The growing importance of ESG is reflected in dealmaking, including specific ESG due diligence and clauses, but it is not yet highly weighted in determining the choice of target in transactions.
Investors’ expectations around ESG disclosures and management have increased over the years, and it is expected that this will play an increasing part in investors’ decision making going forward.
The search for a supplier, business partner or employer is increasingly influenced by a company’s environmental and ethical standards, as well as its effective corporate governance and anti-corruption measures. Both investment and talent can be lost as a result of poor levels of ESG reporting and compliance. Companies with ESG-focused strategies tend to be perceived by the market as being more resilient and having strong leadership, as these strategies usually require long-term programmes and commitment, but transparency in reporting is really key to attracting investors.
Even though just 3% of deals are driven by ESG considerations, the CMS 2023 M&A Study shows that focus on ESG in the deal process itself is rapidly increasing. In 2022, 33% of transactions included specific ESG due diligence and 45% of SPAs included specific ESG provisions.
Key drivers
The lack of a standardised approach to ESG reporting means that it can be difficult for investors to compare different targets in an accurate way. It can be equally difficult for them to access relevant information in order to carry out their assessments. The information available is often incomplete. There is also a difference between the standards to which small, medium and large companies are held and their ESG reporting – larger companies have more resources available to them to collect, process and publish ESG related data. This does not necessarily mean that smaller companies are less ESG focussed, it may simply be harder to find out about and make a meaningful assessment of that focus and that can lead to investors disregarding those smaller companies for investment purposes.
Comparing apples with apples
While ESG compliance may still have a limited impact on the choice of target, practice shows that ESG plays a significant role in the transactional context and that (known or potential) risks impact the negotiation process and ultimately the price. Investors’ expectations around ESG disclosures and management have increased over the years, and it is expected that this will play an increasing part in investors’ decision making going forward.
Intervention by FDI authorities can undermine the rationale of the deal.
To compound the issue, companies operating worldwide frequently face complex and conflicting legislation across markets where they operate, and increasingly undertake diligence on their own ESG policies and performance, including analysis of:
regulatory compliance (of the target and its supply chain)
contracts (ESG undertakings/obligations)
ESG policies and governance
compliance models and risk monitoring measures
market reputation
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For the target company ESG risk avoidance is likely to start with a review of corporate strategy to try to determine where a company sits (and aspirations as to where it should sit) on the ESG spectrum. Dialogue with shareholders and partners will also be important (including establishing the expectations of institutional investors and addressing shareholder activism), as will be preparations for future trends and requirements. The latter can include observing the market, adapting business strategy and communication, monitoring legislative initiatives and soft law standards, and adjusting governance standards.
However, as set out above, it can be difficult for targets and investors to accurately quantify ESG risks and hence ESG related costs/losses. There are over 160 companies providing ESG assessment services and over 700 different measures that can be applied.
The quality and scope of the due diligence, and also of the disclosure process, will play a role in assessing a certain target’s ESG compliance and risk profile.
ESG as a subject covers a vast array of matters, so all SPAs will include some ESG related warranties, for instance on basic environmental, employment and governance issues. As yet, there is no standard approach to ESG specific warranties. What is important to one business may not be important to another, even if they are similar businesses. ESG related warranties must therefore be bespoke to each transaction.
Where warranty and indemnity insurance is taken out as part of a transaction, it is not certain that cover would be provided by the insurer. The final coverage position will hugely depend on the quality of the due diligence and any known risks. Insurers will additionally be reluctant to cover known ESG specific issues.
Where risks are identified, depending on what those risks are, there are various legal solutions that can be applied to protect the buyer.
Dealing with deficits
ESG as a subject covers a vast array of matters, so all SPAs will include some ESG related warranties, for instance on basic environmental, employment and governance issues.
Investors’ expectations around ESG disclosures and management have increased over the years, and it is expected that this will play an increasing part in investors’ decision making going forward.
In addition, the position is evolving at a rapid rate, so it is difficult for companies to keep up. In May 2023, 60 organisations representing over EUR 8.5 tn in assets released an open letter for the European Union to act on ESG disclosure standards, stating that those preparing and consuming ESG data worldwide struggle with a profusion of reporting frameworks and standards making consistent and comparable disclosures difficult.
ESG as a subject covers a vast array of matters, so all SPAs will include some ESG related warranties, for instance on basic environmental, employment and governance issues.
The lack of a standardised approach to ESG reporting means that it can be difficult for investors to compare different targets in an accurate way. It can be equally difficult for them to access relevant information in order to carry out their assessments. The information available is often incomplete. There is also a difference between the standards to which small, medium and large companies are held and their ESG reporting – larger companies have more resources available to them to collect, process and publish ESG related data. This does not necessarily mean that smaller companies are less ESG focussed, it may simply be harder to find out about and make a meaningful assessment of that focus and that can lead to investors disregarding those smaller companies for investment purposes.
To compound the issue, companies operating worldwide frequently face complex and conflicting legislation across markets where they operate, and increasingly undertake diligence on their own ESG policies and performance, including analysis of: