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ESG due diligence in private company M&A – context, drivers, challenges and practical considerations

Snapshot

In an M&A deal, environmental, social and governance (ESG) factors can create, preserve or destroy value; they can drive M&A as well as derail a transaction. Whereas full-scale ESG-focussed due diligence exercises are common only in transactions involving publicly listed and the largest private companies, smaller private companies are increasingly going beyond the scope of traditional M&A due diligence and using ESG due diligence to identify and assess ESG-related risks (and opportunities) that may influence the price of a target company (“TargetCo”) and the overall deal structure. Once identified, such risks and any potential liabilities can be accounted for and mitigated through the transaction agreement.

In this briefing, we look at (i) the drivers of ESG in a private M&A context; (ii) the value of ESG due diligence; (iii) specific challenges of which parties should be aware; and (iv) practical considerations for approaching ESG due diligence.

Drivers of ESG considerations in private M&A

Private companies of all types, sizes and in all sectors are recognising the need to improve their performance on ESG issues, in part as the result of a proliferation of new mandatory ESG disclosure requirements. These mandatory disclosure requirements – which continue to evolve in the UK, EU, US and elsewhere around the world – tend to bite directly on the largest companies (typically listed or very large private companies). They are, however, designed to cascade throughout the private sector, through value and investment chains.

This cascade effect occurs when a company within direct scope of an ESG reporting obligation needs to engage with the entities in its value chain and/or investment portfolio in order to comply. For example, a large investor or large company will need to elicit carbon emissions data, emissions reduction targets and reduction plans from its portfolio companies or suppliers in order to calculate its total carbon footprint. Through this cascade mechanism, it is intended by policymakers that all businesses will increasingly be held to similar standards of ESG practice and reporting.

In this context where all businesses are effectively compelled to measure and disclose more ESG information and are under more scrutiny on ESG issues from their stakeholders, ESG is also starting to drive M&A deal flow, with buyers looking to invest in businesses that enhance their overall ESG profile and to capture commercial opportunities. On the flip side, in some cases businesses also look to offload businesses or activities that are no longer in alignment with their ESG strategies.

The value of ESG due diligence in private M&A

At a high level, the case for conducting ESG due diligence in private M&A is strong. ESG due diligence can shed light on issues that traditional due diligence would not typically uncover, including ESG-related  reputational risks,  adverse environmental or human rights-related impacts (actual or potential) in the TargetCo’s operations or value chain and risks relating to poor culture or workforce engagement.

Reasons why ESG factors should be considered in private M&A due diligence include:

  • Reductions in energy use and waste can drive down operating costs;
  • Strong ESG performance, data collection and reporting can be indicative of potential to attract investors and access lower cost of capital, whether through green or sustainability-linked debt finance and/or as result of achieving a stronger credit rating, as rating agencies increasingly integrate ESG factors into their analysis;
  • Strong ESG credentials may position TargetCo well to attract and retain the best talent and to access new markets and synergistic opportunities for its goods or services – whether that involves attracting and building brand loyalty with ESG-conscious consumers and/or, in B2B relationships, demonstrating to its suppliers and customers that TargetCo is aligned with and will help them deliver on their ESG commitments;
  • Strong ESG strategy that is integrated into TargetCo’s business model and business planning may be indicative of its readiness to tap into ESG and decarbonisation-related commercial opportunities;
  • Good ESG governance is often an indicator of good governance and effective management more generally; and
  • Where ESG due diligence shows that TargetCo has good ESG credentials, a buyer may be able to proceed with greater confidence that the acquisition will support (or at least not compromise) any sustainability commitments it has made or plans to make.

Specific challenges to be aware of and overcome

ESG due diligence in the context of smaller private companies will often present challenges. With foresight, awareness and planning, however, such challenges can often be overcome. Three particular challenges are described below.

  1. Data: TargetCo may not be able to provide accurate, quantitative ESG-related data in response to the buyer’s requests.

    What data is available will often depend on the stage TargetCo has reached in its ESG maturity journey and the extent to which it is already capturing or preparing to capture data on material ESG issues for itself or in response to requests from its commercial stakeholders. Ideally, information provided by TargetCo should be quantitative and verifiable. Where such data is lacking, a buyer can opt to take a more hands-on approach, for example  by conducting site visits and interviews, to detect and uncover the state of play and readiness on ESG issues. It can also be useful to use any publicly available ESG data about comparable companies as a reference point, to help identify potentially material ESG risks and opportunities for the TargetCo and therefore topics for the buyer to explore in due diligence.

  2. Lack of alignment: the buyer and seller may not align on how to assess, quantify or account for ESG risk, including for example which metrics to use.

