Getting your E&S into G – What this means for Mergers and Acquisitions

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While many New Zealand companies have not formally considered, or adopted, an Environmental, Social, Governance (ESG) strategy, ESG factors are increasingly being assessed and brought to account in Merger and Acquisition (M&A) processes. ESG is becoming a value driver or determinant, particularly where those processes involve an overseas purchaser.

With this in mind, if you are thinking of selling your business, and you want to maximise value, you should be considering:

  • What each element of ESG means to your business;
  • What your ESG strategy will be; and
  • How this can be demonstrated.

Some business owners may, consciously or unconsciously, already be applying principles similar to those found in an ESG strategy and so it may simply be a process of documenting what those principles are and how the business ensure that they are adhered to.

In this article, we explain how ESG may impact on a seller in a merger and acquisition process and points that you should consider to maximise value.

What is ESG?

There is an increased expectation on corporates to play a larger role in society, not just looking to maximise shareholder value. Companies are being expected to adopt principles to show how they will meet these societal needs and demonstrate that such principles are embedded as part of their corporate strategy – this is at the heart of an effective ESG strategy.

While companies are likely to have different ESG strategies (for instance, a power company is likely to have a significantly different ESG strategy to a software company), an ESG strategy may include:

  • Environmental: contributions made, or costs, to climate change through emissions and carbon footprint, the impact the business has on natural resources, pollution, waste, land contamination, biodiversity, energy use, sustainable resourcing, recycling of resources used etc.
  • Social: modern slavery, human rights, labour standards across the supply chain, pay equity and adherence to workplace and industry health and safety standards. Diversity and inclusion also feature strongly as does contribution and impact on communities.
  • Governance: themes surrounding corporate governance and behaviour, including ethics, corruption, transparency, response to sanctions, political contributions, anti-competitive practices, human rights abuses and corporate sustainability.

While recognising and adopting policies is a starting point, a company will also need to be able to demonstrate how these policies are woven into their corporate strategy and their day to day operations.

How does this impact M&A?

Increasingly we are seeing purchasers look to an ESG strategy as an important factor when assessing risk, and pricing that risk, in their potential investment. They may have their own ESG strategy which will influence how they assess the value of an opportunity and how they assess the ‘fit’ of the target company. In particular, we are seeing a number of investment funds who have incorporated ESG considerations as part of their investment mandate and criteria.

In our experience, where a company has an ESG strategy (and can demonstrate its application in its operations) purchasers are viewing this as an indicator that the company has:

  • Conducted an in-depth review of their business and the sector in which they operate;
  • Looked to maximise opportunities and reduce risks;
  • Looked to future-proof its operations in light of an evolving environmental, political, economic and legal framework; and
  • Strong corporate governance, which flows into its day-to-day operations.

Not surprisingly, in such circumstances purchasers have placed premiums on such businesses and their potential returns.

Pre-transaction – consideration and adoption

If you want to use an ESG strategy as a value differentiator, we suggest you should adopt your strategy early and put in place measures to ensure that you can demonstrate how your strategy is embedded and measured. Experience suggests that those businesses who are early adopters will extract the most value, as they will be able to demonstrate a track record of how they have implemented the strategy.

In adopting an appropriate strategy, you should:

  • Identify and assess the elements of ESG that resonate the most for you and your business;
  • Consider what your competitors or sector are doing;
  • Know what your upcoming ESG related disclosure obligations will be (if any);
  • Consider ESG risk exposure and mitigation;
  • Consider how you can demonstrate the positives coming from adoption of ESG principles; and
  • Understand the cost, risk and opportunity associated with your current ESG state and the desired future state.

Where you have identified a potential purchaser(s), you should review the purchaser’s ESG strategies (if any) and consider how your business might align with the potential purchaser’s ESG and other strategies – and use that as an opportunity to demonstrate the cultural ‘fit’ that the transaction will create.

Due diligence

While traditional due diligence can highlight areas such as health and safety and environmental risk, we are seeing more targeted questions relating to ESG strategies.

To assist with this process, you should:

  • Have clear documentation setting out the ESG policies you have adopted (including the reasons and your aims in adopting them); and
  • Be able to demonstrate how these policies are communicated and woven into operations and understood by the internal and external stakeholders (this is likely to include communicating your policies to stakeholders and third parties and including them within contracts with your suppliers/customers).

Our observation is that where you have clear documentation, that is organised and available, this will help your discussions with a purchaser and increase deal certainty and value.

Sale and purchase agreement (SPA)

To deal with ESG risk, we are seeing an increase in the number of specific mechanisms being included in the SPA. These have included:

  • Inclusion of specific indemnities to cover perceived and actual risks and costs;
  • Requiring the seller to take certain actions before completion;
  • Requiring the company to take certain actions after completion – see comments below regarding alignment of ESG principles and costs; and
  • In worst case scenarios, allowing for termination of the transaction prior to Completion.

Alignment of ESG principles

Once the transaction has completed, we are seeing purchasers requiring alignment of ESG strategies. If a seller is required to stay on in the business and/or the SPA contains an earn out clause, you may want to consider the following:

  • Will the business have the expertise / resources to align ESG strategies?
  • Will this create extra work for you and will you be appropriately remunerated for this?
  • If the SPA has an earn out:
    • Does the earn out contemplate who will pay for the alignment or implementation of ESG strategies?
    • How will alignment or implementation of ESG strategies be accounted for?
    • What impact will the new ESG principles have on the earn out and/or should the cost of effecting these be excluded from the calculation of the earn out?

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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