As private equity funds (PE funds) face increased scrutiny for their environmental, social, and governance (ESG) practices, it is increasingly important for PE funds to consider ESG factors in their investment decisions and operation of portfolio companies. This article discusses the trend of integrating of ESG considerations into M&A deals.
A focus on ESG can be a competitive advantage for target companies, PE funds, and other strategic acquirers. It assists PE funds and portfolio companies in creating value, mitigating risk, and becoming more resilient. Consideration of ESG factors in M&A transactions is undeniably rising. Failing to account for critical ESG elements can negatively impact a business and undermine its success.
PE funds are displaying a heightened level of selectivity in light of the evolving ESG landscape. According to the results of PwC’s 2021 Global PE Responsible Investment Survey,[i] 37% of respondents reported declining investment opportunities based on environmental, social, and governance considerations.
To ensure that ESG factors are effectively considered in M&A transactions, PE funds should conduct ESG-focused due diligence, allocate ESG risks in the transaction agreement, and perform post-closing ESG integration. This article explores the growing importance of ESG in M&A and provides guidance on how to integrate ESG considerations into the deal-making process.
Drivers of ESG Importance
The business landscape is undergoing significant transformation, as consumer consciousness, spending habits, employee demands, regulatory environments, and industry perspectives have all shifted towards ESG considerations. The growing impact of climate change on the operations and value of companies has prompted a significant shift in investment, as ESG trends continue to gain traction. Natural disasters, which have caused an estimated $280 billion in losses in 2021 alone,[ii] have made the risks associated with ESG all the more tangible and quantifiable, affecting M&A activities. In addition, businesses must also consider the impact of ESG on financing, as poor ESG ratings and performance can restrict access to capital. Lenders and institutional investors have made it clear that prioritizing ESG is now a must for businesses, or they risk losing access to funding. The United Nations–supported Principles for Responsible Investment (UNPRI) is an example of a growing group of investor signatories incorporating ESG issues into their investment analysis, promoting responsible investment. UNPRI consists of approximately 3,800 asset owners and investment managers with nearly $121 trillion in assets under management.[iii]
Across jurisdictions, the ESG regulatory landscape is steadily evolving. Regulators along with other oversight bodies have been expending resources to monitor and create rules and guidance on ESG matters. The US Securities and Exchange Commission (SEC) is evaluating current disclosure practices of climate-related risks and has proposed rule[iv] changes that would require registrants to include certain climate-related disclosures in their registration statements and periodic reports, including information about climate-related risks that are reasonably likely to have a material impact on business, operations, and financial condition, and certain climate-related financial statement metrics. PE funds should not only consider impending changes to regulations but should also consider “soft” laws such as standards, recommendations, and codes of practice. ESG factors will be a key consideration for both the buyer and target, as various regulatory bodies continue to bring additional ESG rules and regulations into force.
Demands of LPs
Limited partners (LPs) are frequently demanding that PE funds asses investment opportunities from an ESG lens and ensure that any portfolio companies are evaluated using ESG metrics. A recent survey[v] conducted by Bain & Company and the Institutional Limited Partners Association found that 80% of surveyed LPs expect to ramp up requests to their general partners for ESG reporting during the next three years. It is common for LPs and other stakeholders, such as lenders, to require the PE funds to provide non-regulatory reports on ESG matters. As such, a PE fund should ensure that it has established and implemented an effective ESG framework for any investment decision. Once the acquisition is complete, it should also establish effective ESG policies and procedures, including setting ESG metrics and targets, for each portfolio company. In doing so, a PE fund can not only avoid potential liability relating to ESG issues, but also attract new investees, as portfolio companies that can establish that they continually address ESG issues have an opportunity to create value.
Shareholders and investors are becoming increasingly attuned to ESG issues. By directing their investments to companies with comprehensive and established ESG disclosures, shareholders and investors globally are a key driving force behind growing ESG disclosure. Since ESG factors overlap with core corporate values, failure to address ESG issues may have a disproportionately negative reputational impact on a business. When considering a transaction, PE funds should understand all ESG matters associated with the transaction, evaluate how to mitigate any reputational risks, and ensure that processes are in place to monitor the business’s reporting method.
ESG Due Diligence
PE funds should consider broadening the scope of their due diligence to include performing targeted ESG investigations. ESG due diligence will look different for each transaction and will depend on the nature and type of business the target is conducting and the relevant operating jurisdictions. Due diligence should go beyond a routine examination of organizational performance and consider wide-ranging impacts and dependencies across the global value chain.
The due diligence process must integrate ESG into each stage of the deal and should inform the PE fund of any potential impact of the merger or acquisition on its sustainability strategy and the long-term value of the combined entity. Red flag checks may include assessing the future fitness of the target and relevant assets and media scans to understand any major ESG-related risks. Due diligence should identify any human rights violations, corruption, environmental degradation, privacy breaches, data breaches, harassment, workplace misconduct, workplace diversity issues, gender inequity, greenhouse gas emissions, and previous instances of non-compliance, as well as the target’s ESG ratings, the use of ESG standards, and the target’s level of community engagement. This will identify potential liabilities or cultural concerns that can be investigated further. Other due diligence considerations may also flag physical and transitional risks associated with climate change. Because ESG due diligence covers such a broad scope, PE funds should consider engaging experts in different areas to review their respective ESG findings with other experts to capture a comprehensive and interdisciplinary view of ESG risks.
