sustainability investing in M&A

Impact investing takes center stage as ESG gains momentum in M&A

Environmental, social, and governance (ESG) factors are becoming more prevalent in M&A deals all around the world. ESG factors are important starting in the early phases of a deal’s evaluation and continue to be so during the due diligence process, the negotiation of the definitive agreement, and even after the transaction has closed.

When contemplating mergers and acquisitions transactions, investors are increasingly considering ESG factors in their business decisions. These factors influence investors’ decisions to divest certain assets, while others may decide not to participate with a target firm with a poor ESG track record. 

According to a Forbes article published in January 2022, ESG standards are one of the key variables to be considered at the bargaining table in Latin American countries. ESG is especially important for cross-border deals involving Brazil, where the federal government’s Amazon policies have created worries about the environmental and social policies of many Brazilian corporations.

Acquirers are starting to examine the degree of alignment with their ESG strategy in the US and Canada by assessing the ESG risks and opportunities in the target’s business against their ESG policy. Since prospective suitors are likely to consider the target’s ESG practices, it is becoming more typical, even for private companies, to be conscious of their ESG practices generally and to prepare ESG material at the early phases of a negotiation.

ESG issues are frequently actively examined in significant cross-border M&a deals in the United Kingdom. Clients regard ESG-related risk concerns as more essential than in past years. As a result, companies with a positive ESG story, such as renewable energy companies, are better able to attract finance.

ESG considerations might be important during the due diligence and LOI phases. While there are no standard ways to evaluate the relevance of ESG aspects (which frequently depend on the relevant industry and the character of the potential buyer), there are several considerations that acquirers should bear in mind. 

Establishing benchmarks

The first stage in generating ESG diligence materials is to determine whether ESG data exists and to analyze the veracity of the data. Then, risks like regulatory, shareholder activism, reputational, and litigation threats should be recognised. 

Climate risk and human rights lawsuits are the most often observed litigation hazards. Environmental risks may be high depending on the business, location, and type of the transaction, and environmental due diligence should be emphasized. In Venezuela, for example, a firm might face legal and criminal responsibility for its environmental policies.

Acquirers are increasingly assessing a target’s activities when deciding whether to pursue a transaction, and even if their activities are legal, acquirers are interested in whether the target’s current business practises will be regarded favorably by stakeholders (primarily investors and customers) – particularly in relation to supply chain, emissions, and modern-day slavery. 

Regulatory compliance

Other factors to consider include whether the target complies with the soft law or industry standards expected for their sector, whether the target has made climate-related claims that can be validated, and, if such claims cannot be validated, what risks the acquirers face due to greenwashing claims. 

Acquirers will also want to know if the target has done its due diligence on suppliers and other third parties. They will also want to look at the underlying contracts to see whether there are any applicable terms or warranties in the supplier/third-party contracts.

ESG provisions are still uncommon in M&A agreements in the United States. However, in light of the #MeToo movement, several companies have used the so-called “Weinstein Clause,” which states that, to the best of the company’s knowledge, no charges of sexual harassment have been made against any current or past executive officer. As investors continue to place a premium on ESG performance, we may see more ESG-specific features in contracts. Specific representations and warranties, revisions to Material Adverse Effect provisions, closing conditions, and perhaps ESG-specific indemnities might all be included.

Environmental and labor, anti-bribery and corruption, and anti-money laundering representations have always been included in large deals in Europe and North America and will continue to be relevant, even though they may not properly address specific ESG concerns. In the future, warranties and indemnity insurance may provide coverage for such risks, albeit insurers are unlikely to give such coverage at present market pricing.

Specific ESG contractual terms are uncommon in Latin America, however standard assurances on compliance with environmental and labor regulations are frequent.

Much of the advice that arises from ESG due diligence focuses on activities to be done after the transaction is completed. These are not often steps taken to assure or fulfill the completion of an acquisition; rather, they would be considered part of the acquisition’s 100-day or 12-month strategy. 

Future alignment

Finally, the purpose of ESG due diligence in M&A transactions is to look at what the target firm will look like in the future, and that vision should be spelled out in the agreements that are signed. Parties should also think about what specific ESG measures, if any, will be included in the acquisition announcement.

Professor Srinivasan Balakrishnan is a geopolitical, governance, and strategic consultant. He was also chosen as the Chairman of Aadhan Strategic Solutions, an Editorial Board Member and Honorary Member of International Society of Zoological Science, China and served as Student Affiliate of Royal Society of Biology in London.