The potential impact of ESG on M&A and Valuation

The potential impact of ESG on M&A and Valuation

?The integration of ESG factors into M&A activities is not just a trend, but a necessity. As regulatory pressures mount and consumer awareness grows, businesses are recognizing the importance of ESG considerations in their M&A strategies.

Firstly, ESG performance is becoming a key determinant of a company's attractiveness for acquisition. Companies with strong ESG credentials are likely to command higher valuations, as they are seen as better equipped to navigate future regulatory, environmental, and social challenges.

Secondly, ESG risks are increasingly being factored into the due diligence process. Potential acquirers are scrutinizing targets' ESG performance to avoid reputational damage, regulatory penalties, and potential litigation.

Lastly, post-merger integration is expected to involve more rigorous ESG alignment. Acquirers will need to ensure that their targets' ESG policies and practices align with their own, to maintain stakeholder trust and ensure smooth integration.

while making?strategy of M&A , organization should?avoid the acquisition of "ESG-toxic" businesses. ESG-toxic businesses are those with poor Environmental, Social, and Governance (ESG) standards or records. They might be engaged in activities that have negative impacts on the environment, treat their workers poorly, have a record of unethical behavior, or fail to demonstrate good corporate governance.

Acquiring such businesses can present significant risks and challenges, which can be broken down as follows:

1. Financial Risks: Companies with poor ESG practices are generally seen as more risky, which can lead to higher cost of capital and lower valuations. For instance, they may face potential liabilities related to environmental damages or lawsuits over labor issues. These liabilities can directly impact the financial performance of the acquirer post-acquisition.

2. Reputational Risks: Associating with a business that has a poor ESG track record can harm the acquirer’s reputation among customers, investors, and the wider public. This could lead to a loss of customer loyalty, decreased investor confidence, and ultimately, a loss in shareholder value.

3. Regulatory Risks: ESG-toxic businesses may face stricter scrutiny from regulatory bodies, leading to potential fines or sanctions. The regulatory landscape is becoming increasingly stringent when it comes to ESG matters, so acquiring a company with poor ESG performance could lead to problems with regulatory compliance down the line.

4. Integration Challenges: Integrating a business with poor ESG standards into a company with strong ESG standards can be challenging and costly. The acquirer may need to invest significantly in improvements to bring the acquired business up to its own ESG standards.

5. Human Capital Risks: Companies with poor ESG records may struggle to attract and retain talent. Studies have shown that employees - particularly millennials and younger workers - prefer to work for companies that prioritize ESG issues.

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Case Study: Volkswagen's Dieselgate Scandal

Volkswagen’s Dieselgate scandal can serve as an illustrative example of the reputational, financial, and regulatory risks associated with poor ESG practices. The scandal erupted in 2015 when it was revealed that Volkswagen had installed software in its diesel vehicles to cheat emissions tests. This resulted in severe damage to Volkswagen's reputation, billions of dollars in fines, and significant loss in market value. For an acquirer, these are exactly the kind of risks they would want to avoid by conducting a thorough ESG due diligence and steering clear of ESG-toxic businesses.

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Further ESG ?has modified due diligence review M&A deals.

The inclusion of ESG (Environmental, Social, and Governance) factors in the due diligence review process represents a fundamental shift in how businesses assess potential mergers and acquisitions (M&As). This new approach recognizes that ESG risks and opportunities can have significant material impacts on a company's financial performance, reputation, and long-term sustainability. Therefore, instead of merely focusing on financial and legal aspects, due diligence now has to consider ESG elements as well.

Here's how ESG modifies the due diligence review process:

1. Environmental Analysis: This involves an evaluation of a target company's environmental footprint and sustainability practices. This can range from assessing the company's compliance with environmental laws and regulations to examining its efforts to mitigate environmental risks. For instance, this could include analyzing the company's carbon emissions, waste management practices, resource usage, and the potential for environmental liabilities (e.g., related to contamination).

2. Social Analysis: The social component of ESG involves evaluating how a company manages relationships with its employees, suppliers, customers, and the communities where it operates. This could include reviewing the company's labor practices, human rights policies, data protection measures, and community engagement initiatives.

