ESG, which stands for Environmental, Social, and Governance, refers to three critical variables that are used to assess a company’s sustainability and ethical impact. It has received a lot of attention in recent years from both investors and customers to the point that it has become a common business jargon. ESG indicators assist in evaluating an organization’s capacity to retain customers, employees, and bring about growth opportunities. ESG considerations have become a key check box in shareholder meetings while considering potential M&A transactions. In the upcoming years, this concept is expected to grow rapidly, as more and more organizations step forward to integrate ESG norms in their system as a way to generate future value.
At present, there is no universally adopted standard reporting requirement across countries. Nevertheless, many countries have turned to the sustainability standards provided by the Global Reporting Initiative. In India, ESG norms have been in place since 2009, but compliance has been voluntary. Recently, however, the Securities Exchange Board of India (SEBI) has mandated ESG disclosure requirements for the top 1000 listed companies. Additionally, financial institutions have been encouraged to follow voluntary guidelines on ESG risk management when providing funding to companies, as issued by the Indian Banks’ Association (IBA). In the past, companies would focus mainly on financial metrics when evaluating potential M&A targets, but today, ESG factors are playing a larger role in decision-making. This shift reflects a growing recognition of the importance of sustainability and responsible business practices, both in terms of meeting stakeholder expectations and mitigating risk. In this blog, we’ll explore the ways in which ESG considerations are impacting M&A transactions.
ESG’S Impact in Due Diligence Findings
Since long-term investors now place the high reliance on ESG compliance, a thorough risk analysis is essential for all crucial transactions in order to avoid reputational harm, legal action, and penalties.
One of the most significant ways in which ESG is impacting M&A transactions is through due diligence. Companies that are considering an acquisition must conduct extensive due diligence to assess the target company’s financial performance, strategic fit, and operational capabilities. In recent years, ESG considerations have become an increasingly important part of this process.
ESG due diligence involves assessing the target company’s performance in areas such as environmental impact, social responsibility, and corporate governance. This includes analyzing the company’s compliance with environmental regulations, its social impact on communities, and the strength of its governance policies and practices.
By conducting ESG due diligence, companies can identify potential risks and opportunities associated with the target company’s ESG performance. For example, a company that is heavily reliant on fossil fuels may face significant risks related to climate change and transitioning to renewable energy sources. Similarly, a company that has a history of labor violations or poor working conditions may face reputational and legal risks.
ESG due diligence can also uncover opportunities for value creation. For example, a company that has strong sustainability practices may be able to reduce costs and improve efficiency, while also enhancing its brand reputation and attracting customers who value sustainable products and services.
Transaction documents and ESG
Once the due diligence exercise highlights the ESG risks, buyers can then proceed to negotiate the acquisition terms in the transaction documents. Typically, representations and warranties included in any M&A transaction only seek to cover standard matters such as regulatory, legal, and environmental compliance. While tailored warranties may be included in the transaction documents, depending upon the industry in which the company operates, ESG specific risks relating to modern slavery, maintenance of financial risks and sustainability policies, etc., may not be covered under narrowly drafted warranties.
Accordingly, buyers may push for ESG-focused representations and warranties, which for instance, focus on compliance with generally required ISO standards or codes, specific compliance with import laws where the business primarily relies on imported raw materials, compliance with foreign exchange regulations where risks pertaining to overseas direct investment are involved, or climate change matters when manufacturing plants form the primary asset.
It has been observed that the investors have become very particular in the due-diligence procedures which includes ECG compliance, especially in US and Europe, and has also seen rapid growth in India. ESG considerations are becoming increasingly important in the world of M&A. It shall be borne in mind that while enforcing ECG compliance by way of detailed warranties, the company may face some practical challenges. For instance, there may be circumstances where it is difficult to determine the loss that resulted from a particular breach. In such situations, purchasers might consider imposing stringent pre-completion conditions, such as stipulating that sellers implement a certain standard, undergo a data privacy and security assessment, sign written agreements, address liabilities in supplier agreements, etc. This may result in delay in the completion of transactions and the company may face loss resulting from such delay. Hence, it is essential that the ESG compliances are carried out in a viable manner and any potential risk is avoided in the most efficient manner.