Dealmakers should continue to weigh the impact of ESG issues on M&A deals as ESG standards evolve.
By Richard Butterwick, Pierre-Louis Cléro, Paul A. Davies, Tobias Larisch, Michael D. Green, James Bee, and Catherine Campbell
Environmental, social, and governance (ESG) issues have become increasingly important for corporates in recent years, driven initially by investor and consumer demand, and now by legislative developments across multiple jurisdictions.
As ESG becomes a growing part of the dealmaking conversation and acquirers seek to improve ESG credentials through individual acquisitions, the M&A market is showing a greater demand for enhanced ESG due diligence, particularly in relation to value chains. A wider range of deal provisions are being considered in light of their potential to enhance the ESG outlook of acquisitions. Further, regulatory developments and forthcoming changes mean that reporting obligations, both voluntary and mandatory, should remain front of mind. In this M&A Views article, we consider how corporates and M&A dealmakers are responding to the growing importance of ESG.
We continue to see growing demand from acquirers for enhanced ESG due diligence. Key themes include climate change, human rights and modern slavery, diversity, data privacy, and corporate governance as a whole.
Amid the stronger focus on enhanced due diligence, technology is playing a central role to enable acquirers to capture a wide range of ESG issues more efficiently. There are an increasing number of tools available to help M&A deal teams facilitate this efficiency at an early stage of a transaction, such as Risk Horizon (a digital platform and risk screening tool that Latham & Watkins helped develop and that allows corporate acquirers to benchmark companies on a sectoral and geographic basis).
Value Chain Verification
Corporate acquirers are extending their focus beyond the target itself to now scrutinise all elements of the value chain.
Global supply chains have come under significant pressure in recent years, compounded by the effects of the COVID-19 pandemic, shifting global policy agendas, and an acceleration in legislative action on the supply chain. The EU has indicated that it will propose legislation in relation to mandatory supply chain due diligence, and individual Member States have also taken steps to address this subject. The German parliament passed the Supply Chain Act in June 2021 — coming into effect on 1 January 2023 for companies with at least 3000 employees, and 1 January 2024 for companies with at least 1000 employees. The Act imposes a binding obligation on companies to establish procedures to improve compliance with core human rights and certain environmental provisions in supply chains. Companies with average annual sales of more than EUR 400 million may be required to pay a fine of up to 2% of the average annual sales of the company. In France, the Corporate Duty of Vigilance law places the onus on large companies to identify and prevent risks to human rights and the environment that could occur as a result of their business activities (including by their suppliers), and there are indications that additional legislative action may be on the way. Further, the US has underlined its stance on supply chain issues with the Uyghur Forced Labor Prevention Act.
This regulatory backdrop raises the stakes for corporate acquirers and, as highlighted by recent examples from the retail sector and elsewhere, ESG-related supply chain issues can cause long-lasting reputational damage. In our view, supply chain analysis and management will remain critical to avoid reputational and other risks, including loss of revenue and goodwill. Performing diligence on a target is no longer enough — rather, the target’s value chain requires careful analysis to determine resilience, uncover risk areas, and identify opportunities.
While ESG-linked M&A deal terms such as ESG warranties and indemnities 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 the PE space for ESG-linked terms, such as ratchets. Corporate deal teams should monitor this trend.
Meaningful performance targets and earn-out provisions, though uncommon for private acquirers, have been discussed on some deals and can help foster stakeholder alignment on the importance of post-completion ESG enhancements to an acquired business. Over time, we expect to see more ESG-linked performance metrics on remuneration. Linking ESG-related performance metrics (such as progress towards the UN Sustainable Development Goals) to employee remuneration has already been seen in publicly listed companies.
Source: PwC, Linking executive pay to ESG goals, June 2021
In the financing market, access to ESG-linked financial products has grown in recent years, providing an opportunity for acquirers to obtain favourable terms if certain ESG conditions are met. Investor demand for green bonds has resulted in a “greenium” for acquirers with strong ESG credentials, with cheaper pricing and more attractive terms available.
The European Green Deal has further identified the need for more capital to be deployed in sustainable financing as the EU aims to become climate neutral by 2050. Accordingly, we expect sustainability-linked bonds, green bonds, social bonds, and hybrid arrangements to remain in focus.
ESG Reporting in 2022 and Beyond
The movement towards introducing mandatory ESG reporting standards for companies means that dealmakers must continue to consider the impact of ESG issues on deals.
Traditionally, companies that have undertaken ESG reporting have done so in line with one of several voluntary frameworks, including the Sustainability Accounting Standards Board (SASB), the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), and the Global Reporting Initiative (GRI) (see below). However, a number of governments/regulators (including in the UK, the EU, and the US) have either introduced, or stated that they are looking to introduce, mandatory ESG reporting standards. These initiatives include the introduction of the requirement for listed and large companies to report in line with the TCFD recommendations in the UK, and the Corporate Sustainability Reporting Directive in the EU.
Further, international reporting obligations will continue to drive the focus on ESG across the corporate world. The International Sustainability Standards Board (ISSB), developed by the International Financial Reporting Standards (IFRS) Foundation, has pledged to create a set of ESG reporting standards for corporates in an attempt to consolidate global standards. Several governments and institutions, including the UK and the G7, have welcomed its work, and we expect the ISSB standards to have a significant impact in 2022 and beyond.
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