3. Governance Analysis: This part involves reviewing a company's corporate governance structure and practices. This may involve examining the company's board structure, executive compensation, shareholder rights, and its policies on issues such as bribery and corruption.

4. Risk Assessment: Incorporating ESG into due diligence means identifying and assessing ESG-related risks that could potentially impact the financial and operational aspects of a deal. This could involve understanding potential liabilities, the cost of addressing ESG issues, and the potential impact on the company's reputation and brand.

5. Opportunity Identification: Beyond identifying risks, ESG due diligence also involves identifying opportunities. This could involve uncovering potential for value creation through improved ESG performance, such as cost savings through energy efficiency, or revenue generation through new sustainable products or services.

Case Study: Nestle’s Acquisition of Blue Bottle Coffee

When Nestle acquired a majority stake in Blue Bottle Coffee in 2017, ESG factors played a significant role in the due diligence process. Nestle, a company with a strong commitment to sustainability, was keen to ensure that Blue Bottle Coffee’s own sustainability practices aligned with theirs. Blue Bottle Coffee’s commitment to organic farming, fair trade practices, and environmental stewardship made it a suitable match for Nestle from an ESG perspective.

ESG Risk Categorisation

The IFC uses a process of categorisation to reflect the magnitude of risks and impacts associated with an investment transaction. The following general descriptions apply to categorising potential investments according to their E&S risks and impacts:

Category A: Activities are likely to have significant adverse environmental, social or health and safety impacts that are diverse or unprecedented. An impact is considered “significant” if it is irreversible (e.g., leads to loss of a major natural habitat), affects vulnerable groups or ethnic minorities, poses major risks of injury or to health, involves involuntary displacement and resettlement, or affects important cultural heritage sites.

Category B: Activities may result in specific environmental, social or health and safety impacts, but these impacts are site-specific and few if any of them are irreversible. In most cases, mitigation measures are predetermined in the IFC PS, EHS Guidelines or design criteria. Potential adverse impacts on human populations or environmentally, socially, or culturally important areas are less adverse than those of Category A.?

Category C:?Activities have minimal or no adverse environmental, social or health and safety impacts.?

Due Diligence is mainly focused on below aspect in addition to local environmental, Labour and other relevant law.

-?????????IFC Performance Standards for Environmental and Social Sustainability (PS):

o??PS1: Assessment and Management of Environmental and Social Risks and Impacts

o??PS2: Labour and Working Conditions

o??PS3: Resource Efficiency and Pollution Prevention

o??PS4: Community Health and Safety

o??PS5: Land Acquisition and Involuntary Resettlement

o??PS6: Biodiversity Conservation and Sustainable Management of Living Natural Resources

o??PS7: Indigenous Peoples – No risks to or impacts on any communities of Indigenous Peoples or their access to land and resources are likely as a result of the Target’s operations; and

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-?????????World Bank Group (WBG) General Environmental, Health and Safety (EHS) Guidelines

-?????????International Labour Organisation (ILO) Core Labour Standards

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Impact of ESG on deal fundamentals

ESG factors can potentially serve as deal breakers in M&A transactions. If a target company has significant ESG issues that cannot be effectively addressed or remediated, it may deter potential acquirers. Some ESG-related deal breakers include:

Non-compliance with environmental regulations: If a target company has a history of environmental violations or faces substantial environmental liabilities, potential acquirers may consider the associated risks too significant to proceed with the deal.

Reputational risks: ESG issues that have caused significant reputational damage, such as involvement in scandals or controversies, can make a target company undesirable to potential acquirers who want to maintain a positive brand image.

Ethical concerns: ESG factors related to human rights violations, labor exploitation, or other unethical practices can raise ethical concerns and lead to deal termination, particularly for acquirers with strong ESG principles.

?Influence on Business Plan and Valuation

ESG considerations can influence the business plan and valuation of a target company. Acquirers may incorporate ESG factors into their strategic objectives and financial projections. Some aspects include:

Cost of remediation: If a target company requires significant investments to address ESG issues and bring its practices in line with industry standards or regulatory requirements, it can impact the business plan and valuation. The cost of remediation and the timeline for implementation need to be factored into financial projections.

