How ESG Considerations Can Impact and Create Value in M&A Transactions

Whether operating on a global or domestic level, many businesses are facing unique challenges that may hinder their growth, ability to operate and even survivability. In its Global Risks Report 2024, the World Economic Forum identified a number of risks that may impact businesses worldwide in the next two to 10 years, including a volatile geopolitical landscape, increased political and social polarization, rising inflation, economic downturn and an array of environmental risks resulting from climate change, collapsing biodiversity, severe weather and critical changes to the earth’s systems.^[1] In the face of these challenges, businesses that can demonstrate their durability and resilience, and exhibit strategic decision-making for the benefit of their stakeholders, can meaningfully differentiate themselves.^[2]

Mergers and acquisitions (“M&A”) are transactions with a potential for immense strategic value and are an important means by which companies can consolidate and collaborate with their peers to safeguard the longevity of their businesses, realize on synergies, and grow and remain competitive in the wider industry. Against this backdrop, environmental, social and governance (“ESG”) considerations are playing an increased role in M&A transactions by presenting new opportunities and opening new pathways to value, driving companies’ need to demonstrate a broader understanding of risk overall and helping companies understand and plan for the impacts, financial and otherwise, of a wider risk profile over a long-term horizon.^[3] It is not surprising, therefore, that ESG considerations are moving closer to the forefront of the M&A landscape. A recent study conducted by KPMG Global on ESG due diligence in M&A transactions, which surveyed 150 active dealmakers across Europe, the Middle East and Africa, noted that 82% of respondents currently have ESG considerations on their M&A agendas.^[4] A 2022 survey conducted by Bain & Company of various C-suite executives revealed that 65% of respondents (281 executives) expected their own company’s focus on ESG to increase over the next three years.^[5]

From a legal perspective, ESG considerations can have a significant impact on the identification, mitigation and rectification of risks prior to and following the closing of an M&A transaction (“Closing”) and can also influence the drafting of definitive and key transactional documents. In this article, we set out the specific impacts that ESG considerations have on the entire M&A process in the public and private market context, from the early stages wherein potential target entities (“Targets”) and potential acquiror entities (“Acquirors”) are contemplating a business combination transaction, to the more involved due diligence, negotiation and drafting stage, and the periods leading up to and following Closing.

Evaluating Targets and Acquirors

Acquirors will conduct a preliminary assessment of the Target to determine the initial estimated purchase price, which may be adjusted subject to the risks identified in the course of the Acquiror’s due diligence and the associated costs of any instances of the Target’s non-compliance, or any existing ESG practices implemented by the Target. A company’s strong ESG performance has been shown to positively impact the company’s valuation on account of a lower cost of capital, higher valuation multiples, higher profitability and lower exposures to tail risk.^[6] As such, C-suite executives have indicated that they are willing to pay a premium for strong ESG performance, based on the belief that ESG performance is associated with overall management quality. A recent study conducted by the University of Pennsylvania indicated that for every 10% increase in emphasis on material ESG concerns, a company’s value increases by 1.4%, while a similar increase in attention on non-material ESG matters leads to a 3% decline in value.^[7] Furthermore, Acquirors will also assess whether the Target is likely to enhance the Acquiror’s own ESG performance by introducing measures that the Acquiror has not otherwise implemented, or otherwise align with the ESG-related goals and targets that the Acquiror has already set for itself. For example, it was observed in 2022 that certain Acquirors looking to complete M&A transactions are paying closer attention to potential Targets’ greenhouse gas emissions to determine whether a potential acquisition may be accretive or dilutive to the ESG target that the Acquiror has already set.^[8] Generally, undertaking this analysis enables Acquirors to determine whether or not entering into a business combination transaction with the Target is likely to create synergies that can have positive impacts on a post-Closing basis.^[9] For example, should an Acquiror enter into a business combination transaction with a Target with strong proven ESG practices, it may be able to increase revenue (e.g., by overcoming regulatory barriers to access new markets, increasing customer engagement through positive ESG performance, acquiring wider social licences to operate, etc.) and improve cost of capital (e.g., by mitigating risks, gaining access to alternative funding, improving operational efficiency through sustainable practices, optimizing capital expenditures, investments and assets, etc.).^[10]

