ESG: managing risks and capitalising on opportunities in M&A transactions

The rising focus in the Australian market on environmental, social and governance (ESG) issues is now finding its way into more and more acquisitions, both as a driver for M&A and as a part of due diligence.

Buyers are focused on how they can best capture sustainable and ethical opportunities, and how they can achieve maximum value and monitor for ESG risks. This can take the form of dovetailing the acquisition with their own processes for ensuring transparency on climate risk, social justice, sustainability and corporate governance.

There is no doubt that ESG is now a key risk for buyers. Poor ESG can have reputational, financial and sometimes legal consequences for the buyer. As a result, we are seeing private equity funds and strategic acquirers looking for due diligence to include an ESG-focus. That due diligence is designed to both understand the risks and to identify value opportunities.

There will be opportunities for those buyers who develop an effective and verifiable ESG risk and governance model. An increasing number of significant Australian and overseas private equity and other funds use sustainability or ESG metrics as a value add, or increasingly as a focus for standalone ESG or impact funds.

Having a strong understanding of ESG risks and weaknesses provides a buyer with the opportunity to build and strengthen the saleability and value of the firm post acquisition. At a macro level, an acquisition thesis needs to incorporate ESG risks and note how the transaction will fit and be consistent with the overall ESG strategy of the buyer.

Our clients are increasingly managing their businesses to identify and mitigate ESG risks – and considering this when making deals. By building ESG considerations into the M&A process, acquirers can find assets that supercharge existing ESG initiatives. Conversely M&A deal teams and boards are increasingly looking to identify whether new businesses have the potential to create an ESG-related contagion, undermining hard won ESG gains.

Often, the primary risk of an accidentally ‘introduced’ ESG contagion will be the reputational damage that it might cause in the minds of customers and investors. A number of recent examples in the listed market have demonstrated the significant impact that poor ESG management can have on a business. These corporate reputation wounds have the potential to place the tenure of the C-suite and the board at risk – and of course reduce value and liquidity.

For the M&A team, the consequences of an ESG misstep can be grave and warrant serious consideration. There needs to be a comprehensive plan to identify, monitor and mitigate all such risks. The consequential losses that can flow from damage to a buyer’s reputation are not usually covered by seller indemnities and so the issues need to be fully understood pre-signing.

As we wrote in 2021 (Climate-related risk: a rising bar for directors’ responsibilities), the nature of the duty and the degree of care and diligence required of a director depends upon the nature and extent of the foreseeable risk of harm. Today there are material and understood issues associated with ESG risks, particularly in relation to climate change, that would likely be regarded by a court as foreseeable. Can the directors demonstrate that the acquisition will be in the best interest of the company over the long term and have they considered the full range of risks – including ESG risks? At the very least, directors will need to be able to demonstrate that they considered the issue.

Australian regulators are increasing their focus on sustainability related disclosures and we expect that trend to continue in line with the recent focus on “greenwashing” and “greywashing”. Read our two previous Insight articles here: Mind the splashback: greenwashing and greywashing in sustainability-linked financing and Financial institutions a growing target amid global greenwashing crack down.

Of course, it is not just regulators focused on greenwashing. Australia has also seen an increase in shareholder, environmental and human rights activists taking steps to ensure ESG-related commitments are upheld.  

ESG due diligence investigations will not be the same for each target. The nature of the investigation will be highly dependent on the particular circumstances of the target and the purchaser. For example, certain sectors heavily reliant on unskilled labour may have elevated risks of modern slavery; organisations may be exposed to jurisdictions with significant integrity issues; manufacturing processes or product input may have negative environmental or climatic impacts.

ESG due diligence can take many forms but should be undertaken with subject matter expertise and a clear understanding of the interrelationship between the myriad of ESG related risks. Where there are elevated integrity risks, there will be corresponding elevated human rights risks. When environmental damage occurs, surrounding communities are often impacted. ESG risks require careful understanding and scrutiny to ensure any risk profile is rigorous and provides the buyer with an accurate picture in the acquisition documents.

In some cases there may be ESG issues that need to be remedied or certified as conditions precedent to ensure the matters are addressed before completion. In other cases, ESG issues arising at the time of purchase may create opportunities for value creation as the buyer works with the new acquisition to build and strengthen ESG performance.

It is clear that effective ESG-focused diligence has the potential to create, preserve and identify value in the acquisition process. The nature of ESG means this will need to be a bespoke process, both in terms of understanding the underlying issues that the target business faces and how those challenges need to be addressed through appropriate policies and procedures. Investors are increasingly using ESG as one of their investment criteria and an effective integrated ESG risk and governance model has the potential to significantly enhance the exit value for target businesses.

In summary, even with the above exclusions, if an acquirer is willing to undertake a little more due diligence and negotiation, it is still left with a meaningful set of warranties otherwise absent on a public transaction. In our view, having this option must be a good thing, and may well evolve to a more uniform approach where a sensible set of warranties is accepted as a standard approach and provided with a stapled W&I policy.