IN FOCUSSustainability in M&A transactions

As sustainability climbs higher on the agendas of boards and management, there is a sharpened focus on sustainability in mergers and acquisitions.

Sustainability is increasingly seen as a question of value-generating business development. A buyer who includes sustainability in their transactional work can make better investment decisions, thereby unlocking the potential value of sustainability and reducing the harm resulting from any possible faults. This also leads to a valuable foundation for work after the transaction has been completed.

Sustainability issues are gaining ground in transactions as more and more actors on the M&A market are developing a systematic approach towards sustainability.

Sustainability issues are gaining ground in transactions as more and more actors on the M&A market are developing a systematic approach towards sustainability. The approaches have broadened as the focus on human rights and labour conditions has grown alongside environment and anti-corruption issues. At the same time, they also have become more in-depth, with many companies now taking a closer look at more steps in the value chain.

ESG issues influence value
In M&A transactions, the concept of ESG – environmental, social and governance issues – is often used to encompass sustainability issues. There are several ways in which ESG issues may play a role in M&A transactions. ESG issues may add value in and of themselves, for example, when a buyer is looking to acquire a well-developed, sustainable business to access knowledge and experience that may improve resource efficiency, and thus cost efficiency, in the buyer’s operations. Gaps between the buyer and the target business in terms of attitude towards and handling of ESG issues may increase integration costs, and therefore must be taken into account by the buyer when valuing a target company. Also, ESG issues may entail high costs and negative publicity if they come with, for example, the risk of severe contamination, demands for emission reductions and efficiency increases, direct or indirect violations of human rights, poor working conditions, the risk of corruption, etc., be they systematic issues, single incidents or just rumours.

The possibility of adequate contractual protection against ESG risks in practice is limited. A seller rarely wants to provide guarantees related to third parties, and many ESG risks are in fact located in the target company’s relationships with its suppliers and other business partners. In cases where a guarantee covers a past event, it is difficult to measure the extent of damage, which is a prerequisite for effective protection. What is the loss suffered by a front-page scandal on The Wall Street Journal or Dagens industri? It is even harder to remedy the damage once it has occurred.

Sustainability review of a target in several steps
A sustainability review before a transaction, a due diligence, has become more important. However, it is in the nature of these matters that ESG issues are not easily identified or quantified. Finding actual problems requires an extensive, in-depth analysis, which often does not fit well with the process or within the project budget. Furthermore, a seller is often unwilling to allow such in-depth due diligence, particularly in competitive processes. To find a reasonable balance between cost and buyer comfort, a sustainability due diligence review can be undertaken in several steps.

The first step is to decide whether ESG issues may be relevant to the transaction at all. If they are, this leads to the second step – including ESG issues as part of the due diligence review, within which the presence of risk is evaluated against the target company’s risk management objectives. General risks are identified based on the target company’s industry, geography (including suppliers at various levels) and specific operations and business model. The target company’s risk management is evaluated via an analysis of its codes of conduct and other policy documents, processes and routines, general awareness about ESG issues, etc. These two – that is, the presence of risk and the company’s risk management – are compared with each other to develop a view of specific, enhanced ESG risks for the target company.

Where there are enhanced risks that have a potentially large scope, a third step could be an enhanced due diligence review involving the consultation of local or technical expertise.

From an ESG perspective, the outcome of this review should give the buyer sufficient information to form an investment decision. With an understanding of the identified risks, the buyer can decide to allow the cost of future integration work or the cost of a heightened risk be reflected in the bid, to require more comprehensive covenants, or even to withdraw from the transaction. At the very least, the buyer acquires the ability to plan their operations after the acquisition to improve sustainability efforts as quickly and efficiently as possible.