ESG considerations are becoming increasingly relevant for prospective Acquirors when evaluating potential Targets and determining whether or not to enter into a letter of intent (“LOI”) with the Target. Even without the benefit of an in-depth due diligence process, which would typically commence once the LOI has been entered into, Acquirors can still conduct risk-based due diligence to a certain extent to determine whether the Target presents an unsuitable degree of risk for the Acquiror and, to a lesser degree, the scope and depth of the ensuing due diligence process. In conducting this preliminary analysis, Acquirors can consider the reputation of the Target, news releases, general considerations about the industry and jurisdictions in which the Target operates, and voluntary or mandatory disclosure published by the Target itself, either on its website or, if the Target is a public company, through continuous disclosure mandated by applicable securities laws. When consulting these sources, Acquirors may consider, for example, the environmental risks posed by the known aspects of the Target’s operations, the social risks posed by known information about the Target’s labour practices, and the risks posed by operating in the jurisdictions in which the Target conducts business (which is a particularly relevant concern in cross-border and multijurisdictional transactions).

This initial analysis is not exclusive to Acquirors as Targets will often look to complete M&A transactions to grow their own businesses by combining with larger entities and capitalizing on their resources. Targets can consult the above-noted sources, as applicable to the Acquiror, to determine the degree of risk posed by entering into a business combination transaction with the Acquiror and the ability of the Acquiror to enhance the Target’s own ESG performance or align with the ESG-related targets and goals set by the Target.

Bearing these points in mind, it is evident that ESG considerations can become relevant well before the Acquiror and Target establish contact with each other.

Conducting Due Diligence

Certain ESG considerations already form part of the traditional M&A due diligence process. Acquirors will typically review a Target’s environmental assessments, permits and violations, for example, to confirm whether the Target has complied with applicable environmental laws and regulations. Acquirors will also review items such as the terms of employment contracts, the facts and applicable documentation related to any ongoing, past or potential disputes with employees, and the health and safety policies of a Target to ascertain whether the Target has complied with applicable employment standards. During the due diligence process, Acquirors will also review governance-related documentation, including minute books, corporate policies and procedures to assess the strength of an entity’s governance and ensure compliance with applicable corporate laws and regulations.

Many businesses operating in the current market are facing numerous, novel challenges which pose risks to their businesses and introduce a new standard of performance that they must, or may wish to, exhibit in order to meet the expectations of their various stakeholders. Accordingly, the scope of due diligence is widening and a number of ESG-related considerations, such as those set out below, are increasingly relevant in this wider arena:

1. Greenhouse Gas Emissions. As a number of businesses look to establish net-zero targets, exhibit carbon neutrality or otherwise reduce their carbon footprint, Acquirors often examine a Target’s greenhouse gas emissions to determine whether, in adding the Target to its portfolio, it will be increasing its own carbon footprint, thereby exposing itself to scrutiny or dismissal by various stakeholders, including investors who may examine an entity’s emissions when deciding whether to invest.
2. Forced Labour and Child Labour Risks in Supply Chains. A number of entities in jurisdictions around the world are subject to supply chain reporting requirements in which they must report on the use of forced or child labour in their supply chains.^[11] Acquirors may already be subject to a supply chain reporting requirement (and, in some jurisdictions, requirements that go beyond reporting and mandate particular actions and diligence) and, on a post-Closing basis, may need to report on the Target’s activities and related supply chains as well. Alternatively, if an Acquiror is not already subject to a reporting requirement but the Target is, on a post-Closing basis, the Acquiror will be required to report on the use of forced or child labour by the Target, or in the Target’s supply chain. Therefore, in the due diligence stage, Acquirors should discern whether they will be subject to new or expanded reporting requirements on a post-Closing basis and should generally examine a Target’s supply chain to determine whether there is a risk of forced or child labour as well as any policies (including supplier codes of conduct), procedures or supplier contract provisions a Target has implemented to mitigate those risks.
3. Greenwashing.^[12] Public and private companies alike are facing increased scrutiny from regulators and shareholder activists who are looking to hold such companies accountable for alleged greenwashing. During the due diligence process, Acquirors are increasingly examining the Target’s public disclosures, whether made voluntarily or in compliance with applicable laws and regulations, to ascertain whether there is a risk that the Target has greenwashed its ESG performance or goals, as greenwashing may expose the Acquiror to a risk of litigation or regulatory action on a post-Closing basis.
4. Social Considerations and Company Culture. Many executives looking to complete M&A transactions often place a strong emphasis on company culture^[13] and there is a great deal of evidence that diversity amongst an entity’s employees, executives and directors may enhance the culture and efficiency of an entity.^[14] As such, an Acquiror may examine the extent to which equity, diversity and inclusion are meaningfully practised throughout the Target’s operational levels and in its hiring practices and nomination processes. The implementation of anti-discrimination and anti-harassment policies is also seen as crucial to ensuring the kind of healthy culture that is attractive to Acquirors. Accordingly, as part of the due diligence process, Acquirors may evaluate whether an entity has implemented such policies and codes of conduct, and the extent to which compliance with those policies and codes are monitored.

