For some, it’s a fad; for others, it’s the next bugbear after the Corona pandemic; for still others, it’s the last attempt to save the world. All this is hidden behind three magic letters: E – S – G. “E” stands for Environmental, “S” stands for Social and “G” stands for Governance. But what actually stands behind these?
In October 2018, the Intergovernmental Panel on Climate Change (IPCC) published its special report (World Climate Report), which caused a stir and alarm around the world. This is because it not only described the need to limit global warming, but also showed how this need must be addressed quickly and intensively with measures in all areas of society.
It is not only the German legislator that has been moving at a rapid pace since then. In Germany, the so called Due Diligence Act (“Sorgfaltspflichtengesetz”) which has also been named as Supply Chain Act (“Lieferkettengesetz”) is in the starting blocks. The German government has agreed on a respective draft and the act is to come into force in full from January 1, 2023. The Due Diligence Act is intended to oblige companies to ensure compliance with environmental protection and human rights in their national and international supply chains. If they fail to do so, they could face substantial fines of up to two percent of their sales and possibly civil claims for damages.
European lawmakers are also stepping up the pace on ESG. It is based on Article 3 (3) of the Treaty on European Union, which regulates the establishment of the internal market. Among other things, the internal market is to work towards the sustainable development of Europe on the basis of balanced economic growth and a high level of environmental protection and improvement of environmental quality.
The EU Action Plan on Sustainable Finance
Also under the influence of the World Climate Report, the EU presented a concrete agenda, in particular with the so-called EU Action Plan on Sustainable Finance in 2018 (APSF 2018). The APSF 2018 sets out the overarching goal of climate neutrality by 2050 (the so-called Green Deal). In order to achieve and sustain this goal, a comprehensive transformation of the economy and society towards a sustainable economic and financial system is envisaged.
In this respect, the APSF 2018 provides for ten concrete measures to achieve the aforementioned goals, of which the following are particularly noteworthy:
- Introduction of an EU classification system for sustainable activities (so-called Taxonomy Regulation),
- Promotion of investments for sustainable products,
- “Clarification” of the obligations of institutional investors and asset managers (this involves amendments to the AIFMD / UCITS Directive),
- Sustainability in supervisory regulations (amendment of CRD V).
- Disclosure of sustainability information in financial reporting
- Promotion of sustainable corporate governance
- Reduction of short-term thinking in capital markets
It is clear that companies from regulated industries will in the first place be directly affected by the implementation of measures following the goals set out above. This applies to banks, insurance companies, regulated asset managers, but also capital market-oriented companies. For corporate governance or activities that are not aligned with ESG criteria will make it significantly more difficult to raise capital on the capital markets in this way. However, as a result of the indirect regulatory approach, medium-sized and smaller companies are also increasingly under pressure to comply with ESG criteria. One example: a German based medium-sized supplier to the automotive industry manufactures components for electric cars in the Far East using child labor or employing polluting techniques. Such a company will have difficulties to continue to supply to a (listed) OEM. It will also have difficulties in obtaining financing for its business model in the form of loans from German or European banks and, moreover, it will have to accept significant valuation discounts when it tries to find investors or to sell its company.
The aforementioned example shows the noticeable influence of ESG criteria on the M&A market. In light of this, it may be assumed that M&A transactions will be influenced by the increasing importance of ESG criteria on various levels, especially on the following levels:
- Selection of suitable target companies,
- valuation of target companies,
- (acquisition) financing by lenders,
- (legal) due diligence,
- drafting of agreements.
Impact by ESG criteria on the selection of target companies
Already, not only capital market-oriented corporations and non-profit companies, but also private equity funds and other professional financial investors, are increasingly taking ESG criteria into account when selecting target companies. Social impact investing is becoming increasingly significant, even if the market in this regard is currently still in an early development phase. This trend will intensify from January 1, 2022 as on July 12, 2020, the so-called Taxonomy Regulation came into force as one of the first legal acts implementing the APSF 2018. The Taxonomy Regulation is intended to clarify two important issues – first: Under what conditions is an economic activity to be considered environmentally sustainable? And second: Under what conditions and to what extent is an investment in that activity environmentally sustainable?
The Taxonomy Regulation will apply with respect to climate change objectives from January 1, 2022, and with respect to all other environmental objectives from January 1, 2023.
Impact of ESG criteria on company valuation
With regard to the Taxonomy Regulation, anyone who thinks that the impact of ESG criteria is solely determined by regulation is mistaken. This would also not explain why the trend towards compliance with ESG criteria is so strongly anticipated in practice, i.e. even without the Taxonomy Regulation already being in force. In fact, many studies in recent years have shown that compliance with these criteria has a positive impact on the financial performance of companies. For example, the analysis of 2000 studies since 1970 by the University of Hamburg showed that 63% of the studies found a positive correlation between consideration of ESG criteria and the financial performance of companies. This does not mean that the return and risk criteria relevant to buyers in M&A transactions would be replaced by ESG criteria. These criteria remain relevant. Rather, ESG criteria take their place on an equal footing with these objectives.
