With the growing urgency surrounding climate and sanitation issues and the economic challenges they present, Environmental, Social, and Governance (ESG) factors have become increasingly important for all stakeholders in commercial businesses and organizations. It's no surprise that ESG has also become a hot topic in M&A projects, as it can impact the value, risk, and reputation of the buyer, seller, and target.
In this article, PwC, our Platinum Partner, explores the importance of including Tax, Legal, HR and Operational related ESG topics in every step of a deal process:
(i) pre-deal phase: deal sourcing / target identification / due diligence
(ii) execution phase: structuring the transaction and negotiating the SPA
(iii) post-deal phase: operational and legal integration of the target company
The Pre-Deal phase: ESG in Target Identification and Due Diligence
During the pre-deal phase, potential buyers may want to consider key ESG parameters to determine their longlist/shortlist of potential targets. On the other hand, potential sellers may want to enhance the value of the target by upscaling/regularizing its ESG compliance and value creation.
ESG due diligence should help the purchaser to: (1) incorporate the target company into its business and identify and minimize the complex risks associated with ESG issues before they cause significant reputational damage or financial liabilities (2) identify the value levers related to ESG that should be considered when valuing the target. Hence, the great benefits of performing an ESG due diligence prior to entering into a transaction cannot be denied.
We have witnessed ESG due diligence evolve from a pure compliance, tick-the-box, exercise to a more comprehensive approach that includes opportunities for value creation. The usual topics covered in an ESG due diligence include materiality assessment, maturity, performance and benchmarking and the transformation roadmap. It's important to identify the most critical ESG-related factors since the ESG landscape is vast, and covering every single matter would be laborious and irrelevant. The maturity, performance, and benchmarking of the target are then assessed for these significant areas. Benchmarking can be done against industry players, a basket of comparable companies, or the buyer. In some cases, a transformation roadmap is included, providing a comprehensive view of the steps to take, associated costs, and the impact on the target's value.
Tax and legal aspects should also be included in this assessment. Tax-related ESG aspects cover for example ESG related taxes (plastic taxes, energy taxes, CBAM, etc) and the question whether Target has a sustainable tax paying level and a robust tax risk control framework. Legal and HR related ESG aspects are e.g. an avalanche of new legislation (“hardlaws, not softlaws”), respect of minimal labor laws and human rights, upcoming ESG CSRD reporting obligations and Corporate Supply Chain due diligence requirements in various countries.
In many cases, the M&A process is competitive, and ESG aspects can highlight additional sources of risks or opportunities that impact the value, bids, and ultimately the outcome of the deal.
The Deal phase
In the previous section, we focused on the impact of financial, tax, and legal aspects of ESG during the pre-deal phase. ESG considerations continue to play a significant role during the execution phase of the deal. Transparency and accountability are heightened, and ESG factors shape financing terms, deal fundamentals, and contractual provisions. By strategically incorporating ESG in the execution phase, companies can mitigate risks, create value for stakeholders, and position themselves for long-term success. The impact of ESG will depend on the buyer's ESG strategy and whether it is an objective or a component of the deal.
Generally, ESG issues identified during the pre-deal phase can impact a Deal on three main levels:
(i) Financing
Lenders and investors conduct ESG due diligence to assess the potential risks and opportunities of their investment and how they align with their own sustainability strategy or ESG classification. They may adjust their financing terms based on ESG factors.
Companies with strong ESG practices can secure more favorable financing terms, while those with weak practices may face higher interest rates or be refused financing. Unlocking success in high-debt leveraged deals, like those prevalent in private equity buy-side transactions, poses a unique challenge. A recent survey revealed a surprisingly low appetite among private equity players in integrating ESG metrics into their deal structures and financing strategies[1]. The main hurdle stems from the fact that ESG initiatives currently lack a well-defined, short-term financial ROI or a compelling value-creation narrative. This challenge is further compounded by the standard ownership timeline of around five years for a private equity-owned portfolio company.
(ii) Deal fundamentals
ESG issues can impact the fundamentals of the transaction. Depending on the buyer’s ESG strategy and the gravity of the issue, these issues may even be deal breakers or at least impact the business and cash flow plans, affecting the valuation of the target.
This can lead to situations where the Seller is forced to re-organise their group operationally in a pre-closing restructuring or add investments in certain social initiatives. In certain cases, this may lead to a carve out of certain ESG “negative” parts of the business up for sale or on the contrary carve-in ESG “positive” divisions into the transaction perimeter. As ESG reporting obligations under the CSRD have quite some interconnections with the group structure, such pre-closing restructurings need to take into account the impact on the ESG data collection points in the group[2].
The difficulty can also lie in projecting the relevance of the ESG issues or synergies in an ever-evolving ESG landscape and in quantifying the impact of the issue on the valuation of a business. Earn-outs and Management Incentives[3] may be a useful tool to capture future swings in valuation but the immediate challenge will be agreeing the ESG metrics of such earn-outs.
Creating transparency around the ESG related impact on the deal fundamentals, demands a broad scope ESG due diligence. This diligence goes beyond mere compliance scrutiny, delving into risks and opportunities to paint a holistic picture and ultimately resulting in an early sneak peek of the possible transformation roadmap.
