ESG and M&A – two communicating vessels

September 2022 | EXPERT BRIEFING | MERGERS & ACQUISITIONS

financierworldwide.com

Whereas five years ago it seemed like a distant prospect, environmental, social and governance (ESG) has now become a topic that no successful company can afford to ignore. Not only is there an exponential increase in regulatory and legislative initiatives, but awareness among both consumers, shareholders and investors is also pushing companies to put ESG at the top of their agenda.

Moreover, it seems that ESG will become even more important in the coming years, which means that every company should take it into account in its long-term strategy.

This growing importance of topics such as diversity, sustainability and equal pay has of course its consequences within the world of M&A. Companies are adapting their M&A strategy to the emerging interest in ESG, as thinking and acting on ESG in a proactive way creates more value for shareholders.

A survey by McKinsey & Company on ‘The ESG Premium’ shows that executives and investment professionals today largely recognise that ESG issues can affect company performance, and that the financial impact of ESG programmes is likely to increase as expectations and scrutiny from investors, consumers, employees, and other stakeholders continue to grow.

In this article we will discuss the way in which the increasing importance of ESG impacts companies’ M&A strategy, its impact on the different phases of the M&A process and the influence of ESG on post-merger integration.

Strategy on M&A activity

Although ESG is mainly perceived as an end in itself, it can also be used by companies as a means to create additional value for their stakeholders or to present themselves to the outside world as future-facing and sustainable. This is clearly reflected in how companies link transactions to ESG objectives. From both the buy and the sell side, a business can approach a transaction to protect itself against ESG-related risks, but it can also see it as a chance to seize new opportunities. By integrating ESG considerations into their M&A strategy, companies can safeguard their long-term success.

From the perspective of the sell-side of a transaction, companies will have to adapt their M&A strategy to incorporate ESG-criteria and goals that are defined by the management. Examples include selling ‘critical’ activities, transforming risk areas into new business models and incorporating ESG into the company’s governance.

Well in advance of the sales process, a company will want to incorporate a culture of ESG in its organisation and highlight its ESG story, or even integrate ESG considerations into core aspects of its corporate strategy. Not only will this make the business more attractive to potential investors, but the company will also be able to attract more capital.

This is illustrated in a 2020 sustainability disclosure report by BlackRock. BlackRock achieved its goal in 2020 of having 100 percent of its active and advisory portfolios ESG-integrated. This means that every active investment team at BlackRock considers ESG factors in their investment processes. In another study, performed by Ernst & Young in 2018, nearly all responding investors answered that ESG information has occasionally (62 percent) or frequently (34 percent) played a pivotal role in their investment decision-making process.

On the buyer’s side, there are other ways in which ESG influences a company’s M&A strategy. Companies will want to keep ESG in mind when looking for potential acquisition targets. In order to screen these targets, a need for standardised metrics, which can be used to compare different companies, arises. To this end, buyers could link financial values to the various ESG factors.

However, this is not an easy task. Companies will face challenges such as the absence of standardised metrics, difficulties in converting information into quantifiable form and a lack of access to accurate information. In choosing potential targets, buyers also have to ensure alignment with the company group’s ESG strategy by integrating the relevant ESG criteria in the decision-making process. Through acquisitions, a company can also improve its ESG profile and the ability to create long-term value for stakeholders.

M&A process

ESG will play a role right from the start of the M&A process, during the first discussions about the price of the target and when the letter of intent is drawn up. The target company’s performance in this area is an increasingly important way of influencing the price of a business. In McKinsey & Company’s ‘Global Survey on valuing ESG programs’, performed in 2019, 83 percent of C-suite leaders and investment professionals indicated that they would be willing to pay about 10 percent median premium to acquire a company with a positive record on ESG issues over one with a negative record. The selling party will want to include ESG considerations in the letter of intent to demonstrate long-term securities and growth prospects in view of its negotiating position in the next stages of the transaction process.

As attention around ESG has grown, so has the pressure to make information and data about it public. In order to conduct proper due diligence, parties should make clear agreements in the letter of intent that the seller will disclose information to the buyer and that ESG falls within the scope of the due diligence. Some investors or interested buyers may even want to include compliance with ESG legislation as a possible precondition for the further course of the M&A process.

As for the due diligence itself, parties should use the data resulting from the due diligence to determine for themselves the impact of the transaction on their business. For example, the ESG performance of a company may determine whether a buyer decides not to proceed with the transaction because of the high regulatory compliance costs or potential reputational damage. It is therefore necessary for parties to identify the possible post-closing risks associated with potential litigation, damages and remediation as well as reputational concerns. They may even have to go so far as to require due diligence of the entire supply chain of the target. After all, the outcome of this analysis can not only have an impact on the valuation of the target, but also on the structure of the deal.

During negotiations and while drafting the transaction documents, parties will have to integrate ESG-considerations into the core aspects of dealmaking. Buyers should ensure that the ESG-risks identified during due diligence are adequately covered by the representations and warranties (R&W). Even when parties cannot agree on specific ESG-related representations and warranties – because ESG-warranties are often considered too buyer-friendly – then ESG can still be a way of strengthening or broadening the standard R&W. When ESG compliance and performance are an essential aspect of the transaction, the parties can go even further and include ESG in the conditions precedent or in the post-closing undertakings of the deal.

With the increasing risks surrounding ESG and the growing attention on everything related to this topic, it is not surprising that companies and investors are looking for a way to cover themselves. In addition to the tools discussed above, warranties and indemnities (W&I) insurance and other insurance policies specifically targeting environmental risks can also provide a solution for worried market players. In this way, parties can not only cover themselves for future risks, but can also cover their liability for historical environmental risks and issues that have arisen during the due diligence process.

Post-merger integration

When defining the strategy prior to the transaction, after the due diligence process but also during the transaction itself, buyers should keep in mind the impact of integrating the target into their own business. After all, the post-integration process entails both risks and opportunities and it is important that the buyer prepares for this.

When integrating the acquired target into the buyer’s ESG policy, companies will have to look at how the combined company can efficiently handle ESG risks and how it can create synergies in this area. Furthermore, ESG considerations will lead companies to adjust their governance structure after acquisitions to ensure that the acquired target is also subject to ESG monitoring and responsibilities. There are many options to achieve this goal, among which possible are carve outs, remediation of any areas of ESG non-compliance and establishing ESG key performance indicators for senior management.

Conclusion

The emergence of ESG and the growing recognition that commitment to it enhances a company’s long-term value have clear implications for M&A transactions. Although there are still many regulatory uncertainties, the rapidly changing and dynamic ESG landscape is forcing companies to adapt their M&A strategy.

During the M&A process itself, both buyers and sellers should pay attention to opportunities that ESG offers to create value, but also to the risks it entails that could harm their businesses. In doing so, it is important that companies revisit their M&A strategy based on ESG criteria and goals defined by management, that they integrate ESG criteria in decision-making processes about the potential target and that they plan the post-merger integration of the acquired company to apply ESG standards.

Virginie Frémat is a partner and Frederik Verstreken is a junior associate at CMS. Ms Frémat can be contacted on +32 496 61 91 52 or by email: virginie.fremat@cms-db.com. Ms Verstreken can be contacted on +32 475 55 08 31 or by email: frederik.verstreken@cms-db.com.

Virginie Frémat and Frederik Verstreken

CMS