Revenue and growth opportunities: Strong ESG performance can open up revenue and growth opportunities. For instance, a target company with sustainable product offerings or innovative environmental technologies may be valued higher due to its potential to capture market share and drive future growth.

Risk assessment: ESG risks can influence the perceived risk profile of the target company. If the target company has a robust ESG framework and effective risk mitigation strategies in place, it may be viewed as less risky, potentially enhancing its valuation.

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Impact on Deal Structure and Financing

ESG factors can also influence the deal structure and financing arrangements of an M&A transaction.

Key considerations include:

Earn-out provisions: To account for uncertainty related to ESG performance or milestones, earn-out provisions may be incorporated into the deal structure. This allows for a portion of the purchase price to be contingent on achieving specific ESG targets post-acquisition.

Financing terms: Lenders and investors increasingly consider ESG factors when evaluating financing opportunities. If a target company has strong ESG performance, it may be more attractive to lenders, leading to more favorable financing terms. Conversely, if ESG risks are significant, lenders may impose additional conditions or higher interest rates.

When reports of ESG diligence concerns surface, it is imperative that the transaction team continuously poses the question, "What is the implication?" This aids them in promptly disregarding any issues unlikely to significantly affect the company's overall worth or enterprise value.

Moreover, when certain matters are flagged as materially significant, it is crucial to rigorously examine the rationale and assumptions utilized to arrive at such determinations. For instance, the cumulative liability arising from employee compensation claims could be portrayed as a matter of material significance.

However, in many cases compensation claims are settled by the company’s insurer and will not impact enterprise value.?

Source:- Deloitte

Integration planning: ESG considerations may impact the integration process. Acquirers need to carefully plan how to integrate ESG practices and culture into the target company, ensuring a smooth transition and effective implementation of ESG strategies.

?Case Study: BP's Acquisition of Chargemaster

?In 2018, BP acquired Chargemaster, the UK's largest electric vehicle charging company. The acquisition was driven by BP's strategy to expand its presence in the low-carbon energy sector. ESG considerations played a crucial role in the deal, as BP aimed to enhance its ESG performance and align its business with the transition to renewable energy. The deal structure and financing arrangements reflected BP's commitment to ESG, emphasizing the integration of Chargemaster's sustainable technology and expertise into BP's operations.

Possible Deal Breakers

ESG-related issues can serve as deal breakers in M&A transactions. For instance:

?Environmental Concerns: If the target company has a poor environmental track record or significant undisclosed environmental liabilities, it could halt the deal. This could include issues like pollution, waste management, or non-compliance with environmental regulations.

Social Issues: Problems related to labor practices, community relations, or customer satisfaction can also be deal breakers. For example, ongoing labor disputes, poor working conditions, or significant customer complaints could signal deeper operational issues.

Governance Problems: Governance issues such as lack of board diversity, poor executive compensation structures, or a history of regulatory fines and penalties can also halt a deal.

ESG implications on approach to M&A

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Case Study of a Successful M&A with Strong ESG Considerations

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One example of a successful merger and acquisition (M&A) that incorporated strong ESG considerations is the acquisition of Burt's Bees by Clorox in 2007. Burt's Bees, a personal care products company, had a strong commitment to environmental sustainability, which was a key factor in Clorox's decision to acquire the company.

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Clorox, a multinational manufacturer and marketer of consumer and professional products, was looking to expand its portfolio into the natural products market. Burt's Bees' commitment to environmental sustainability, ethical sourcing, and natural ingredients made it an attractive acquisition target.

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Clorox recognized the value in Burt's Bees' ESG commitments and sought to preserve and enhance these values post-acquisition. Clorox continued to operate Burt's Bees as a standalone business, maintaining its commitment to sustainability and natural ingredients. This acquisition has been successful, with Burt's Bees continuing to grow and expand its product offerings, while maintaining its commitment to ESG principles.

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?Case Study of an M&A Where ESG Issues Resulted in Deal Failure or Complications

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-?????????An example of an M&A where ESG issues led to deal failure is the attempted acquisition of Sky Broadcasting by News Corporation in 2011. News Corporation, a multinational mass media company, was in the process of acquiring the remaining shares of Sky Broadcasting that it did not already own.