    In this case, coming to a consensus may be made possible by engaging the help of a sustainability specialist who can assist with identifying material ESG issues for TargetCo and relevant stakeholders, as well the most industry-appropriate metrics. Ultimately, this will need to be negotiated and reflected in the transaction documentation. Where an uncovered issue is curable, this may be reflected as a condition to signing or closing or as an undertaking. Where an uncovered issue is not curable, this may be reflected by way of a carve out or ringfencing, through a purchase price reduction or with an indemnity.

  3. Immature ESG strategy: TargetCo many have a poorly developed (or non-existent) ESG strategy.

    As with a lack of data, the absence of an ESG strategy may prompt the buyer to take a more tailored and/or hands-on approach to direct the ESG due diligence. It may be that certain ESG considerations have in fact been integrated into areas of the TargetCo’s business under different labels, such as governance or compliance. This may therefore call for integrating ESG due diligence into the more traditional M&A due diligence, rather than seeing it as an additional or separate exercise, to elicit the requested information. It can also be helpful to start with broad, high-level questions before drilling down into detail, to encourage TargetCo to think broadly in its responses and not exclude information that is in fact ESG-related, even the TargetCo might immediately identify as such and/or package it internally as something else.

For example, such as:

  • How, if at all, are ESG considerations factored into TargetCo’s strategy, decision making or risk analysis?
  • To what extent does the board and/or management become informed of and/or consider ESG factors (e.g., risk and opportunities)?
  • What has been the ESG external profile and/or performance of the company (e.g., controversies, litigation, lawsuits, stakeholder activism)?
  • To what extent are TargetCo’s products/services compatible with a net-zero economy?

Practical considerations for approaching ESG due diligence in private M&A

The following are factors to consider from a buyer’s perspective:

Scope

Buyers should consider broadening the scope of ESG due diligence from a focus on the customary liability areas (such as environmental and health and safety compliance, for example) to include an evaluation of TargetCo’s ESG capabilities and readiness.

 

This might involve an assessment of any ESG governance structure or ESG objectives set, of the extent to which TargetCo already collects and monitors relevant ESG data points (e.g., a baseline of its GHG emissions) and of any ESG policies, plans or processes in place, including any net zero transition plan, any supply chain due diligence process and any steps taken to increase diversity. This will help to identify additional ESG-related risks that need to be dealt with in the transaction documentation that may impact on the valuation of TargetCo or, for the biggest issues, may cause the buyer to walk away from the deal.

Timing Early identification of ESG risks will maximise the buyer’s time in terms of assessing their impact, both in terms of negotiating the allocation of such a risk with the seller but also the impact of such a risk in terms of integrating TargetCo into the buyer’s group while keeping the timetable of the transaction on track.
Expertise Where a buyer has developed skills and expertise in ESG policies and initiatives internally, this knowhow can be harnessed when evaluating the impact of an acquisition on the buyer. Where no such internal knowhow exists, buyers should ensure that they are working with advisors who are aware of and knowledgeable on these issues and can coordinate an ESG due diligence exercise working with ESG specialist consultants where appropriate.
Impact In addition to the early identification and evaluation of any risks to TargetCo and buyer’s group, a broader ESG due diligence evaluation will also, crucially, enable a buyer to spot ESG-related opportunities which could impact upon business plans and targets set by the management team.

The following are factors to consider from a seller’s perspective:

Competences At the same time as it is getting its house in order with a view to selling TargetCo, a seller should consider strengthening TargetCo’s ESG performance by, for example, reviewing or streamlining TargetCo’s operating model with a view to reducing the use of resources and waste or putting in place an appropriate ESG governance structure. Even if the sale does not proceed according to plan, this will stand TargetCo in good stead for any future sale and benefit the business more broadly in the meantime.
Timing Working with its advisors prior to the start of a sale process to pre-empt likely areas of enquiry from a prospective buyer by performing its own ESG due diligence exercise will put a seller on the front foot when the sale process begins. This will also help a seller to identify any ESG risks and opportunities in TargetCo that can be remedied (or at least understood and quantified) or exploited as appropriate in advance of the sale process commencing.  

Final thoughts

We expect that in-depth ESG due diligence exercises will steadily become a more mainstream feature of private M&A. It is important to bear in mind that there is no one size fits all approach for all companies or industries to ESG due diligence. Each company and industry presents its own ESG issues and stakeholder interactions that must be reviewed and considered. Ultimately, parties should use the data resulting from ESG due diligence to determine for themselves the impact of the transaction on their business and/or how to reflect it in the transaction documentation.

Please email your Charles Russell Speechlys contact for more information and tailored advice as needed.

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