Environment, social and governance (ESG) or “sustainability” factors are criteria that are used to measure a company in a way that is not typically included in the company’s financial statements. For example, ESG can include examining a company’s (i) compliance with climate change mandates or carbon limits; (ii) stance on human rights, including with regard to its suppliers or distributors; or (iii) organizational and management structure. Traditionally, ESG has been underutilized as a tool in M&A transactions, but recent overall trends have brought these factors to the forefront as a method for both mitigating risk and enhancing value. As we will dive into below, ESG in M&A is important to consider — not only for potential buyers but also for potential sellers and their owners.

I. Current Uses of ESG in M&A Transactions

The vast majority of M&A transactions already consider and are conscious of certain ESG factors. This is most common during the fact-finding due diligence process. Standard in this process is the disclosure of material items that can cause future liabilities for the buyer, such as possession or disposal of hazardous materials that could violate environmental laws, or potential violations of labor or employment laws. For buyers, this helps mitigate risk as these potential sources of liability can be drafted around, while for sellers, having this surface-level ESG knowledge can help in terms of lowering negotiating costs and making a deal much more likely to close. The governance aspect of ESG also plays a role in most current M&A deals. Disclosure schedules will often include a list of the equity holders, directors, managers and/or other stakeholders. Understanding the dynamics of the management of the company and the interplay among stakeholders can ease negotiations and make post-merger or acquisition integration go more smoothly. A critical aspect of the M&A process is the post-deal integration of new leadership into the existing company. The higher a company scores in ESG’s governance factor, the higher the likelihood this integration can be done successfully. This benefits both buyers and sellers, especially with the common use of rollover equity in today’s M&A transactions.

II. Using ESG to Mitigate Risk

Utilizing ESG effectively requires an expansion of the normal due diligence process but in exchange can provide advantages to both buyers and potential sellers. Companies that score higher on ESG metrics are often more aware of upcoming regulatory changes, contract requirements or other changing factors that could materially affect their business. A wider look at ESG-relevant diligence can pick up potential liabilities such as lawsuits, diminution of customer bases, or supplier issues or shareholder challenges prior to signing or closing of an M&A deal. Early detection and knowledge can allow both sides to negotiate these issues and deal with them with normal M&A tools. These can include enumerating certain excluded liabilities, providing for holdbacks or escrows, or even changing the purchase price.

This risk mitigation enhanced by ESG is along the same lines of general risk mitigation practiced in normal deal-making; however, each potential source of risk is expanded and looked into further. For example, environmental diligence not only can bring up current hazardous materials usage or current violations of environmental law but can be expanded to include whether the company or its suppliers down the chain comply with climate/pollution-related targets (even those that are not yet firm law). This same logic can be applied to the social and governance aspects of ESG as well, especially considering that many post-merger liabilities can be mitigated due to greater understanding of the company’s culture, workforce and larger community. This is without even considering the potential legal ramifications of social and governance challenges that can be avoided by factoring in ESG.

III. ESG as a Value Enhancer

In addition to being used to mitigate risks, ESG factors can be used to (i) enhance value from the company’s perspective or (ii) provide insight into a target’s true long-term value. Companies that rate well on ESG metrics can generally be measured to have a higher value than companies that may have similar financial numbers but do not score as highly in ESG. Part of the reason for this is that, as discussed above, being more attuned to ESG can lower a company’s risk exposure for future adverse events. Higher ESG scores have also been correlated with higher financial returns.

There are also additional advantages, even to those on the buy side. ESG can assist with target selection for buyers, identifying targets that can be assimilated into a larger portfolio because of their corporate culture as well as those that are resilient to potential environmental or social changes in the future. This can be especially helpful in comparing targets within an industry. ESG reporting requirements are also becoming more common up and down the M&A chain, so it behooves buyers to add target companies with high scores on ESG metrics. There is also some evidence that higher ESG scores correlate with better financing terms or lower costs for loans.

IV. What Does This Mean for Your M&A Deal?

Above, we discussed potential advantages for valuing and incorporating ESG factors into an acquisition or a sale. The natural follow-up question is: How does this actually look and get incorporated into an M&A deal? The main two ways are as follows:

  1. Due Diligence: As discussed above, ESG will require an increase in both the scope and the depth of due diligence done for a deal. This expanded diligence will allow parties to be aware of potential legal issues and technical, operational factors. In addition, ESG factors will be at the forefront of the representation and warranty insurance process.
  2. Changes to the Purchase/Merger Agreement: The result of this diligence can lead to, depending on the deal, increased disclosures made on disclosure schedules; fine tuning of representations and warranties, particularly those that deal with ESG-related topics; and in extreme cases, changes in purchase price, and additional excluded liabilities or indemnities. The agreement can also allow for flexibility for these issues to be resolved either as a covenant or a closing condition. The above changes could also lead to considerations of different deal structures, such as asset purchases instead of stock sales or separating the signing from the closing.

V. Private Equity Impact

Given their frequent role as a player on both the sell and buy sides of M&A deals, private equity firms are in a unique position to utilize effective ESG factors. As mentioned, ESG metrics measure sustainability and can be a good barometer of long-term success for a company. Private equity firms that are selecting targets are often looking for sustainable growth and for evidence that their targets will be in a position to remain attractive in a potential sale down the road.

Using ESG as a way to differentiate between companies in the same industry is also a boon to private equity looking to invest in a new industry. Furthermore, having a high-scoring ESG portfolio could increase the reputation of a private equity fund, particularly among younger demographics that are more conscious of ESG elements. This can provide an advantage in terms of recruiting talent or future partnerships. All of this means that consideration of ESG factors is fundamental in an M&A deal.