ESG will become an increasingly important aspect in M&A transactions in the coming years. This is partly because a high ESG valuation contributes to future value creation within the company and is therefore attractive to both investors and strategic buyers.
ESG is also increasingly becoming part of the due diligence to be carried out by a buyer of a company. ESG aspects (can) affect the transaction structure, the construction of the purchase price and the negotiations on the indemnities and warranties in the Share Purchase Agreement (SPA) to be concluded.
ESG regulations
The Corporate Sustainability Due Diligence Directive (CSDDD) and the Corporate Sustainability Reporting Directive (CSRD) provide a framework of ESG regulations with which companies must comply. These directives make compliance with ESG obligations no longer just a moral obligation, but a legal duty. To assess whether the CSRD and associated European Sustainability Reporting Standards (ESRS) apply to the target company(s) in question.
Now that companies are given an ESG score based on their performance in terms of sustainability and ethical impact, that ESG score is also increasingly playing a role in the valuation of a company and the level of the applicable EBITDA multiple. ESG is also increasingly important for obtaining (bank) transaction financing and its terms.
In addition, a buyer also wants to avoid potential reputational and financial damage, not be confronted with a company that is guilty of ESG fraud (such as greenwashing) or has not received an unqualified opinion from its auditor (with all its consequences). All the more reason to look carefully at the relevant ESG aspects in an M&A transaction.
Curious as to what the buyer should pay attention to in an ESG due diligence process and what agreements can then be made in the transaction documentation? Then read on.
ESG in due diligence
A buyer of a company does not want to buy a pig in a poke and will therefore want to have a good look under the hood before effecting a transaction. Also, based on established case law, the buyer of a company has a duty to investigate. Buyer will therefore have to conduct a due diligence on the target company(ies) in which the buyer (and its advisers) will look at all relevant legal, financial and tax aspects of the company. The seller, in turn, will have a duty of disclosure towards the buyer whereby she must provide sufficient information to the buyer so that she can make a correct representation regarding the target company(ies).
In the due diligence, all material risks of the company must be mapped out, including ESG-related risks. The extent to which the target company or companies comply with the ESRS or sustainability reporting requirements must be assessed. This analysis will be different for each company because other ESG factors play a role. To illustrate: a steel manufacturer with a substantial carbon footprint will obviously have a different ESG focus than an IT SaaS platform.
ESG paragraph
The due diligence questionnaires (questionnaires) used by the (advisers of the) buyer to request information will therefore increasingly include an ESG paragraph, ideally tailored to the type of company concerned. It is important (for the buyer in connection with its duty of investigation) that the questionnaire contains the most complete question possible.
It is also important for the seller to be able to indicate with respect to the target company or companies whether, and if so to what extent, the applicable ESG regulations have been complied with, the mandatory audit by the external auditor has taken place and assurance has been provided. The buyer also wants to be able to exclude the possibility that, for example, the Netherlands Authority for the Financial Markets (AFM) has at some point investigated the target company or companies and that no ESG fraud, such as greenwashing, has taken place.
By way of background, businesses that engage in the concept of greenwashing, one of the manifestations of ESG fraud, mislead consumers regarding the environmental benefits of their product or service. At the heart of greenwashing is the discrepancy between a business's actual environmental impacts and the way they present those impacts to the outside world. Given its duty of disclosure and to avoid post-closing liability, the seller will need to truthfully answer the questions posed since the buyer will want to hedge those given answers, among other things, in the Share Purchase Agreement (SPA) with warranties to be issued by the seller. Any specific identified risks a buyer will want to hedge in the SPA with a specific indemnification.
It is also possible that certain risks / issues cannot be adequately covered by indemnities or guarantees and need to be resolved first before the transaction / acquisition is effected. In that case, resolution of the identified risk / issue may be included in the SPA as a condition precedent. It is also not inconceivable that any ESG risks will affect the amount or systematics of the purchase price (including a possible earn-out arrangement).
Timely attention to ESG
We advise a buyer but certainly also the seller and the target company(ies) to pay attention to the possible ESG factors that may affect the proposed transaction at an early stage of an M&A transaction (preferably before / during the term sheet / letter of intent phase).
By asking the right questions in a timely manner, ESG-related risks can be identified and a solution can be found for them between the parties in the SPA. For the seller, correctly answering the ESG questions asked by the buyer is crucial to avoid potential post-closing liability.