Should the due diligence process reveal any ESG-related risks, Acquirors could consider classifying those risks as operational (i.e., impacting the business of the Target), financial (i.e., impacting the revenues and assets of the Target) or reputational (i.e., impacting the entity’s social licence to operate, or ability to retain and attract investment). Acquirors should consider how unmanaged risks may impact the entity in the future and if management is required, as well as whether any deficiencies can or ought to be rectified on a pre-Closing or post-Closing basis. When assessing the impact of a deficiency, Acquirors should consider possible impacts to business value and the environment, society and economy associated with the Target, and short- and long-term impacts in order to formulate a thorough understanding of the ESG risks involved.

As noted previously, ESG-related due diligence can help identify the risks associated with the transaction and highlight the opportunity for post-Closing synergies that can enhance the respective businesses of the Acquiror and the Target, as discussed in further detail in “Post-Closing Matters” below. During the due diligence process, Acquirors can assess the available information to begin formulating preliminary synergy hypotheses so that ESG synergies can be implemented and any ESG-related deficiencies can be addressed immediately on a post-Closing basis.^[15] As a result, value can be created by reducing risks, enhancing operational efficiency and improving stakeholder relations.^[16]

Definitive Agreements and Key Transaction Documentation

Due diligence investigations typically impact the negotiation and drafting of transaction documentation in all M&A transactions, including principal agreements and many ancillary documents, such as employment agreements with key employees, operational contracts and service agreements. While definitive agreements typically contain representations and warranties that speak to certain ESG-related matters, including environmental considerations, labour practices as well as anti-bribery, anti-corruption and anti-money laundering practices, if the due diligence process reveals certain specific, material ESG risks, definitive agreements may include more tailored representations and warranties and/or specific indemnities. For example, particularly in cases where the Acquiror has not had the opportunity to conduct extensive due diligence into the Target’s supply chain, the definitive agreement may require the Target to represent that there is no forced or child labour in its supply chain, or risk of the same, and such representation may not be limited by a knowledge qualifier. The use of so-called “Weinstein clauses” has become more popular in definitive agreements as well, whereby the Target represents that, to the knowledge of the company, no claims of sexual harassment have been made against any current or former executive officers. In drafting such representations, setting out the scope of any defined terms (which will ultimately impact the scope of any related representations) will be important, as well as any clauses elsewhere in the definitive agreement that may impact the survivability of such representations, or other qualifications to such representations (e.g., certain time periods) are delivered.^[17] Other examples of ESG representations that are starting to appear in definitive agreements include stating that: (i) the Target does not have any ongoing disputes with non-governmental organizations or community groups (found in 7% of M&A deals completed in 2022); (ii) the Target does not have, and has not had, any claims from or disputes with Indigenous persons or communities (found in 9% of M&A deals completed in 2022); and (iii) the Target has not violated any laws, regulations or standards in respect of local protected areas, such as archaeological sites or endangered species reserves (found in 11% of M&A deals completed in 2022).^[18]

