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

While many New Zealand companies have not formally considered or adopted an environmental, social, governance (ESG) strategy, ESG factors are increasingly being assessed and taken into account in merger and acquisition (M&A) processes. ESG becomes a value driver or determining factor, especially when a foreign buyer is involved in these processes.

With that in mind, if you are thinking of selling your business and want to maximize its value, here are some things to consider:

  • What each element of ESG means for your company;
  • What is your ESG strategy; and
  • How that can be shown.

Some business owners may already knowingly or unconsciously apply principles similar to those of an ESG strategy.

In this article, we explain how ESG can affect a seller in a merger and acquisition process and what to look for in order to maximize value.

What is ESG?

Businesses are increasingly expected to play a bigger role in society rather than just maximizing shareholder value. Companies are expected to adopt principles to show how they meet these societal needs and that these principles are anchored 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 (e.g., an energy company is likely to have a significantly different ESG strategy than a software company), an ESG strategy can include:

  • Environment: Contribution or cost to climate change through emissions and carbon footprint, the company’s impact on natural resources, pollution, waste, soil pollution, biodiversity, energy consumption, sustainable resources, recycling of used resources, etc.
  • Social: modern slavery, human rights, labor standards throughout the supply chain, equal pay and compliance with health and safety standards in the workplace and in industry. Diversity and inclusion are as prominent as contributions and impacts on communities.
  • Guide: Topics related to corporate governance and conduct, including ethics, corruption, transparency, sanction response, political contributions, anti-competitive practices, human rights abuses and corporate sustainability.

While recognizing and adopting policies is a starting point, a company must also be able to demonstrate how those policies are incorporated into its corporate strategy and day-to-day operations.

How does this affect M&A?

We are increasingly seeing buyers viewing an ESG strategy as an important factor in assessing risk and pricing that risk in their potential investments. They may have their own ESG strategy that affects how they view the value of an opportunity and the suitability of the target company. In particular, we see a number of mutual funds that consider ESG issues as part of their investment mandate and criteria.

In our experience, when a company has an ESG strategy (and can demonstrate its application in operations), buyers see it as an indicator that the company has:

  • Conduct an in-depth review of their business and the industry in which they operate;
  • Wanted to maximize opportunities and reduce risks;
  • Looking for future-proof operations in the face of an evolving environmental, political, economic and legal framework; and
  • Strong corporate governance that flows into day-to-day business.

Unsurprisingly, in such circumstances, buyers put premiums on such businesses and their potential returns.

Before the transaction – review and acceptance

If you want to use an ESG strategy as a value differentiator, we encourage you to adopt your strategy early and take steps to ensure that you can show how your strategy is embedded and measured. Experience shows that those companies that are early adopters will get the most benefit as they will be able to demonstrate a track record of executing the strategy.

In adopting an appropriate strategy, you should:

  • Identify and evaluate the elements of ESG that resonate most with you and your company;
  • Think about what your competitors or your industry are doing;
  • Find out about your upcoming ESG disclosure requirements (if applicable);
  • Consider ESG exposure and mitigation;
  • Think about how you can demonstrate the positive effects of adopting ESG principles; and
  • Understand the costs, risks, and opportunities associated with your current ESG state and the desired future state.

Once you’ve identified one or more potential buyers, you should review the buyer’s ESG strategies (if any) and how your business might align with the potential buyer’s ESG and other strategies – and take this as an opportunity to to demonstrate the cultural ‘fit’ that creates the transaction.

Due diligence

While traditional due diligence can highlight areas like health and safety as well as environmental risks, we see more specific questions about ESG strategies.

To support this process, you should:

  • Have clear documentation that includes the ESG policies you have adopted (including the reasons for and your goals when it was implemented); and
  • Be able to demonstrate how these guidelines are communicated and incorporated into the operation and understood by internal and external stakeholders (this will likely include communicating your guidelines to stakeholders and third parties and including them in contracts with your suppliers / customers).

Our observation is that having clear documentation that is organized and available will make your conversations with a buyer easier and increase the safety and value of the deal.

Purchase contract (SPA)

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

  • Inclusion of specific compensations to cover perceived and actual risks and costs;
  • Asking the seller to take certain actions before completion;
  • Asking the company to take certain actions once it is closed – see comments below on aligning ESG principles and costs; and
  • In the worst case scenario, the transaction can be terminated before it is closed.

Alignment of the ESG principles

Once the transaction is complete, we will see buyers who need to adjust their ESG strategies. If a seller needs to stay in business and / or the SPA has an earn-out clause, consider the following:

  • Will the company have the expertise / resources to align ESG strategies?
  • Will that mean extra work for you and will you be adequately rewarded for it?
  • If the SPA has an earn out:
    • Does the earn out take into account who is paying to target or execute ESG strategies?
    • How is the alignment or implementation of ESG strategies taken into account?
    • What effects will the new ESG principles have on the earn-out or should the costs of implementing them be excluded from the earn-out calculation?

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