By Paul A. Davies, Tom Evans, Nicola Higgs, Farah O’Brien, David Walker, Michael Green, Hannah Berdal, Anne Mainwaring, and Catherine Campbell

Green shoots emerge as PE firms consider new ways to incorporate ESG into dealmaking.

Market sentiment and the increasing importance of environmental, social, and governance (ESG) to firms’ competitiveness across the market, combined with wide-ranging and rapidly developing ESG regulatory reforms, are driving increased focus on ESG at both LP and GP levels across Europe. As a result, the market is showing demand for enhanced diligence, and a wider range of deal provisions are being considered in light of their potential to enhance the ESG outlook of PE investments.

From Diligence

We continue to see growing demand from acquirers for enhanced ESG diligence. Key themes include climate change, supply chain issues (such as human rights and modern slavery), diversity, data privacy, and governance as a whole. In Europe, regulations such as the Sustainable Finance Disclosure Regulation (SFDR) are broadening disclosure and transparency requirements in relation to ESG matters. Increasingly, in-scope PE firms must ensure that relevant ESG credentials of a PE fund are attained through individual investments, including through diligence.

To Reporting

The trend of greater data availability and disclosure in the market is increasing the level of scrutiny from LPs in relation to the ESG credentials of funds more generally. This level of scrutiny will become even more acute in Europe when the Taxonomy Regulation takes effect in January 2022, which will require certain funds to make enhanced ESG disclosures.

A recent FCA consultation on disclosure reform, which, if implemented, would capture certain PE firms at the entity and fund product level and, would require annual reporting disclosures against standard climate-related metrics from 2023/2024, depending on firm size. The consultation specifies that the proposed approach aims to bring into scope the asset management activities of PE and other private market firms — a development that firms will need to monitor.

To Documentation

Access to ESG-linked financial products and loan facilities has become more widespread in recent years, providing greater opportunity for PE sponsors to obtain capital on favourable terms if certain ESG-specific targets or conditions are met. While ESG-linked M&A deal terms have largely remained off the table for auction processes (often due to the competitive tension and compressed timetables imposed on bidders), on suitable deals we have seen early interest in ESG- linked terms (such as ratchets, but nothing more substantive as yet).

Linking ESG-related performance metrics (i.e., UN Sustainable Development Goals) to employee remuneration has been seen in publicly listed companies. While currently uncommon for PE deals, meaningful performance targets and/or earn-out provisions that align to a PE firm’s expected investment horizon have been discussed on some deals and can be a useful tool to help foster stakeholder alignment on the importance of post-completion ESG enhancements to a target business.

Balancing Demands

Deal teams must continue to balance the demands of regulators, investors, sellers, and other stakeholders, particularly given the highly competitive, seller-friendly market across much of Europe and the US. However, these developments represent a positive opportunity to move towards a more holistic approach to tackling ESG matters on transactions.

Disclosure Regulation in Europe

What is SFDR?

  • SFDR requires in-scope financial market participants to classify funds in one of three ways: Article 8 (funds that promote environmental or social characteristics), Article 9 (funds with sustainable investments as their objective), and Article 6 (all other funds).
  • GPs are (depending on their structure) likely to be subject to these rules if they are based in Europe or market into Europe.
  • LPs may also be subject to these rules, driving further focus on the importance of ESG diligence within acquisition and lifecycle monitoring. LPs may need information on the ESG credentials of a PE fund to discharge the LP’s own obligations.
  • Classification as an Article 8 or 9 fund under SFDR imposes a number of ongoing regulatory obligations, including the need to embed sustainability considerations within the investment decision-making process. This necessitates enhanced ESG diligence to ensure that the fund’s relevant ESG credentials are attained through individual investments; failure to do so risks potential greenwashing, litigation, and/or reputational risks.

What is the European Taxonomy Regulation?

  • The Taxonomy Regulation establishes a classification system to determine the environmental sustainability of economic activities, to address the current absence of consistent terminology in relation to how to define whether a particular activity qualifies as “green”.
  • GPs and LPs that are in scope of the SFDR and have classified their funds as either “Article 8” or “Article 9” will be subject to enhanced disclosure obligations when the Taxonomy Regulation takes effect in January 2022 in relation to any fund that promotes certain environmental objectives.

What is the FCA Consultation in relation to enhanced climate-related disclosures for asset managers?

  • The FCA is currently consulting on introducing climate-related financial disclosure rules for FCA-regulated asset managers. The draft proposals would capture UK-regulated GPs undertaking asset management activities.
  • The disclosures are aligned with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) and would require an annual entity level TCFD report on how climate-related risks and opportunities are taken into account in managing investments on behalf of investors as well as annual fund level disclosures against certain climate metrics.
  • The final rules, which are expected in late 2021, will determine the precise impact of this initiative on private equity firms.