While Environment, Social, and Governance (“ESG”) started as a disclosure mechanism intending to make companies responsible entities, ESG has surfaced as a significant factor in the sale and purchase of entities, too. Now, companies look at ESG as a considerable criterion for determining potential target companies as much as they look at the target’s turnover and economies of scale.
This shift is motivated by the current positive sentiment of investors and consumers who wish to associate themselves with responsible and sustainable businesses. Keeping aside the flaws of defining and evaluating ESG, which warrants discussion elsewhere, this sentiment has stirred the pot to create an inclination towards positive ESG entities. ESG has also been identified as one of the top three enterprise risks, followed by technological and political uncertainty, reflecting the market’s emphasis on ESG. To avoid being caught up at the receiving end of scams involving fund misappropriations, human rights violations, unethical conduct, manipulating emission standards and oil spills, etc., ESG-positive companies provide a haven to the concerned investors.
Companies, to meet their forecasted ESG standards, are not just making changes in their organization organically but also looking to meet those forecasts by acquiring ESG-positive companies. Others are considering ESG as a factor when acquiring or merging with other entities.
Consequently, while performing due diligence, the ESG of the target is also evaluated, and investors factor the concerned ESG risks into the decisions and the value of the enterprise.
· Creation of synergy: Aligning with companies with similar policies towards ESG helps them magnify the effect and result of the combination. It also helps in a smooth transition in cases of merger, e.g., Exxon Mobil’s announcement to acquire Denbury Inc. in July 2023 to utilize Denbury’s experience in carbon capture and utilization. On the other hand, companies that have negative ESG look for companies with favorable ESG so that the combined effect of the acquisition can paint a positive image in the market. E.g. an oil company buying a renewable energy company.
· Demand of investors: Perhaps the most crucial reason why ESG has recently become a factor is that investors have been demanding high standards of ESG and their desire to be associated with ethically run companies. So, to keep the investors’ concerns at bay, acquirers look for companies that are ethically run and have positive ESG.
· Government scrutiny: Several regulators and government bodies now seek ESG performance details through reporting mechanisms, making companies conscious of these parameters, now available in the public domain. This move of the governments is given the environmental targets that they have committed to at international forums and conventions among other considerations.
· Avoiding the risk of litigation and reputational risk: Non-disclosure or non-commitment to ESG often leads to a risk of future litigations that can lead to bankruptcy and tarnishing of the parent company’s image. The government could also require disclosure of ESG practices in retrospect, exposing the resultant company to unanticipated litigation risks for yesteryears.
· Enhanced stakeholder value: Choosing healthy ESG target companies attracts ‘woke’ or conscious investors who will invest long-term in the target and the parent company. It also reduces employee attrition rate, promotes healthy corporate governance (so there are chances of past fraudulent activities), and creates a positive image in the community. This increases consumer support for the enterprise, leading to increased price premiums and higher shareholder returns.
· Competitive advantage: Target’s strong positive ESG performance reflects on the parent company. Future opportunities, increased shareholder returns, and different avenues of financing and investment are attracted, leading to a competitive edge in the long term. On the contrary, companies with challenged ESG performance may suffer higher costs of raising capital or unfavorable financing terms.
· Obtaining higher valuation: Since ESG is a decisive criterion in capital allocation by many investors, both the target and the acquirer can utilize the positive ESG performance to increase their valuations in the market. This is because “investors perceive value in businesses that align with environmental protection, societal well-being, and strong corporate governance.”
· Tax consideration: Most environment and socially impactful businesses are eligible for tax rebates that can help reduce the cumulative tax the resultant company pays. For instance, the US Inflation Reduction Act, which aims to support investment in energy transition and renewable technologies, can be used by acquirers to look for suitable targets.
ESG has been criticized for being a “woke” strategy that considers political and unachievable goals over shareholders’ interests. The ESG parameters can’t be standard for each company, nor can their outcomes be conclusive. Parameters set by JP Morgan Chase and Wells Fargo differ from those considered by Goldman Sachs and Blackrock. Similarly, these parameters can’t be used across sectors. ESG also can’t be quantified. Given these significant roadblocks in defining and setting parameters for ESG, the value of ESG has faded over time. ESG, when practiced by companies, is often costly, time-consuming, and resource-consuming, taking away precious time and opportunities from the hands of corporate management.
As an acquirer’s lawyer, intensive due diligence on the target’s ESG policies and plans is imperative. ESG due diligence differs from the conventional industry-specific due diligence that non-legal consultants and experts conduct.
To deliver effectively, the lawyer must inquire about the expectations of the acquirer, including the negotiables and non-negotiables of ESG. The acquirer’s organizational standards must be studied to provide a seamless transition and the most suitable partner. Starting from the government reporting mechanisms, lawyers can meander through the internal policies, plans, and strategies, past and future agreements, past and possible violations, probable litigations and legal liabilities, supply chains, human rights concerns, etc., should be viewed through the lens of all ESG elements.
If the acquirer is a publicly listed company, past reports with the regulatory authorities may make the lawyer’s work easier. However, lawyers should beware of companies’ ‘greenwashing’ tactics. This eye for scrutiny substantially increases if the target is a private company. Compliance costs for companies required to meet net-zero mandates should also be considered. For instance, a potential target overstated “the percentage of its revenue and customer base tied to clean energy,” and a due diligence exercise discovered that “the target’s decarbonization roadmap would cost around $300 million, making the valuation assumptions unworkable”.
Past and future financing avenues must also be scrutinized through the lens of ESG. Performance and future projections of the concerned sector in which the target company operates can also be seen from an ESG perspective, which will help the lawyer generate forecasts and anticipate regulatory moves. Identifying ESG risks and challenges associated with the sector, countries involved, and their political systems is also essential to ESG due diligence.
Reports and interviews with key managerial personnel often would not be enough. Ground reality can be effectively unearthed by site inspections and interactions with the relevant stakeholders, as well as with the members of the local community.
Unlike other parameters, ESG cannot be evaluated with a standard set of inquiries since there is no one-size-fits-all formula for it. Since more suitable methods of incorporating ESG in the company’s valuation have yet to evolve, lawyers must innovate to provide the client with the optimal answer.
Whether it is ‘conscious capitalism’, woke capitalism, or stakeholders’ approach to corporate governance or corporate citizenship, all point to the rising demand for making companies more sustainable and responsible. Governments of around 130 countries have committed to net zero by or before the year 2050, pushing the regulators to facilitate scrutiny of more and more companies on ESG components. Many European banks have pledged to curb financing certain fossil fuel-based enterprises, making those companies unviable for takeovers and increasing their capital costs. Similarly, the US government is encouraging investment in renewable energy by pooling in investment. Many international frameworks and guidelines have helped in understanding the ESG perspective in business.
Explaining the significance of ESG to the CEOs of the world, Blackrock’s famous CEO Larry Fink wrote in his Annual CEO Letter, “Stakeholder capitalism is not about politics. It is not a social or ideological agenda. It is not ‘woke.’ It is capitalism, driven by mutually beneficial relationships between you and the employees, customers, suppliers, and communities your company relies on to prosper.”
While ESG has a growing influence in Mergers and Acquisitions worldwide, there is an urgent need to uniformize the definition and parameters of ESG in order to generate comparable data for investors and the public to comprehend and use in the right direction. Till then, lawyers must innovate!