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However, during the acquisition process, News Corporation became embroiled in a phone-hacking scandal. This scandal raised serious ethical concerns about News Corporation's governance and business practices. As a result of these ESG issues, public and political opposition to the acquisition grew.

?The UK's communications regulator, Ofcom, stated that it had a duty to be satisfied on an ongoing basis that the holder of a broadcasting license was "fit and proper". Given the ethical issues surrounding News Corporation, Ofcom indicated that it might review whether Sky Broadcasting would remain a "fit and proper" license holder if the acquisition went ahead.

Faced with growing opposition and the potential loss of Sky Broadcasting's license, News Corporation ultimately withdrew its bid to acquire the remaining shares of Sky Broadcasting. This case demonstrates the significant impact that ESG issues can have on M&A transactions

-?????????Another ?case where ESG issues led to M&A complications is the attempted acquisition of EnergySolutions by Waste Control Specialists (WCS) in 2016. EnergySolutions, a nuclear waste disposal company, was set to be acquired by WCS, a company that also specializes in the treatment and disposal of nuclear waste.

?However, the deal faced significant opposition from environmental groups and some government officials due to concerns about the environmental and public health risks associated with nuclear waste disposal. These stakeholders argued that the merger could lead to a near-monopoly in the sector, potentially reducing incentives for the companies to manage nuclear waste responsibly and safely.?In response to these concerns, the U.S. Department of Justice sued to block the deal on antitrust grounds. Although the companies contested the lawsuit, they eventually decided to abandon the merger in 2017 due to the ongoing legal challenges and public opposition.

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Using Warranties and Indemnities to Manage ESG Risk in M&A

As businesses become more aware of the potential risks associated with ESG issues, warranties and indemnities are increasingly being used to manage these risks in transaction agreements. For instance, the seller might provide warranties about its compliance with environmental regulations, its labor practices, or its corporate governance standards. If these warranties are breached, resulting in financial loss for the buyer, the indemnity provisions in the agreement would typically require the seller to compensate the buyer for this loss.

In addition to these general warranties, transaction agreements may also include specific ESG-related warranties. For example, in a transaction involving a manufacturing business, the seller might warrant that it has not violated any environmental laws, that it has all necessary environmental permits, and that there are no ongoing environmental litigation or investigations.

ESG-related representations, warranties, and indemnities form an integral part of a transaction agreement, helping to allocate ESG risks and liabilities between the seller and the buyer.

The Importance of ESG Representations, Warranties, and Indemnities

ESG-related representations, warranties, and indemnities serve several key purposes in transactions:

1. Risk Allocation: They help allocate ESG risks and liabilities between the buyer and the seller, thus enabling both parties to protect their interests.
2. Information Disclosure: They incentivize the seller to disclose material ESG information, thus helping the buyer make an informed investment decision.
3. Compliance Assurance: They can ensure compliance with ESG regulations, standards, and commitments, thus reducing the likelihood of post-closure surprises and penalties.
4. Value Preservation: They can help preserve the transaction's value by preventing, mitigating, or compensating for ESG-related financial losses.

Negotiating ESG Representations

ESG representations are statements made by the seller about the target's ESG status and performance. They give the buyer a clear understanding of the target's ESG risks and liabilities and shape the scope of the seller's potential liability. Here's how to negotiate ESG representations:

1. Scope of Representations: The scope of ESG representations can vary depending on the target's sector, geographical location, and ESG profile. The buyer should seek broad ESG representations covering key ESG aspects relevant to the target.
2. Specificity of Representations: ESG representations should be specific and detailed rather than generic and broad. They should explicitly address the target's compliance with ESG regulations, the status of ESG permits and licenses, the history of ESG incidents and violations, the adequacy of ESG policies and systems, and the exposure to ESG-related litigation and liabilities.
3. Disclosure Schedules: The seller should provide a disclosure schedule listing any exceptions to the ESG representations. The buyer should review this schedule carefully and consider its impact on the transaction's risk and value.

