Integrating ESG considerations into the due diligence process

July 2024  |  SPECIAL REPORT: MERGERS & ACQUISITIONS

Financier Worldwide Magazine

July 2024 Issue

The M&A world has mainly been guided by financial factors. In recent years, however, non-financial factors have begun to play an increasingly prominent role.

The most high-profile of such non-financial factors is undoubtedly environmental, social and governance (ESG), which relates to a company’s impact on the environment, its social responsibility and its governance practices. ESG principles have emerged as a crucial standard for stakeholders dedicated to implementing practices that are both sustainable and ethical. Around the world, acquirers are increasingly incorporating ESG considerations into their investment strategies and are even prepared to offer higher prices for companies that have compelling ESG-narratives. The increased emphasis on sustainability reporting, social diversity, carbon neutrality and overall regulatory compliance has made conducting ESG due diligence during the M&A process essential to achieving the objectives of corporate and financial investors.

Whereas in previous years ESG was a relatively minor, vaguely defined element in the M&A process, it has now become a more tangible concept for both corporates and private equity (PE) firms, and is considered key to companies’ growth prospects. ESG is no longer just about the investment case and core pricing; rather, target companies are subject to demands from their suppliers and contractual counterparties to adhere to certain ESG requirements. Divestments may now be driven by concerns that a certain business line is incompatible with long-term ESG and sustainability goals.

Scrutiny of ESG issues in deals is likely to rise significantly in the next three years.

The link between ESG and due diligence

ESG is increasingly serving as a guideline for the transaction process, from target identification to integration of representations and warranties (R&W) in transaction documentation. Within this transaction framework, ESG has a significant impact on both buyer and seller due diligence.

When combining ESG and due diligence, the Corporate Sustainability Due Diligence Directive (CS3D) comes to mind. The goal of this directive is to promote sustainable and responsible business practices by embedding human rights and environmental concerns into corporate operations and governance. This new regulation requires companies to address the negative effects of their activities, including the impact of their activities both within and beyond Europe. The directive outlines how a due diligence process should be conducted to take ESG factors into account.

Approaching ESG during the early stages of the transaction process

When determining the scope of due diligence, it is important to make ESG a vital part of the exercise and allocate sufficient resources to it. The pressure to disclose ESG data is intensifying as stakeholders, investors, regulators and the public demand greater transparency from businesses and institutions. Regulations such as the EU’s Corporate Sustainability Reporting Directive (CSRD) set clear expectations for ESG disclosures and provide a framework for consistent and comparable reporting. Such reporting should be considered during due diligence. Parties should clearly state the nature and extent of information that the target must disclose on everything ESG-related to allow for thorough due diligence.

Buyers may find it useful to use the letter of intent or non-binding offer to establish certain ESG considerations as a precondition for completion. By doing so, the buyer can clearly set out its intentions and what role ESG will play. This way, the seller is aware of the buyer’s intentions from the beginning, helping negotiations to run more smoothly and the parties to head in the same direction.

However, a balance must be struck so that ESG-considerations do not unnecessarily complicate the transaction and deter the seller. After all, a letter of intent or non-binding offer is only a starting point, and the parties will need to work together to bring the deal to a successful conclusion.

Integrating ESG into the core of the due diligence process

Integrating ESG into the due diligence process requires a structured approach, combining traditional financial analysis with non-financial assessments. Of course, the purpose of due diligence is to comprehensively evaluate a business or asset before entering into a transaction. However, in combination with ESG considerations, it can also be used to examine how the target can contribute to the achieving sustainability targets or to identify which aspects of the target are critical to the buyer’s values and investment strategy, and by extension its ESG objectives.

A clear framework should be created for the key ESG considerations within the target company’s sector, industry and activities. Applicable ESG regulations, corporate governance structures and social responsibility practices should be examined. This way, the target’s current ESG performance can be measured against similar entities. New reporting requirements under the CSRD can help in this regard. The CSRD obliges companies within its scope to report on a wide range of ESG information, such as climate change, energy efficiency, waste management, workforce diversity, human rights and corporate governance. Moreover, companies are required to use the European Sustainability Reporting Standard, which makes ESG information from different companies comparable, consistent and reliable.

Once a framework of benchmarks and comparable metrics has been established, the target’s ESG performance should be considered. To form a clear picture of this, the buyer will need to gather a comprehensive set of documents relating to the target’s business and operations. This includes contracts, regulatory filings, public records, environmental permits, employees’ handbooks and other documents relevant to ESG considerations. In addition, it may help to conduct interviews with key stakeholders such as senior management, compliance officers and HR managers, as well as engage with other entities in the company’s supply chain.

Once this is done the buyer can undertake a risk assessment of the target’s ESG practices. This should cover issues material to furthering the transaction and drafting the transaction documents. This may include ESG R&W, specific indemnities for certain identified risks or certain commitments on the seller’s behalf.

Analysis should also consider how the target will fit within the buyer’s ESG strategy and policy. Besides risks and red flags, the buyer should also look at what opportunities and improvements can be made regarding the target’s ESG development. These areas can guide post-transaction strategies and implementation, and create additional value.

There is a growing emphasis on evaluating ESG aspects when reviewing material agreements, including in the context of existing regulations such as the CSRD and CS3D. This covers a target’s ESG policies, initiatives and compliance models. Close coordination between legal experts and non-legal specialists such as financial or technical advisers is needed. ESG factors also play a more significant role when negotiating transactional documents, such as share purchase agreements and asset purchase agreements, particularly in the context of representations, warranties and covenants related to ESG standards.

Conclusion

ESG considerations have become central to successful M&A. ESG due diligence provides a comprehensive framework to assess not only the financial and legal aspects of a target company but also its sustainability practices, social responsibility and corporate governance. As investors, regulators and stakeholders increasingly demand transparency and accountability, integrating ESG into the due diligence process is necessary to justify a transaction within a buyer’s long-term strategy. Moreover, ESG due diligence can reveal opportunities for improvement and development, allowing buyers to identify synergies and initiatives that contribute to sustainable growth.
As the corporate world moves toward greater sustainability and responsibility, M&A transactions that incorporate ESG due diligence are better positioned for success. By prioritising ESG factors, companies not only mitigate risks but align themselves with broader societal goals, fostering a more sustainable business environment and moving toward a world where business growth and responsible practices go hand in hand.

 

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. Mr Verstreken can be contacted on +32 475 55 08 31 or by email: frederik.verstreken@cms-db.com.

© Financier Worldwide

BY

Virginie Frémat and Frederik Verstreken

CMS

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