Impact of ESG criteria on (legal) due diligence
Buyers in M&A transactions are likely to have to intensify their due diligence efforts with respect to compliance with ESG criteria in the future. Conversely, sellers will have to pay particular attention to clarifying ESG-relevant facts and documenting compliance with ESG criteria when establishing exit readiness and preparing a sale. This comes along with additional transaction costs for both sides of the transaction.
At the same time, a general standard for the verification of ESG criteria is currently still lacking. It is also still unclear whether another work stream, e.g. a separate sustainability due diligence work stream, will be established here in addition to the common due diligence work streams (tax, financial, commercial, legal, etc.) or whether, alternatively, the review of the relevant criteria will be carried out as part of the established due diligence work streams. In favor of the latter is the fact that ESG is, to a certain extent, a cross-cutting issue.
For the area of legal due diligence, which depending upon its scope often also includes the area of corporate compliance, the area of ESG will insofar regularly include the following questions:
- Does a code of conduct or guidelines for compliance with ESG criteria exist, and do these documents adequately take into account the ESG criteria relevant to the company?
- Has the code of conduct or ESG guidelines been effectively introduced in all Group companies or how is it ensured that the ESG criteria are observed in all Group companies?
- Are there agreements with suppliers and (especially in the B2B area) with customers on compliance with ESG criteria?
- Are there functioning internal or external systems for the (early) detection of risks of non-compliance with ESG criteria?
- Have there been any breaches of compliance with ESG criteria in recent years? If so, how was this responded to?
- Are these systems equipped with adequate human and financial resources as well as competencies to fulfill their task. In particular, are there no conflicts of interest?
- How is the functioning of these ESG compliance systems regularly monitored by management? In particular: How is management involved in this regard?
- How is management incentivized? Are there adequate incentives for compliance with ESG criteria within the framework of management employment contracts?
With regard to obtaining the information and documents required for (legal) due diligence, an acquirer can benefit from the fact that European capital market-oriented companies have already to report on their material developments from the areas of environmental, employee and social concerns, respect for human rights, and combating corruption and bribery since 2017. Even beyond this, many companies today already produce their own sustainability reports. In addition, sustainability rating agencies and corresponding certificates already exist, which can be requested as part of the due diligence process.
Impact of ESG criteria on acquisition financing
If the acquisition of a company – as is particularly common with private equity funds – involves the use of financial debt, the ESG criteria can also have an impact on acquisition financing. If there are risks of non-compliance with ESG criteria, this can lead to significantly higher interest rates or, if there is even complete non-compliance with ESG, to the failure of the acquisition financing.
Impact of ESG criteria on SPA or APA negotiation
The acquirer’s interest in compliance with ESG criteria will also have a lasting impact on the drafting of share purchase agreements or asset purchase agreements. The first thing to think about is the purchase price and how it is structured. For example, if a seller wants to claim a higher multiple for calculating enterprise value based on a particularly impressive ESG performance, a buyer may want to negotiate an earn-out. Since ESG is about sustained compliance, a buyer may also insist on rather longer earn-out periods. The same may apply if there are breaches of ESG obligations and it is unclear whether these exist.
It is also conceivable that compliance with ESG criteria can influence the transaction structure and lead to delays in the completion of the transaction, for example if the target company still has to conclude agreements with suppliers on compliance with ESG criteria as part of the completion requirements.
The design of the representations and warranties should also be considered. Here, it is to be expected that in particular the typical guarantees on general compliance, which are usually feared by sellers, are likely to experience a noticeable expansion. If there is knowledge of relevant facts suggesting a violation of ESG compliance, only a specific indemnification may come into consideration, as otherwise – at least in typical German SPA or APA – knowledge of relevant facts could preclude the enforcement of the representations and warranties.
An increasing point of contention in connection with representations and warranties as well as indemnifications may also be provisions on the limitation of liability, as the sanctions against ESG violations in Germany are now draconian.
The bottom line is this: The world is changing in leaps and bounds right now. These changes will not leave the M&A market untouched. Legislative developments in Germany and Europe are just at the beginning of a potentially noticeable increase in government dirigisme to comply with ESG criteria. In a positive sense, this approach can stimulate the economy by creating new markets characterized by sustainable products and services and accelerating the transformation of the economy. This is where M&A will be able to make a significant contribution. In any case, this development will also have an impact on M&A transactions. This starts with the selection of target companies and continues with company valuations. Accordingly, due diligence and the drafting of contracts will also undergo massive changes from a legal perspective while standards still need to be established.