Negotiating ESG Warranties

ESG warranties are assurances given by the seller about the truth and accuracy of the ESG representations. They provide a basis for the buyer to claim damages if the ESG representations prove to be false or misleading. Here's how to negotiate ESG warranties:

1. Warranty Coverage: ESG warranties should cover all ESG representations made by the seller. They should also cover any ESG-related promises or commitments made by the seller during the negotiation process.
2. Warranty Period: The warranty period should be long enough to allow the buyer to discover any ESG issues that might not be immediately apparent. The length of the warranty period can depend on the nature and severity of the potential ESG risks and liabilities.
3. Warranty Limitations: The seller might seek to limit the warranty liability by setting a cap on damages or a threshold for claims. The buyer should carefully consider these limitations in light of the potential ESG risks and liabilities.

?Negotiating ESG Indemnities

ESG indemnities are commitments made by the seller to compensate the buyer for specific ESG-related losses that might occur after the transaction's closure. They provide an additional layer of protection for the buyer against unforeseen ESG risks and liabilities. Here's how to negotiate ESG indemnities:

1. Indemnity Triggers: The triggers for ESG indemnities should be clearly defined and should include both known and unknown ESG risks and liabilities. They can include breaches of ESG representations and warranties, non-compliance with ESG covenants, and realization of ESG contingencies.
2. Indemnity Coverage: ESG indemnities should cover not only direct losses but also consequential losses, such as loss of profits, reputational damage, and regulatory penalties. They should also cover the costs of remediation, mitigation, and legal defense.
3. Indemnity Period: The indemnity period should be sufficiently long to cover the potential emergence of latent ESG issues. Some ESG risks, such as environmental damage or human rights violations, might take years to surface.
4. Indemnity Limitations: The seller might try to limit the indemnity liability by imposing caps, baskets, and de minimis provisions. The buyer should negotiate these limitations judiciously, considering the potential ESG risks and liabilities.

Negotiation Strategies for Buyers and Sellers

The negotiation of ESG-related representations, warranties, and indemnification provisions involves a delicate balancing act between the interests of buyers and sellers.

For Buyers:

1. Push for Broad and Specific Representations: Buyers should aim for broad and specific ESG representations to gain a comprehensive understanding of the target's ESG performance and risks.
2. Demand Robust Warranties: Buyers should demand robust ESG warranties to ensure that the target will maintain good ESG performance and compliance post-closure.
3. Insist on Strong Indemnification Provisions: Buyers should insist on strong ESG indemnification provisions to protect themselves from potential ESG liabilities. This could include high indemnification caps, low indemnification baskets, and long survival periods.

For Sellers:

1. Limit the Scope of Representations: Sellers should try to limit the scope and specificity of ESG representations to manage disclosure risks. They should also ensure that the representations accurately reflect their ESG performance and risks.
2. Negotiate Reasonable Warranties: Sellers should negotiate reasonable ESG warranties that reflect their ability to control ESG outcomes. They should also try to limit warranties to present and past performance, rather than future outcomes.
3. Cap and Limit Indemnification Provisions: Sellers should try to cap and limit ESG indemnification provisions to manage their post-closure liabilities. This could involve negotiating lower indemnification caps, higher indemnification baskets, and shorter survival periods.

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Challenges in Using Warranties and Indemnities to Cover ESG Risk

While warranties and indemnities can provide a measure of protection against ESG risks, they are not without their challenges. One of the key challenges is the difficulty in defining and quantifying ESG risks. Unlike financial or operational risks, which can often be quantified with relative precision, ESG risks can be more nebulous and difficult to measure.

Another challenge is the potential for moral hazard. If a seller knows that it is indemnified against certain ESG risks, it might have less incentive to manage those risks effectively. This underscores the importance of careful due diligence and ongoing monitoring of ESG issues, even in transactions where warranties and indemnities are in place.

Finally, there is the challenge of enforcement. If a breach of warranty or indemnity claim arises, it can be difficult and costly to enforce the claim, particularly if the parties are in different jurisdictions or if the seller lacks sufficient assets to satisfy the claim.

Despite these challenges, warranties and indemnities remain important tools for managing ESG risk in transaction agreements. As ESG considerations continue to rise in importance, the use of these tools is likely to become even more prevalent and sophisticated.

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