potential source of risk is expanded and analyzed in more detail. For example, environmental due diligence can not only uncover current use of hazardous materials or current violations of environmental law, but can be expanded to include whether the company or its suppliers in the chain meet climate/pollution-related targets (even those that are not yet being charged by environmental laws). This same logic can also be applied to the governance and social aspects of ESG, especially considering that many post-merger liabilities can be mitigated due to a greater understanding of the company’s culture, workforce and community at large. This is without considering the potential legal ramifications of governance and social challenges that can be avoided by considering ESG.

ESG as a value enhancer

In addition to being used to mitigate risk, ESG factors can be used to (i) increase the value of the company’s perspective or (ii) provide information about the true long-term value of a target. Companies that rank well on ESG metrics can often score higher than companies that may have similar financial numbers but don’t score as high on ESG. Part of the reason for this is that, as discussed above, being more attuned to ESG can reduce a company’s risk exposure to future adverse events. Higher ESG scores were also correlated with higher financial returns.

There are also additional perks, even for those on the buy side. ESG can help with target selection for buyers by identifying targets that can be assimilated into a larger portfolio because of their corporate culture, as well as those that are resilient to potential environmental or social changes in the future. This can be especially useful when comparing goals within an industry. ESG reporting requirements are also becoming more common in the M&A chain, so it behooves buyers to add target companies that score high on ESG metrics. There is also some evidence that higher ESG scores correlate with better financing terms or lower borrowing costs.

What does this mean for your M&A business?

Above, we discussed the potential advantages of evaluating and incorporating ESG factors into an acquisition or sale. The natural follow-up question is: how does this really look and feel incorporated into an M&A deal? The two main ways are as follows:

  1. Due Diligence: As discussed above, ESG will require an increase in the scope and depth of due diligence done for a deal. This expanded due diligence will allow the parties to be aware of potential legal issues and technical and operational factors. In addition, ESG factors will be at the forefront of the representation and warranty insurance process.
  2. Changes in the Purchase/Merger Agreement: The result of this diligence may lead, depending on the business, to an increase in the disclosures made in the disclosure schedules; fine-tuning representations and warranties, especially those dealing with ESG-related matters; and in extreme cases, changes in purchase price and additional liability or indemnities excluded. The agreement may also allow flexibility for these issues to be resolved as an agreement or a condition of closure. The above changes may also lead to considerations of different business structures, such as buying assets instead of selling shares or separating signing from closing.

Private equity impact

Given their frequent role as a participant on both the buy and sell sides of M&A transactions, private equity firms are in a unique position to utilize effective ESG factors. As mentioned, ESG metrics measure sustainability and can be a good barometer of a company’s long-term success. Private equity firms that are targeting often look for sustainable growth and evidence that their targets will be in a position to remain attractive in a potential sale in the future.

Using ESG as a way to differentiate companies in the same industry is also a boon for private equity looking to invest in a new industry. Additionally, having a high-scoring ESG portfolio can enhance a private equity fund’s reputation, particularly among younger demographics who are more aware of ESG elements. This can provide an advantage in terms of future talent recruitment or partnerships. All of this means that consideration of ESG factors is critical in an M&A deal.

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