ESG Considerations in Private Company M&A Transactions

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Environment, social and governance (ESG) are nothing new, but their importance has grown significantly in recent years with movements such as #MeToo and Black Lives Matter putting various social issues in the spotlight and events such as last year’s COP26 summit and the goals Net Zero global events drawing attention to the need to tackle environmental and energy issues. In this context, companies are scrutinized by a range of stakeholders, including consumers, employees and investors. As a result, ESG considerations have become a key part of the agenda of shareholders and boards of directors and they now play an important role during mergers and acquisitions, from target selection and due diligence to integration. post-merger.

In this article, we examine where ESG factors are relevant in private enterprise M&A transactions, how to address these factors, and what can be done before a transaction, from both the seller’s and the company’s perspective. ‘Buyer.

Sales preparation for a business

One of the key elements in securing the proceeds of a sale is ensuring that the buy-side due diligence is well managed by the selling shareholders and their advisers, with any business risk issues being anticipated well before they occur. be raised by the buyer’s advisers. Sellers should therefore consider conducting their own pre-sale due diligence process. This can include reviewing contracts to ensure they are up to date and ensuring that a company’s assets are carefully documented and recorded. This is especially important in sales processes led by a salesperson.

As ESG considerations become increasingly prioritized, sell-side due diligence can also be an opportunity to demonstrate and build on a company’s ESG successes by giving the company the opportunity to put the focus on improvements to its operating model (e.g. reducing energy consumption), demonstrating effective management structures (such as well-designed board governance guidelines) and highlighting future opportunities offered by its ESG strategies. By critically assessing the company’s ESG approach as part of pre-sale planning, this could have a positive impact on deal value and the sale process.

Selection of targets from the buyer’s point of view

Companies are increasingly looking for transactions to improve their ESG credentials to create greater long-term value for their company, their shareholders and other stakeholders. Buyers are interested in the simplicity of the process of integrating an acquisition into their existing business (and key to this is how well it measures against their existing business’ internal ESG standards). If, for example, a company acquires a target with a corporate culture significantly different from its own, this can make integration difficult, and the operation may then fail. Various ESG research and rating providers have now developed quantitative measures for aspects such as corporate culture, which can be used to assess the likelihood of long-term acquisition success.

Contribution of ESG to valuation

A good ESG strategy could potentially increase the value of a company due to:

  • Positive shareholder and broader stakeholder engagement.
  • Retain employees and attract new recruits.
  • Attract ESG-focused investors.
  • Customer engagement and loyalty.
  • Potential cost reduction.
  • Reduced regulatory interference.

By framing the assessment of ESG around the management of value and risk across a company’s operations and demonstrating how these positively impact business performance, it should minimize the negative impact on the valuation of a transaction (and could be used in the negotiation of the sales contract) .

Due Diligence by a Bidder

Certain ESG factors have long been part of a buyer’s regular due diligence processes, such as a target’s governance structure or its approach to health and safety. However, such due diligence analysis did not explicitly seek to assess a target company’s adoption of ESG. The addition of a dedicated environmental and social approach offers the possibility to identify and quantify different types of risks and opportunities.

Appropriate ESG due diligence largely depends on the nature and type of business, however, as ESG becomes an integral part of a company or bidder’s operating model, areas of growing interest include :

  • The target’s policies and programs aimed to track its ESG progress, compliance with its ESG objections and address risks.
  • Detecting and preventing abuse and maintaining labor standards in a company’s supply chain.
  • Employee Engagement and Workforce Culture and Diversity.
  • How a target interacts with its wider stakeholders.
  • Use of environment and energy.
  • Whether a target complies with the ESG disclosure and reporting obligations it has voluntarily chosen to follow (because most private companies are not yet subject to mandatory ESG reporting requirements).

This diligence is crucial to identify the ESG risks and the consequent protections that will be required in the sales contract or to be adopted in the post-closing integration. Additionally, as not all ESG issues may be financially quantifiable, it may be difficult for a buyer to be fully compensated for non-compliance through contractual provisions such as warranties and indemnities (see however below). below). Detailed ESG due diligence therefore ensures that issues are addressed at an early stage before the acquisition is finalized.

ESG in transaction documents

Where due diligence identifies ESG risk, buyers may seek to negotiate acquisition terms as follows:

  • A downward valuation of the target company.
  • Transactional risk insurance.
  • An exclusion of the relevant part of the business that is affected, remaining with the sellers.
  • Certain risks discussed in the transaction documents (such as a pre- or post-closing indemnity or condition); Where
  • Address the relevant risk during the post-completion integration process.

Buyers should consider the materiality of any ESG risks identified through the due diligence process and determine whether they can be mitigated through contractual protections. Many of the typical warranties and representations included in M&A transactions cover standard issues such as legal, regulatory, and environmental compliance. While buyers may consider more specific ESG-focused representations and warranties, for example, regarding compliance with specific codes or principles that the target has voluntarily committed to, or to cover specific issues related to climate change, these specific warranties are generally limited due to the difficulty in determining losses arising from such breaches. Other contractual provisions that may be considered include pre-closing covenants requiring the target to disclose any new ESG risks between signing and closing the deal, or other indemnification agreements for known ESG issues ( although see comments above).

Post-merger integration

After an acquisition is completed, ESG often remains at the heart of the buyer onboarding process. Buyers tend to develop and implement action plans to address material ESG risks of target companies and monitor remediation efforts and future compliance. To ensure that a company’s ESG compliance meets buyer expectations, buyers will require the target to subscribe to their group’s ESG policies, communicate them to relevant stakeholders, e.g. shareholders and employees, and ensures that these are applied by management via, for example, their bonus KPI.

What could a future ESG-led M&A deal look like?

Over time, private company M&A transactions are likely to see more ESG-related performance measures used in both executive compensation and earn-outs for outgoing shareholders. as effective tools to help foster stakeholder alignment by basing these rewards and returns on a combination of financial and ESG performance objectives.

The successful execution of mergers and acquisitions therefore increasingly depends on the due diligence, assessment and effective management of ESG considerations, as these are essential steps that both parties must take before and throughout. throughout the M&A process to mitigate risk and achieve beneficial, long-term results. long-term synergies for both the acquirer and the acquired business.

If you require further information on any subject covered in this briefing, please contact Simon Ward, Beth Balkham or your usual firm contact on +44 (0)20 3375 7000.

This publication is a general summary of the law. It should not replace legal advice tailored to your particular situation.

© Farrer & Co LLP, August 2022

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