ESG in Deals and Investment

The Corporate Finance Faculty of the ICAEW recently published a best practice guideline (authored by Deloitte): ESG in Deals and Investment. This report contains practical guidance on how to incorporate ESG into the strategy and process of corporate deals.  

The report distinguishes between "ESG motivated" and "ESG conscious" transactions.      

ESG Motivated Transactions

This is where a business is using corporate transactions "as a catalyst to advance their ESG priorities and rapidly respond to transitioning markets." The report sets out a strategy framework for these transactions which is based on two deal archetypes: defensive and offensive.

A defensive strategy is about building the resilience of a business which is relatively constrained, perhaps because of balance sheet weakness and/or poor liquidity. In an ESG context this might involve:

• Evaluating the current company/product portfolio and divesting assets which carry significant ESG risk and could, over the long term, reduce the value of the wider portfolio, e.g. an FMCG business divesting a product line with high labour and working condition risks.
• Where the core of the business already has strong ESG credentials (e.g. a waste recycling business) acquiring competitor assets in the same sector to build scale.  
• Smaller, opportunistic deals to secure niche ESG-focused customer channels, e.g. a food retailer acquiring an organic food business.

An offensive strategy may be adopted by businesses which are less constrained and free to make transformational changes in order to capitalise on ESG opportunities:

• Acquiring completely new capabilities to extend the value chain, e.g. a fuel retailer acquiring an electric vehicle charging business to secure new forecourt customers.
• Joint ventures with non-traditional peers and ecosystems to exploit new ESG-related opportunities, e.g. an airline creating an alliance with a jet engine manufacturer and a hydrogen producer. 
• Investing in disruptive innovation assets, e.g. a food producer acquiring a synthesised meat business.

ESG Conscious Transactions

In contrast to ESG motivated transactions, ESG conscious transactions might not have overt ESG-based objectives, but ESG risks could nevertheless still have a material impact in terms of future enterprise value.

Such transactions will require a degree of ESG due diligence, but the target's ESG performance may not be reflected in its valuation. 

The report notes a growing recognition among dealmakers of the importance of ESG risks for corporate transactions in general and cites evidence that a significant proportion (60%) have actually walked away from deals where there was a negative ESG assessment of the target business.

ESG Due Diligence

Given the wide-ranging scope of ESG, undertaking due diligence on the ESG risks of a target business first requires a materiality assessment of relevant sectors and geographies in order to narrow down the number of risk categories that will actually affect enterprise value. The report explains that there are various frameworks available for these purposes, notably the SASB Materiality Map (which the International Sustainability Standards Board is looking to incorporate into its new global disclosure standards). 

Furthermore, material ESG risks can arise throughout the value chain, so it is necessary to diligence not only the direct operations of the target but also its upstream and downstream activities. 

Some examples of such ESG risks might include:

• Upstream Activities: Sourced raw materials which are associated with environmental pollution, hazardous processes or poor labour conditions. Key suppliers in non-OECD countries which have been the subject of ESG-related allegations. 
• Own Operations: Direct operations which include hazardous activities not permitted under local regulations. A large workforce undertaking unskilled work on zero hours contracts.  
• Downstream Activities: Products containing packaging which is not recyclable and harmful to the environment when disposed of. 

Due Diligence Challenges

The report notes that there are a number of challenges in determining the impact of ESG factors on a target business:

• Lack of ESG understanding and knowledge at board level can make it difficult to identify ESG risks and opportunities.
• Lack of standardised ESG metrics and poor data quality (especially from unlisted companies).
• Quantification of risks and opportunities as some of the impacts of a strong ESG position may be intangible.
• Integration of the target business into the acquirer's ESG compliance framework.
• Greenwashing by target businesses and/or unrealistic ESG targets.

How can we help? 

At Burges Salmon, our lawyers combine a deep understanding of compliance and disclosure obligations under UK law with expertise in ESG risk factors to deliver bespoke advice to clients undertaking complex corporate transactions. 

"ESG and responsible investment considerations are profoundly reshaping business models. In the coming years, as stakeholder focus on ESG increases they will become even more intrinsically embedded across M&A. Such change is set to unlock competitiveness, profitability, and attraction of capital. But it is also essential to the trustworthiness of businesses, as customers, investors, employees, societies, and governments all expect companies to contribute towards resolving social challenges while also minimising their environmental impact." ESG in Deals and Investment, Best Practice Guideline 69.

https://www.icaew.com/technical/corporate-finance/corporate-finance-faculty/esg-in-corporate-finance