Greening the deal - how ESG considerations can affect corporate transactions

Posted: 25/10/2022

Introduction

Sustainability issues are becoming critical for businesses with a range of environmental, social and governance (ESG) factors increasingly influencing corporate activity such as M&A, financing and investment decisions as parties look for ways to drive long-term growth and advance their own green agenda.

This article considers the impact that the growing focus on ESG is having on corporate deals and negotiations. It forms part of a series which examines how small and medium-sized businesses are affected by the evolving sustainability landscape.

Other articles in this series include ESG - why SME’s should pay attention now, and Greening the boardroom - the changing nature of directors’ duties.

Setting the (green) scene – preliminary stages

Parties are increasingly focusing on how sustainability can be embedded from the outset of commercial discussions. Ensuring that ESG matters are flagged at an early stage will help facilitate subsequent negotiations and provide an insight as to whether the parties’ sustainability values are in sync. This can be particularly helpful if, for example, there will be an ongoing contractual relationship (such as with an investment or financing) or, in the context of M&A, a buyer factors in post-integration issues, as outlined below.

Consequently, incorporating ‘green’ clauses in preliminary documentation - such as non-disclosure agreements that address the commercial purpose and legal protection of confidential information, along with heads of terms that set out the parties’ key objectives and the main legal protections to be incorporated into binding contracts - will encourage parties and their deal teams to duly consider sustainability factors throughout negotiations. In turn, this will reduce the risk of misunderstandings later on which could result in protracted negotiations between the parties and increased costs.

Due diligence

ESG due diligence is becoming more important for a range of corporate activity such as M&A as it can identify risks which may not be flushed out by traditional due diligence, but that could have severe financial or reputational implications.

Alongside other customary due diligence investigations, the incoming party – be it a buyer, investor or lender - and their advisers will need to consider the scope of diligence focused on ESG issues relating to the target business. This will largely depend on the nature of the target, the transaction and the incoming party. Specific areas of focus may include, for example:

• whether the target has an ESG policy in place;
• board involvement in ESG strategy;
• the business’ performance on carbon emissions ;
• the diversity of the workforce;
• whether the target has procedures in place to protect itself against situations such as modern slavery; and
• long-term ESG risks and opportunities.

Depending on the facts, a target’s ESG performance could increasingly become one of the factors in whether or not (and on what terms) a deal goes ahead. Indeed, unaddressed ESG risks and any resulting reputational damage may, for example, result in a buyer or target failing to obtain any necessary shareholder or investor approvals for a transaction.

Likewise, attracting investment and securing commercial lending, along with the availability and cost of financing for a transaction, may be adversely affected as the focus on sustainability and ratings intensifies.

Appointing and involving a legal team and other professional advisers early on will help to facilitate a well-managed and effective ESG diligence and disclosure exercise that potentially saves costs in the long-run. To read more about the due diligence and disclosure process, see our article here.

Deal documentation

Where due diligence identifies ESG risks, the incoming party, guided by their legal advisers, will have a number of options to consider such as:

• a downward valuation of the target company;
• addressing certain risks in the transaction documents (eg warranties, indemnities or as remedial actions required prior to completion);
• a carve-out of the relevant business part affected (particularly in M&A); or
• the relevant risk may be remedied in the course of a post-completion transformation process.

Any ESG-specific protections in transaction documents will need careful drafting to adequately cover ESG compliance, minimise litigation and reputation risks, while ensuring that any breaches and resulting losses are objectively identifiable.

This is especially important if the parties want to obtain warranty and indemnity insurance in the context of M&A. Likewise, from a target/seller’s or borrower’s perspective, they will want to ensure that any ESG protections are not excessively burdensome.

If an incoming party has any particular sensitivity about certain ESG issues which would not be covered by customary representations and warranties, then more specific provisions will need to be included to address those issues (for example, regarding supply chains or community engagement). In some cases, carefully negotiated ESG indemnities may also be appropriate. 

Crucially, ESG considerations should be seen as continuing to operate beyond completion of the acquisition, investment or financing: for example, in the context of M&A, helping a buyer to integrate the target into its business and ensuring that the complex risks associated with ESG issues are identified and minimised before significant reputational damage or financial liabilities may arise.

Conclusion

Parties that proactively engage with sustainability, bolstered by a team of well-selected advisers to help identify and address ESG risks and opportunities, are more likely to have success in securing investment and completing transactions on terms that advance the parties’ respective objectives.

Our highly regarded corporate team provides clear, pragmatic and practical advice to businesses large and small in the UK and around the globe on the corporate transactions and the legal issues they face. To find out more about our corporate team please click here.

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