In Q4 2022 A&L Goodbody hosted a webinar event 'Private Equity – current trends in a turbulent market'. During the event our experts considered the approach to ESG matters that they are seeing in the market in connection with private equity transactions in Ireland. This article looks at some of the key themes and ideas discussed during the session, suggests practical implications for deal-makers and includes a view on the outlook for ESG-related developments in private equity transactions in the coming months.
We hope what follows is of interest – please reach out to your usual A&L Goodbody contact if you would like to discuss the below further.
In our view, the days of business accountability by reference to financials alone are behind us. Instead, the triple bottom line is here to stay: in addition to performance, people and planet considerations are now of equal significance for corporates.
We are seeing that stakeholders expect business to demonstrate thought leadership in the delivery of their sustainability commitments. Businesses that can do so consistently and coherently can deliver the best results.
Private equity is no exception to these general market trends – houses cannot afford to ignore ESG going forwards. Private equity LPs and institutional investors are becoming increasingly vocal in their expectations around sustainable business. Having said that, strong ESG credentials should contribute to performance rather than coming at its expense and ultimately drive value.
The challenges engendered by the apparent cooling in the market are fueling investor appetite for strategic investment opportunities. Companies with strong ESG credentials are therefore best placed to remain in demand by investors and weather the storm. Conversely, targets and sectors with riskier ESG credentials will likely have to work harder to position themselves effectively in these turbulent times.
The novelty of the ESG lens requires genuine strategic thought: many recent examples demonstrate that acting hastily can have a negative impact on reputational capital. Having said that, silence in this case is not golden – businesses shouldn't expect to be able to ignore the conversation for much longer.
What are we seeing?
This increasing importance of ESG matters to stakeholders is evident – regulators are no exception. In some jurisdictions, publicly listed companies or those providing certain financial services and products are already subject to requirements to make disclosures around non-financial/ ESG matters. In the EU, for example, asset and investment managers are subject to regulations around the sustainability classification of investment products. Further, certain large listed companies are already under obligations to provide non-financial disclosures and statements (in the EU, for example, this is required under the so-called Non-Financial Reporting Directive (Directive 2014/95/EU)).
This focus on ESG will only intensify. We have published extensively on incoming ESG related legislation. For example see here for our client note on the Corporate Sustainability Reporting Directive (CSRD) which is now in force and required to be transposed into national law by 6 July 2024 and see here for our introduction to the reporting standards currently being developed in relation to the CSRD. Another initiative that is already with us is the so-called Gender Balance on Boards Directive (GBBD) which is required to be transposed into national law by 28 December 2024 (see here). Further initiatives will impose additional requirements on larger corporates – for example, see here for our note on the proposed Corporate Sustainability Due Diligence Directive (CSDDD). While some of this legislation is in different stages, as noted much is already with us: the GBBD came into force on 27 December 2022 and the CSRD came into force on 5 January 2023. The largest public companies will be required to report in compliance with the CSRD as early as 2025. The GBBD will require larger listed companies to comply by 2026.
These key initiatives are examples of the increasing EU legislation relating to ESG that will have an ongoing impact on a significant number of companies, both public and private, in the years ahead. Of course, cross-border M&A requires a global outlook. Companies that operate outside the EU are monitoring similar developments worldwide, examples include the SEC's proposed emissions disclosure rules, the IFRS' International Sustainability Standards Board's proposed rules (which build on SASB Standards) and disclosure frameworks such as the Task Force on Climate-Related Financial Disclosure (TCFD). The UK's Financial Conduct Authority already requires London Stock Exchange premium and standard listed companies to make disclosures in line with the TCFD framework.
In addition to the above current and incoming black-letter law requirements, we are also seeing a number of corporates choosing voluntarily to make disclosures against frameworks that may not be strictly legally required of them, for example choosing to achieve B Corporation certification status. This appetite to anticipate the introduction of strict legal requirements is an interesting and telling aspect of stakeholder engagement with matters ESG – it reflects an increasing understanding that in the eyes of the world, it's not enough for market participants to do solely what is strictly required of them. Companies who wish to be seen to be doing well when it comes to ESG are those that are taking a clear-eyed look at the road ahead, anticipating incoming requirements and demonstrating an authentic commitment to sustainability.
Effects on deal-making
Private equity houses, in common with other stakeholders, are demonstrating increasing willingness to meet the challenges and opportunities created by engaging with ESG which is leading to a shift in deal dynamics. We are seeing a much deeper assessment of a target's ESG profile during the due diligence stage of deals. This leads to a clear-eyed understanding of to what extent a target's current trajectory is helpful from an acquisition perspective, and where there may be challenges that must be addressed either pre or post acquisition. In the worst case a target's ESG profile may be a deal-breaker. Fortunately, however it is more typical for parties to agree and implement a turnaround strategy, either pre- or post-closing, and it goes without saying that a well-executed strategy can drive value. This diligence extends to the entire value chain of a business, which reflects in part the incoming requirements of the CSDDD.
This focus on ESG as a necessary component of target value is resulting in an increasing need for ESG specific deal language across the suite of investment documents, from diligence questionnaires, to diligence reports and transaction document terms and conditions. Relevant concerns range across a broad spectrum including environmental matters, privacy, data security, labour relations, diversity, reputational matters such as 'me too' and political positioning as well as the more 'traditional' items such as anti-corruption and bribery. We are also seeing an increasing focus among insurers on ESG language in representations and warranties given by sellers and/or targets, which is manifest at an early stage of the deal process.
This reality that we are witnessing across our deal landscape means that that for funds embarking on any deal journey, ESG must be at the forefront of the 'to-do' list right from the start.
Accordingly, on the deal side we are seeing many companies we work with engaging ESG specialists to conduct ESG specific diligence alongside traditional advisors from early stages in executing deals, particularly where there is a sector-specific concern. This can extend to ESG performance audits and assessments for individual portfolio companies and their supply chains. It is also important to remember, that upon successful completion of a deal there may be value in addressing ESG specifically in transaction messaging in deal announcements. This focus on ESG extends beyond completion: tying director compensation to ESG performance, monitoring execution against any turnaround strategies (both at target and supply chain level) are all rightly attracting interest among deal-makers.
There is also an increasing tendency among investors to take time to undertake peer review of their own funds and their portfolio investments to assess opportunities to improve their own performance and narratives around ESG. One outcome of this focus is the greater prevalence of ESG wrapped investment opportunities for fund clients.
It is clear that an increased focus on ESG will continue to drive the markets for years to come. Sophisticated investors are increasingly cognisant of their obligations and the impending legal timelines that are fast approaching, across the jurisdictions in which they operate. For deal-makers, the wish list now exceeds mere compliance and box ticking; instead the focus is on corporates aiming at strategic leadership and differentiation through astute engagement with ESG matters in addition to mere compliance. There is a genuine opportunity for driving value through more sustainable business practices, and it is key for market participants to ensure advisers are well positioned to assist them in achieving these goals.