ESG Due diligence in M&A Transactions

Joana Andrade Correia of Raposo Bernardo explores, in this Expert Focus article, how ESG factors are of increasing interest to investors, board members and management.

Published on 28 June 2022
Joana Andrade Correia
Ranked in 2 departments in Chambers Europe 2022
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The growing importance of ESG factors in M&A policy

Environmental, social and governance (ESG) factors are increasingly considered in M&A decision-making and strategy, as investors use ESG criteria to assess risks and to identify opportunities for value creation. ESG has clearly become a trend in an international context.

A company's ESG credentials can have an impact on a range of factors, such as ability to attract finance, employee satisfaction and morale, a company's growth opportunities, customer retention and growth, and outcome of project bids. Consequently, assessing an organisations ESG performance and identifying current and potential risks and opportunities are important steps in ensuring that well-informed investment and strategic decisions are made.

Investors have been voicing concerns about sustainability for several decades; now they are translating their words into action.

Furthermore, financiers are also increasing the attention they pay to ESG issues; some may specifically require purchasers to have conducted ESG due diligence before providing financing.

ESG reporting and stakeholder engagement: an uneven field?

Investors, employees, customers, regulators, and other stakeholders are proactively holding companies accountable for their ESG practices such as those relating to climate change and social equality. At the same time, a rapidly evolving regulatory and legislative landscape is upping the chances of proactively manage these risks and being more transparent through ESG reporting (which is still voluntary for now).

In fact, while some companies disclose information about climate risks, for instance, there is no global standard for how those risks are measured or reported. As a result, the facts can be inconsistent, subjective, and difficult to compare between companies. But things are starting to change. Investors have been voicing concerns about sustainability for several decades; now they are translating their words into action.

ESG-reporting obligations in the EU

Overall, there is an ever-increasing expectation that the business community do its part to meet sustainability goals and show corporate social responsibility.

In Portugal, for example, since the implementation of Directive No 2014/95/EU of the European Parliament and the Council by Decree-Law 89/2017, certain large companies which are public interest entities are obliged to disclose non-financial information relating to social, environmental and corporate governance areas. In this regard, the Portuguese Securities Market Commission took a very important step this year in promoting a reporting model for the fulfilment of the duty to disclose non-financial information by the issuing companies admitted to trading on a regulated market. Although it is a model based on voluntary participation, it represents a very significant development for the standardisation of the disclosure of information regarding existing legal duties.

Yet, while regulation in some countries appears to be moving fast, in others it seems to be stalled, waiting for further developments.

Compliance concerns and net-zero in finance

Aligned with ESG concerns, there is the compliance function which is a relevant governance function that can add structure and controls to help establish consistent, repeatable processes for handling and reporting crucial ESG data. That is to say that compliance departments can develop procedures for third-party verification and identify other potential risks, such as gaps in what is reported. Without a strong governance mechanism in place, any ESG efforts are likely to fall short.

A growing number of banks have committed to align their lending and investment portfolios with net-zero emissions by 2050. The Net-Zero Banking Alliance currently includes 55 banks from 28 countries.

ESG issues and corporate valuations

ESG issues have become much more important for long-term investors. The analysis of issues such as climate risk, board quality, or cybersecurity in terms of how they impact financial value in a positive or a negative way is becoming a daily concern. The Principles for Responsible Investment (PRI) which is a UN-supported networks of investors promoting responsible investments is a good example of the impact of those concerns.

These concerns are not innocent since there are financial risks associated with ESG which have several facets: reputational damage and non-compliance can both have financial consequences for organisations. In addition, ESG has become an emerging factor in corporate valuations, ratings, and access to capital.

The integration of ESG into the due diligence process

Proper due diligence is key to securing the position of the purchaser in a share purchase transaction. It not only allows a buyer to feel more comfortable in its expectations regarding the transaction but can also benefit the seller, as going through a rigorous financial examination may, in fact, reveal that the fair market value of a seller's company is more than what was initially thought to be the case. Therefore, it is not uncommon for sellers to prepare due diligence reports themselves prior to potential transactions.

The main purposes of an ESG DD would be to understand the risks profile and exposure of the target company to ESG concerns; also to find any red flags relating to the issues revealed during the DD process and to identify and analyse any risk mitigation measures.

ESG DD can be used to measure how the target company creates value and whether this process is sustainable.

Crucially, ESG DD should be seen as a step beyond the acquisition, helping the purchaser to incorporate the target company into its business and ensure the complex risks associated with ESG issues are identified and minimised before significant reputational damage or financial liabilities grow.

It should be noted that although the DD process has included some health and safety as well as environmental issues for the last 25 years, the review of ESG factors in DD processes has only started to increase in the last four or five years. This change is due to higher demands and expectations from stakeholders and general concerns about climate change and the increasing prices of natural resource.

But more important than this, is the fact that ESG DD can be used to measure how the target company creates value and whether this process is sustainable. Furthermore, by performing DD, the investor would be able to foresee the post-closing remedies it may implement to reduce risks discovered during the DD.

The importance of performing ESG DD prior to entering into an M&A transaction cannot be denied. Usually, the aspects considered in this particular type of DD are related to the target company's product impact and liabilities, management of supply chains, the targets business operation ethics and governance issues.

Representations and warranties

The most commonly used representations and warranties on ESG aspects reflected in the share purchase agreement (SPA) are related to the following:

  • Accomplishment of environmental legislation.
  • Possession of all necessary permits to carry out the operations.
  • Statements of the seller that:
    • is not a party to any environmental court claims;
    • has not caused any toxic or hazardous discharges to the soil, ground and water and;
    • has no obligations to remedy toil at any site.

However, the SPA warranties will not provide the purchaser with full protection, because they are usually in force for a limited period. Some of the main issues related to environmental damages may be hidden for an extended period. Thus, it is crucial that the most essential environmental warranties are deemed fundamental warranties, which remain effective for a more extended period compared to the basic warranties.

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