Amid greater regulatory scrutiny and increased market volatility around the world, today’s investing environment is more challenging than ever. With a heightened focus on climate change, human rights issues, and responsible investment, law firm clients such as investors, funds, PE houses and VC groups are taking closer looks at issues like carbon emissions, child labor, corruption, and boardroom diversity to reduce risk and increase the potential for superior long-term returns. Not surprisingly, Environmental, Social, and Governance (ESG) practice groups are burgeoning in law firms worldwide, helping clients legally navigate ESG and Socially Responsible Investment (SRI) landscapes. There is growing recognition in the business world that ESG factors are economically material and that it’s crucial to integrate such factors in investment decisions. About 93% of private equity firms said a focus on ESG helps generate good investment opportunities, according to a 2020 poll by sustainability consulting group ERM. Increasingly, the world’s biggest companies are prioritizing ESG in their new initiatives, contracts, and hiring decisions. Earlier this year, Coca-Cola announced it will require diversity among law firms who bill it for work in the United States and reduce payments for non-compliance. Indeed, even while the COVID-19 pandemic devastated the world’s economy, causing the S&P 500 index to plummet by 26.9%, companies rated highly for ESG performed almost 4 percentage points better by comparison and low-rated companies performed 7.4 percentage points worse.
Current status of the market
However, only a small portion of institutional (19%) and retail (10%) investors currently invests in ESG products, according to a recent survey by the CFA Institute. One of the likely reasons for that discrepancy is that investors have a hard time getting accurate assessments of how companies and products rate when it comes to ESG. For example, 78% of investors surveyed by the CFA Institute say that there is a need for improved ESG standards due to greenwashing, in which companies provide misleading information or cultivate a false impression of their performance. “The consistency and comparability of ESG data from companies is poor,” concludes the report, noting that there are few government requirements to report such information, leaving companies to determine for themselves what to disclose.
As ESG investing products proliferate amid a growing demand for transparency, the scrutiny of such funds is likely to increase, to verify that they are delivering what they promise. Since it’s a relatively new area, sustainability funds often lack employees who are qualified to accurately assess a company’s ESG record; for example, if an energy firm knows how to downplay its negatives by reporting its carbon emissions in creative and potentially deceptive ways.
In such an investment environment, in which transparency is often lacking, proper due diligence is a requirement for companies pursuing M&A activity and investors. Over half (54 %) of private equity general partners surveyed said they had reduced a bid price after ESG due diligence uncovered problems and risk factors and one third (32 %) said they had increased a bid price.
For example, a private equity firm seeking to buy a genomics firm in India might learn through due diligence (inspections of facilities, interviews with key employees, and a review of policies and procedures) that the company is potentially violating wage and hour laws and has failed to obtain the required environmental permits. Those problems put the company at risk of government fines and criminal prosecution. Armed with such information, the firm can negotiate a lower deal price and demand that those risks are adequately addressed.
ESG vulnerabilities can lead to legal headaches, therefore…
The revelation that a company has been involved in human rights violations, environmental pollution, or corrupt practices can have a significant negative impact on the company and result in steep fines and the loss of major contracts, as well as negative reputational consequences for the acquiring company. In addition, such ESG vulnerabilities can lead to legal headaches, in which a buyer may inherit liability for prior misconduct. Obviously, ESG standards will vary across sectors—since, for example, an agricultural company isn’t expected to have the same environmental impact as a bank—and need to be adjusted to specific industry sectors and geographical regions.
… it is essential to begin ESG due diligence as early as possible
As a result, it it is imperative that ESG due diligence is initiated at the earliest possible stage in the process, since some problems could become dealbreakers or significantly change the terms of the deal. Once such issues have been uncovered, it helps to clarify the acquired company’s risk profile and risk exposure.
Due diligence that provides a comprehensive overview of relevant risks and opportunities is essential when it comes to complex deals and negotiations. Among the factors it considers are:
- How emerging social and environmental trends are expected to impact the company and its market
- What the company’s material ESG risks and opportunities are
- How its potential liabilities and ESG weaknesses can impact costs, cash flow, and the deal timeline
- How the company’s ESG policies and performance measure compared to its peers in the industry and align with industry sector best practices
- Whether the company’s policies and procedures comply with national regulations and international treaties
The scope of ESG due diligence will depend on a series of factors:
- The size and structure of the company (especially if it includes subsidiaries located in different parts of the world)
- The type of physical assets it owns (varying from office buildings to manufacturing facilities)
- Labor type (salaried employees, contractors, subcontractors)
- Supply chain (specific or dedicated, national or international)
- Time (whether any investment will go towards new construction or new product lines and if potential risks are due to legacy problems such as unresolved legal disputes or contaminated land)
- Geography (ensuring compliance with local laws and regulations, as well as any applicable international standards)
Such due diligence should result in an action plan to be discussed with management that gives the client a clear understanding of what needs to be achieved and what risks need to be addressed. This can include specific and measurable targets, a list of recommended actions (both to implement remedial measures and to capitalize on opportunities) ranked by priority based on an assessment of materiality, completion indicators (such as documentary or physical evidence), a clear timeline, and a clear assignment of responsibility on both the individual and departmental levels.
It is obvious that incorporating ESG due diligence into the investment process can lead to better returns, lower costs, and fewer legal headaches. These benefits can be quantified and communicated to investors, other stakeholders, and the media. More broadly, improved ESG management can also positively impact valuable intangible assets such as reputation, brand value, and trust, in addition to generating value for society at large.
Lawyers need to be especially well-informed and mindful of ESG and related due diligence services to assist their clients when it comes to avoiding adverse outcomes, meeting regulatory standards and guidelines, and building a strong reputation for responsibility among investors, employees, and customers. Not only do counsel and in-house legal teams have to play a key role in managing ESG issues for organizations, but they must also become proactively involved in integrating ESG risks and opportunities into the policies and strategies of their companies.