Introduction
The focus on environmental, social, and corporate governance
(ESG) continues in 2023, with ESG considerations firmly on the
decision-making agenda for investors, particularly those
contemplating cross-border M&A transactions.
Most of the mandatory ESG regulations currently apply to listed
companies, large corporates, LLP’s, private equity funds and
financial institutions. Reporting obligations are set out in
various legislation and industry requirements, but there is no
single body or framework in the UK that covers all aspects of ESG.
The main sources of legislation in the UK1 are:
- the UK Corporate Governance Code 2018 (UKCGC);
- the directors’ duties in the Companies Act 2006;
- the Listing Rules;
- the FCA’s disclosure guidance and transparency rules
(DTRs); - the UK Stewardship Code 2020 (UKSC);
- the Large and Medium-sized Companies and Groups (Accounts and
Reports) Regulations 2008; - the Climate Change Act 2008; and
- the Bribery Act.
However, reporting requirements will likely shift toward smaller
companies also adopting ESG reporting standards at some level in
the future. The long-term ESG and sustainability goals of a target
are therefore increasingly featuring as a value driver impacting
its prospects, which is being reflected in target valuation. Those
targets which can credibly prove they are at the forefront of ESG
developments appear to be attracting more market interest and
securing higher valuations from acquirors who are looking to raise
their own ESG credentials.
Given the potential value proposition, many private companies
are electing to report voluntarily to prepare for future
initiatives and to ensure any long-term disposal strategies are not
impacted by poor ESG governance – a wise move in this climate
it seems.
In particular, voluntary ESG reporting frameworks, such as the
Global Reporting Initiative (GRI), the Sustainability Accounting
Standards Board (SASB), the International Sustainability Standards
Board (ISSB), the United Nations’ Sustainable Development Goals
(SDGs), and the Taskforce on Climate Related Financial Disclosures
(TCFD) are proving popular with private companies.
Due diligence
Whilst ESG is not part of traditional due diligence, it has
become increasingly important for investors when making investment
decisions. In the context of M&A due diligence, a clear focus
is being placed on ESG in document review, evaluation of target
companies’ ESG policies and initiatives, and on the assessment
of target companies’ compliance models. Input from legal and
non-legal advisors is necessary and advisable to ensure robust
expert analysis, which allows acquirors to address and evaluate the
position thoroughly.
These are some, but not all, key recommended ESG diligence
areas:
- environmental issues (management of emissions, waste disposal,
climate change, consumption of resources); - health and safety (working conditions, compliance with health,
safety); - commitments to employees (retention, incentives, diversity,
equal opportunities, anti-discrimination, worker rights); - supply chain activity (responsible purchasing policy, supply
chain code of conduct, risk assessment); - security and risk management (security regulation compliance,
cyber security administration, IT and data protection); - operations (crisis management framework);
- board structure (composition, remuneration, decision-making
process); - disclosure and reporting standards and commitments; and
- compliance with anti-corruption regulations.
Seller preparation
Pre-sale planning is key for sellers, and they should be
prepared for ESG queries likely to arise. Sellers who have
committed to ESG initiatives can use the diligence process to show
case specific achievements which will undoubtedly positively impact
valuation. They should aim to highlight to the acquiror:
- progress made with its operations, such as reductions in energy
use, recycling initiatives, efficient waste disposal, sustainable
resources etc; - improvements to governance and guidelines showing positive
outcomes where processes and direction have been implemented and
followed; - retention of employees and the ability to attract new
talent; - customer satisfaction (product sustainability);
- sustainable practices within its supply chain (employment
rights, health and safety, modern slavery); and - prospects and opportunities arising from the implementation of
its ESG strategies.
Acquiror preparation
It is important to review and identify early on any ESG issues
or concerns. Early review will allow an acquiror to appoint
appropriate specialists during the due diligence phase to further
assess and pinpoint material risks which may require ESG focused
warranties, covenants, or indemnification and/or insurance, and to
ascertain any opportunities and prospects which could influence
pricing or earn out arrangements.
Key to this is acquirors being aware of their own commitments
and obligations to ensure that any target it acquires does not
adversely impact its own ESG compliance requirements. This will
also assist the acquiror with the ESG due diligence and review
process.
Specifically, an acquiror should consider:
- its supply chain agreements to ascertain any specific ESG
obligations it has in place with its suppliers (and liabilities for
a failure to comply); - the customer contracts it has in place to identify any ESG
duties or responsibilities it has committed to its customers; - its existing finance arrangements to identify any ESG specific
reporting, disclosure and compliance requirements it may be subject
to (and any ESG covenants proposed for deal related acquisition
finance); - whether its own ESG profile aligns with that of the target to
avoid falling foul of ‘greenwashing’ claims (arising where
statements issued by the acquiror regarding sustainability conflict
with, or are undermined by, a target’s activities); - whether a target’s initiatives around diversity and
inclusion are on a par with its own (to allow positive integration
and to avoid post acquisition issues with misaligned corporate
culture); and - its mandatory and/or voluntary ESG disclosure commitments to
ascertain how the target’s processes will be integrated or
expanded to fit with these.
How to deal with ESG risk
Whilst many general ESG risks can be covered by the standard set
of warranties, eg the compliance with law and the no-litigation
warranty, this is not always appropriate or adequate and acquirors
may therefore consider more tailored representations and
warranties. However, determining the criteria for these and
quantifying financially the damages that could be incurred from
such breaches makes traditional and even tailored warranties
unworkable for certain risks.
So whilst such warranties may be useful for disclosure purposes,
buyers might consider additional protective measures such as:
- indemnification (although depending on the risk note these may
prove difficult to insure); - material adverse change/material adverse event clauses;
- ESG specific W&I insurance (subject to the usual diligence
and carve out requirements); - acquiring only the parts of the business carrying no ESG
liability or risk; - conditions precedent (where the risks relate to compliance and
can be cured before completion); - interim period operating covenants (where there is a split
exchange and completion); - completion conditions (where the risks are lower and a cure is
necessary but not required immediately) potentially coupled with
ESG related liquidated damages, and a reduction in management earn
out remuneration where certain ESG ‘performance related
targets’/conditions are not met within agreed post completion
timeframes.
The materiality of the ESG risk will inevitably steer the
negotiations and ultimately determine the course of action and
approach in the transaction documentation.
Conclusion
For investors future proofing is key. The focus is always on
what the target will look like in the future and whether the
acquisition documents reflect this.
A target company’s ability to comply with current, proposed
and even voluntary requirements around climate, sustainable supply
chains, workforce conditions and energy usage is becoming
imperative. With further developments in reporting on the way in
the UK, such as the new sustainability disclosure requirements
(SDRs) – expected to come into force in Q3 2023 – which aim to set
metrics, goals, and provide a framework that companies can use to
assess sustainability risks, there is no doubt that ESG
considerations are certainly going to continue to impact M&A
transactions going forward.
Footnote
1. Note that European sustainability reporting
obligations can also impact UK companies if they have significant
operations or activities in the EU.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