Crafted on the insights from the prior analyses (materiality, performance, and benchmarking), the transformation roadmap serves a dual purpose (i) identifying value creation levers and outlining necessary investments for sustainable outcomes, and (ii) strengthening the targets’ resilience. The transformation roadmap addresses:
- actions to ensure sustainable value creation and a resilient business model;
- planning the implementation of leading practices, responding to market trends and maximizing value creation, based on insights from all previous modules;
- identifying the UN SDGs applicable to the target;
- assessing target’s positive and negative impact in relation to these SDGs, considering both value to society and to the business;
- assessing the financial value to the target associated with addressing ESG topics;
- spotting potential levers for post-acquisition value creation.
Where possible, the potential financial impact of ESG changes on cash flow is also assessed, which allows a value bridge to be prepared. The figure below shows an example of such a value bridge.
(iii) Impact on transactional contracts
ESG risks and issues may not always fundamentally change the deal but require further consideration in the transaction documents (SPA, APA or JV agreement). To date, ESG aspects have not yet given rise to truly novel, widely used SPA clauses, let-alone established market practices. However, as the relevance of ESG risks and issues continues to increase, we expect them to be addressed in the transaction documents in a broader, deeper and possibly tailored manner.
ESG topics can be addressed in multiple ways. If any ESG topics are of particular relevance to the buyer, but no issues have been identified in the due diligence, risks can generally be addressed using the customary SPA toolbox:
- If the topic is conditional, the buyer can implement a condition precedent (CP) to capture any ESG issues between signing and closing.
- Beyond the applicability of CPs, most ESG risks can be covered by the standard set of warranties, most notably the compliance with law and the no-litigation warranty. It is worth keeping in mind, however, that warranties are not only about damage claims, but also about disclosure. So, even if a buyer ultimately cannot claim damages, the disclosure may still prove to be helpful in the buyer’s quest to understand the ESG profile of its purchase.
- Last but not least, W&I insurance can also offer a solution. It has become a customary feature on larger M&A transactions and is generally also available to cover ESG matters. W&I insurers will apply their usual criteria to ESG issues, e.g., the requirement to do proper due diligence of an area for which coverage is sought, standard exclusions, no coverage of known issues, etc.
The Post-Deal phase
ESG adds a layer to many aspects of the post-acquisition process, making it different but also creating new opportunities. The assessment of day-one-readiness, determination on how to operate post-deal and the development of a 100-day plan to realize synergies, are all still very pertinent. Although it can be debated whether, amidst challenges like the energy transformation and/or the digital transformation companies face, 100 day planning is still enough. Insights from the 2021 PwC M&A Survey in Belgium [4] already hinted at this, and now, with the growing prominence of factors like ESG, additional dimensions have entered the integration landscape.
As in any acquisitions or integrations, the paradigm remains: fix, align and shift higher. All of the below 3 items will in most cases already have been quantified in the deal process mentioned above (synergy assessment), but post-deal each of them will have to be refined, further developed and implemented based on more detailed information which will come available post-deal.
- Fix: This part is all about mitigating risks identified during the due diligence process, including but not limited to tax and legal matters. This seems an obvious part, but often the focus shifts so quickly to synergy realization that developing an action plan to mitigate risks, and following up on this plan, are forgotten. The actions to fix risks are likely to be more short term and part of the day-one-readiness and the 100-day plan.
- Align: Aligning basically means ensuring alignment between the target’s and buyer’s baselines. It’s not simply a matter of moving forward in areas where the target lags, but also of identifying areas where the buyer lags and needs to step up. In other words, it’s about creating the best of both worlds. Alignment needs to happen on different fronts, amongst others also in the target operating model, where ESG is very important as it will co-determine the pace and degree of integration. The purely local-for-local situation might be extended to allow more time to align with ESG requirements in other territories.
- Shift higher: The most exciting part is definitely the shift higher part, where we unlock value through (re-)defining the strategy. One of the points to take into account in doing this exercise is the opportunities offered by ESG. The figure below is an example for a packaging company for cosmetics.
The merger and acquisition market is maturing as it increasingly considers ESG in a more systematic way. This is driven by pushing factors such as the wave of EU regulations and the need for transparent reporting. However, as the Green Deal ambitions are translated into additional regulations, it's important that governments also reflect on how to further support business in transitioning their business models and adapting to a changing world.
Peter Opsomer - Deals Partner - PwC
Nancy De Beule - M&A Partner - PwC
Pierre Queritet - Lawyer - PwC Legal
Jessica De Bels - Lawyer - PwC Legal
Sources
[2] Crossborder pre-closing carve outs/carve-ins to be executed in accordance with the third Company Mobility Directive (Belgian Act of 25 May 2023 holding the transposition of the European Mobility Directive 2019/2121 concerning x-border conversions, mergers, splits).
[3] See our insights on linking pay to ESG KPI’s. https://www.pwc.be/en/services/people-organisation/linking-pay-to-ESG-goals.html
[4] https://www.pwc.be/en/FY21/documents/belgian-m-a-survey-2021.pdf
Also read: This is how you manage ESG data during an acquisition