Nonetheless, while the Target initially assumes the bulk of the risk when making such ESG-related representations, Acquirors should ensure that they have appropriately planned for the financial elements of any gaps or deficiencies in the substance of the representations, whether known or not, either by obtaining sufficient representation and warranty insurance and/or ensuring that appropriate remedial measures are ready to be implemented on a post-Closing basis. Acquirors should also secure appropriate indemnification to ensure they are protected from unforeseen liabilities related to ESG matters that may be discovered during the due diligence process and may materialize post-Closing. Such indemnities can protect the Acquiror from matters such as environmental contamination, corporate governance failures and losses arising from non-compliance with ESG-related laws, regulations or standards.^[19]

ESG-related risks may necessitate the negotiation and execution of other key transaction documents as conditions to Closing. For example, if the standard employment agreement of the Target does not meet applicable employment standards, the Acquiror may benefit from entering into new employment agreements with the key employees that they wish to retain, which would take effect on Closing. Furthermore, if the Target’s operational contracts or supplier agreements expose it to a risk of forced or child labour, the Acquiror may wish to renegotiate and redraft these agreements prior to Closing to ensure the Acquiror is able to manage the Target’s business effectively on a post-Closing basis, or otherwise terminate unsuitable contracts.

ESG-related considerations may also impact the ultimate determination of the purchase price and applicable adjustment mechanisms, which can serve to incentivize strong ESG performance. For example, the Acquiror and Target may agree to link a portion of the purchase price to the achievement of specific ESG milestones, such as reducing greenhouse gas emissions, improving worker safety or enhancing board diversity, to ensure that any planned ESG synergies achieve the desired positive impacts.^[20]

Post-Closing Matters

As noted previously, Acquirors may elect to address certain ESG risks that are identified during the due diligence stage on a post-Closing basis. Such risks may be less time sensitive or critical than others (and are thus not impactful enough to delay Closing or result in a reduction in purchase price), may necessitate a strategy implemented over a longer period of time, or can only be addressed post-Closing. For instance, an Acquiror may wish to rectify the risks posed by the absence of a sustainability committee or the lack of ESG-related expertise in the Target’s board of directors by creating a sustainability committee that is focused on identifying, managing and mitigating, as appropriate, ESG-related risks and opportunities on an ongoing basis, or appointing a new slate of directors with the desired experience and knowledge. It may not make sense to take these measures prior to Closing, as they are inherently tied to the Target’s long-term value creation and, prior to Closing, the Target’s primary business focus is almost always conducting business in the ordinary course.

Where Targets have implemented ESG policies, procedures and programs that were attractive to the Acquiror, the successful integration of these measures on a post-Closing basis is a key focus. As such, implementing a detailed integration policy to ensure a smooth transition, particularly at the board and executive levels but also on an operational level to ensure the successful continuity of the Target’s ESG measures on a post-Closing basis, may be relevant.

Finally, particularly in cases where ESG has played a significant role in the parties’ respective evaluations of each other, and where the parties have determined that the transaction will create value for their respective stakeholders on account of ESG considerations (either wholly or in part), when announcing the Closing of the transaction, the parties may wish to highlight the role ESG considerations have played throughout the transaction and the role that ESG considerations will continue to play on a post-Closing basis to preserve and generate value for stakeholders.

Key Takeaways

As illustrated herein, integrating ESG considerations at every stage in the M&A process has demonstrable value for Targets and Acquirors alike. In assessing their respective ESG performances at the early stages of a potential transaction or arrangement, Targets and Acquirors can identify a wider array of opportunities, synergies and risks posed by a potential business combination transaction, ensure the transaction documentation reflects a more detailed and clear picture of what both parties are looking to accomplish, and appropriately allocate a broader set of necessary items to be completed on a pre- and post-Closing basis. Ultimately, in considering appropriate ESG-related factors, Targets and Acquirors can create the appropriate foundation to ensure that beneficial and long-term synergies are created for both parties.

Conclusion

Aird & Berlis LLP frequently assists public and private companies across various industries with completing M&A transactions that grow and enhance their businesses for the immediate and long-term benefit of their stakeholders. The ESG & Sustainability Group at Aird & Berlis LLP will continue to monitor the impact of ESG considerations on M&A transactions. Please contact the authors if you have any questions concerning any ESG-related considerations in your contemplated or ongoing M&A transactions.