M&A and ESG: The Due Diligence Process
This blog post is co-authored with Amy Wojnarwsky, an attorney at McDonald Hopkins, a Cleveland-based business advisory and advocacy law firm. Amy is a leader in McDonald Hopkins’ Social Corporate Governance & Impact Investing practice and has a strong passion for helping entrepreneurs and businesses on ESG matters.
Environmental, social and governance (ESG) factors have become a growing focus for companies and their stakeholders. In our first co-authored blog post of this series, EPOCH Pi and McDonald Hopkins discussed the growing importance of ESG to companies and their stakeholders and the impact this can have on corporate value overall ranging from cultural alignment to environmental, social and governance risks that are most material to a business and ultimately its long-term financial value.
The emphasis of ESG factors by a company can have a positive impact on corporate performance and governance of a company, and this emphasis leads to increased pressure on dealmakers to consider ESG elements in a transaction. The growing trend to embrace ESG factors is having a dramatic impact on how M&A is conducted. As a gating issue, many dealmakers are beginning to narrow their M&A targeting lens to sustainability and ESG-focused companies as they receive more pressure from their investors to support these initiatives.
Once a target is selected, ESG can play an influential role in the due diligence process of M&A transactions. ESG due diligence can help buyers identify ESG-related risks which may impact the overall deal structure and valuation. Industries like energy, manufacturing, healthcare services, or food production will likely have some form of sustainability initiatives established prior to a sale, and these industries typically encounter greater ESG due diligence from buyers than other industries which are less traditionally ESG focused.
Companies that have an emphasis on sustainability and traditional “E” metrics from ESG can maximize the value of their business by working with their advisors before going to market to ensure compliance with regulatory matters and improving their ESG metrics.
Working with their advisors prior to going to market enables potential sellers to ensure that they have mandatory environmental and regulatory licenses and permits to minimize the risk that a potential buyer’s diligence would result in a decreased purchase price. Additionally, outlining the company’s ESG priorities, initiatives, and measurements in the marketing materials used in the selling process helps to highlight the strength of the company’s “G”, which is always a positive factor in valuation. As Warren Buffet is credited with saying, “You can pay a lot of money for a really good business if you are reasonably sure it is a really good business.”
How ESG Factors Impact the Due Diligence Process In M&A Deals
ESG due diligence is increasing throughout all industries, including those industries which may appear less ESG-driven. In a 2019 survey of senior executives who are split equally between private equity, corporate entities, and asset management firms, 90% of respondents indicated that their firms conduct due diligence on ESG issues at investment and M&A targets.
In recent years, we are seeing an increase in ESG due diligence that goes beyond standard compliance with laws by focusing more on the values, work culture, and social responsibility of the selling entity. For instance, ESG diligence will not only focus on compliance with labor and employment laws, but will also focus on issues relating to workplace diversity, gender inequity, sexual harassment, and workplace misconduct. The American Bar Association Business Law Section 2018-2019 Private Target Mergers & Acquisitions Deal Points Study has recognized this additional focus in M&A deals by including data regarding sexual harassment or misconduct representations for the first time.
Potential sellers can maximize the value of their business by conducting an evaluation of their own policies, procedures, standards, and goals with respect to ESG metrics prior to going to market. Every business has different ESG priorities and a starting place to determine where to focus is the Sustainability Accounting Standards Board’s (SASB) Materiality Map. This helps identify what issues are likely to impact the financial condition and operating performance of companies in a given industry.
On the other hand, potential buyers can maximize the success of the business transition in the long run by determining a framework and prioritization on values, work culture, and social responsibility of potential targets.
As advisors to both buyers and sellers, we can assist clients on both sides of a transaction by determining the types of ESG diligence and preparation that should be employed in order to have a successful deal for both parties.
This preparation will largely depend on the type of business and the jurisdictions in which it operates. The following are specific focus areas for the preparation of an M&A deal:
Governance & Integration – A company’s general position on ESG matters, including its policies and quantifiable metrics for sustainability and other ESG concerns, highlights the company’s culture and can help to determine the long-term viability of a potential buyer or target.
Past Instances of Non-Compliance and/or Risk with Respect to ESG – Evaluation of past issues that may have been hurdles to strong ESG metrics can help to ensure a successful transaction. Reviewing past issues to identify current risks and other potential mitigation efforts can assist buyers and targets to get comfortable with the risk allocation in a transaction.
Current ESG Ratings and Use of ESG Standards – There are several ESG metrics that are used, ranging from the Sustainability Accounting Standards Board Standards, Climate Disclosure Standards adoption of the United Nations Sustainable Development Goals, and the Global Reporting Initiative Standards. Since there is not one universally accepted set of ESG metrics, sellers may consider how their metrics under one set of standards aligns with success under another set of standards. Similarly, a buyer or investor that uses one ESG metric framework may want to conduct diligence of the seller or target using the same metrics that such buyer or investor typically uses.
Stakeholder Engagement – Stakeholders range from employees, customers, vendors, and the general community surrounding the business. The transactions that are most successful and have the smoothest transitions ensure stakeholder engagement on both the buy- and sell-side. A seller’s community engagement and general work culture can be invaluable to a business, particularly when a buyer recognizes this value and similarly prioritizes stakeholder engagement.
Other ESG diligence – While there are several other aspects of ESG diligence that can help maximize the success of a transaction for both sides of the deal, a legal review of matters relating to environmental compliance, human rights, labor standards, anti-bribery and corruption, supply chains, and business contracts can help prepare all companies for their transaction.
In the third part of our series on ESG and M&A, we’ll delve into how to negotiate an ESG M&A transaction to maximize the success of the transition.