Targeted ESG due diligence will assist buyers in identifying ESG risks that may influence a target’s price and overall deal structure. Once fully cognizant of the potential liabilities and risks of a transaction, companies may mitigate ESG risk through the transaction agreement.
M&A transaction agreements, such as share purchase agreements and asset purchase agreements, are already reflecting the growing importance of ESG factors. Since the beginning of the COVID-19 pandemic, the majority of M&A agreements adopted provisions for COVID-19 in material adverse effect clauses and interim operating covenants. COVID-19 tested the resilience of corporations globally, and has shown investors that ESG matters now more than ever.
Through ESG diligence, a PE fund can understand the potential risks and pitfalls that relate to the target’s operations and industry. The PE fund can then look to address any ESG risks in the transaction agreement through specific indemnities, targeted representations and warranties addressing ESG matters, or through various pre-closing conditions or post-closing covenants of the sellers. The transaction agreement will typically contain customary representations and warranties relating to the various aspects of the operations of the business and the regulatory environment in which it operates. These customary representations and warranties may address several ESG factors. Yet, these representations and warranties should be reviewed and revised in light of specific regulations or codes of conduct that apply to the operations of the business and any ESG factors. PE funds should therefore consider and look to negotiate the inclusion of applicable ESG representations, which may include “MeToo” representations requiring targets to disclose misconduct allegations, compliance with specific codes or principles that the target has voluntarily complied with, or compliance with recommendations of applicable codes of conduct or guidelines issued by oversight bodies.
For ESG risks that are identified in diligence, PE funds should consider the materiality of these identified risks and consider how these issues can be addressed. The purchase agreement should be tailored to suit the needs of each transaction. Depending on the issue identified, the vendors may be able to address the concerns pre-closing. This could include adding provisions such as special pre-closing covenants requiring detailed reporting and disclosure of any new ESG issues that may arise.
If the issue cannot be addressed pre-closing, such as non-compliance with ESG-related regulations, the buyer may wish to negotiate a reduction in the purchase price to reflect the risk assumed. In addition, the buyer may wish to consider a specific indemnity to address the risk for known ESG issues and holdback of a portion of the purchase price that the purchaser can set off against any losses it incurs due to the issues identified. The parties may also look to restructure the transaction to assist in mitigating the risk.
Post-closing, the buyer should establish procedures to ensure continuous review of ESG factors relating to the operation of the portfolio company. This will include addressing and managing issues identified during the acquisition, but also continuously monitoring the company for ongoing ESG considerations. The PE fund should confirm that the portfolio company has qualified management and an effective board of directors with knowledge and experience to provide effective oversight of the portfolio company, including ESG matters.
PE funds should ensure that the board of the directors of the portfolio company has policies and processes in place to ensure that it understands how ESG issues may impact the company. In developing ESG risk management policies and procedures, the portfolio company and the board of directors should establish an appropriate governance structure and allocate the roles and responsibilities of directors and different board committees. The designation of specific roles ensures that each party knows who is responsible for certain tasks.
A robust ESG risk management framework within a company is integral to the overall culture and success of portfolio company. ESG procedures and policies will look different for each company depending on its industry and the type of business, but generally, an ESG risk management system should:
- promptly identify material ESG risks;
- implement appropriate ESG risk management strategies that align with the company’s business strategies and ESG risk profile;
- integrate ESG risk and risk management into corporate strategy and business decision-making; and
- properly document and communicate necessary information on ESG risks to applicable parties such as employees, shareholders, and senior executives.
To properly manage ESG risk, the risk must first be identified; to identify risks, companies must develop reporting procedures to gather high-quality ESG data. To maintain consistency among different data sets, companies should aim to have a standard process and create central repositories or reference sets for recording ESG data. Ideally, having automatic processes to record data when possible as opposed to manually adding data would minimize errors in data sets.
As companies, investors, and limited partners are becoming increasingly conscious of social and environmental factors, it is critical to evaluate investment opportunities through an ESG lens. For the foreseeable future, ESG-assessed M&A will be an important tool to generate growth and provide companies with a competitive edge. It will also be crucial in establishing stakeholder trust. For PE funds, decisive steps are needed in risk reduction and long-term value generation. PE funds that take initiative and embrace ESG in M&A will be better positioned to achieve sustainable growth and adapt to constantly evolving expectations.
[i] Global Private Equity Responsible Investment Survey (2021), PwC.
[iv] The Enhancement and Standardization of Climate-Related Disclosures for Investors, Release Nos. 33-11042; 34-94478 (2022), US Securities and Exchange Commission.
[v] Limited Partners and Private Equity Firms Embrace ESG (2022), Bain & Company.