Rising importance of ESG factors to the attractiveness of targets has begun to influence the amount of work required and the risks involved in M&A.
Incoming sustainability rules on supply chain transparency will prompt corporates to further integrate ESG factors into core M&A due diligence processes, potentially adding cost and slowing deal flow.
Patrick Sarch, Partner and Head of UK Public M&A at law firm Hogan Lovells, told ESG Investor that historically dealmakers primarily focused on aspects “within the perimeter” of the target company, but now the due diligence process has extended to encompass many external elements.
Sarch noted that this shift in approach is driven, in part, by incoming and existing rules, such as the EU’s Corporate Sustainability Due Diligence Directive (CSDDD) and Corporate Sustainability Reporting Directive (CSRD).
In June, the European Parliament backed a robust version of the CSDDD which will hold corporates accountable for human rights and environmental violations. The directive is still subject to trilogue discussions with the European Council and the Commission, which are expected to get under way in the coming weeks, with a potential resolution hoped for by the end of the year.
CSRD, which came into effect earlier this year, with first disclosures expected from 2024, will be underpinned by the first set of sector-agnostic European Sustainability Reporting Standards (ESRS), which specify how companies report on sustainability matters and are designed to reflect sustainability report users’ growing needs for comparable, relevant and reliable information.
Hogan Lovells’ Sarch said that when conducting due diligence, an initial assessment of the target’s supply chain and financing “sphere of influence” is required, with additional factors, including its Scope 3 emissions and other relevant ESG-related considerations, also needed in order to assess their potential impact to investors.
“There is currently a significant proliferation of reporting obligations related to due diligence and the requirement to report on findings and actions taken, especially in various countries across Europe,” said Sarch, noting the likely extension of this to the US.
No longer fringe
According to WTW’s M&A Barometer survey, 25% of organisations have an increased focus on ESG as part of their M&A strategy but ESG is not the main rationale behind doing deals as yet.
Speaking with ESG Investor, Jana Mercereau, Head of UK M&A Consulting at WTW, said that the primary rationale for pursuing inorganic growth is to acquire people and or technology, to increase pipeline, gain market share and expand geographically.
But ESG-related issues are becoming more central to companies’ future growth strategies and have become mainstream during M&A due diligence to ensure deal making is not “blindsided” by negative ESG ratings of a potential target, she added.
“Issues relating to ESG are no longer thought of as fringe topics to review during due diligence but are more ‘hygiene’ factors when assessing whether or not to buy or merge with another company,” said Mercereau, adding that organisations with a more mature approach to ESG reporting and policy can command a higher value and those which cannot will need to address potential reputational red flags during due diligence.
“For financial buyers such as private equity, ESG is a key investment measure, and they place a premium on those organisations with an ESG focus.”
Sarch said that the rising importance of ESG factors to the attractiveness of targets has already begun to influence the amount of work required and the risks involved in M&A.
“A notable shift in the M&A due diligence approach is the increased focus on the ESG ratings of your target company and its associated policies, in addition to traditional credit ratings,” he said, adding that this represents a significant change from previous practices, as ESG factors are now integral to the assessment process.
“To perform ESG due diligence effectively, you often have to rely on universal data providers to help identify relevant information,” Sarch said, noting that these providers can assist in determining who the suppliers are, their methods of operation, and the associated risks.
He also noted that the heighted level of transparency required of firms due to the growth in mandatory ESG-related disclosure requirements also introduces a higher risk of litigation.
“With more transparent information available, there is a new surface on which potential claimants can find traction for their cases,” he said, adding that this shift in the landscape of ESG reporting and enforcement, has significant implications for M&A due diligence.
“The pressures on M&A due diligence are expected to increase due to the enforcement of ESG duties through a form of crowdsourcing, where claims may arise either for economic reasons when something goes wrong, or for ideological reasons when issues like new fossil fuel extraction in the UK or non-compliance with new policies come into play.”
According to M&A data from Big Four consultancy firm PwC, deal volumes decreased by approximately 4% between the second half of 2022 and the first half of 2023. For the larger deals – greater than US$1 billion – the decline was 11%. The number of deals of US$1 billion or more has declined by approximately 56% since the record M&A year in 2021. By contrast, deal volumes for deals less than US$1bn declined by approximately 20% over the same period.
The report noted that the sectors witnessing the highest level of megadeals activity – pharma and life sciences and the energy, utilities and resources sectors – are those associated with megatrends such as technological innovation, digitalisation, ESG and the energy transition.
Nicola Evans, Global Lead of Hogan Lovells’ Insurance Practice, noted that social-related factors could potentially become another integral component within dealmakers’ due diligence process.
The Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) are currently consulting on the need to introduce a new regulatory framework to improve diversity and inclusion (D&I) in the UK’s financial sector to deliver better internal governance, decision-making and risk management.
The FCA and PRA proposals outline new rules, guidance and minimum standards on misconduct that could pose a risk to healthy firm culture, such as workplace bullying and sexual harassment, to ensure that firms can take “decisive and appropriate action” against employees that exhibit such behaviour.
They will apply to FCA-regulated asset managers and asset owners, including life insurers and pension providers.
“Financial services companies that are acquiring a target will need to consider this aspect during their due diligence and integration phases,” said Evans, noting that any entity that is acquired and integrated by an acquirer will have to report on it.
“This due diligence will likely highlight any gaps or deficiencies in terms of diversity within the target company, and these will need to be addressed as part of the integration process within the larger organisation,” she said.
“The rules and regulations surrounding the ESG space are not only driving but are expected to further emphasise the need for diligence at the acquisition stage.”