The rise of ESG in M&A transactions

This article is an extract from the European M&A Outlook 2023: Boom & Gloom? For the full report, follow the link at the bottom of this page.

The importance of ESG factors in M&A has grown exponentially in recent years. Investors are facing increasing pressures to uphold a higher standard – across all industries and geographic regions.

Environmental, social, and corporate governance (ESG) considerations have shot to prominence in the M&A landscape across Europe as market participants aim to capitalize on more attractive value creation opportunities and/or are forced to incorporate ESG aspects into their strategic approach to remain competitive.

Whereas in previous years ESG constituted somewhat of a minor and vaguely defined element in an M&A process, it has now become a more tangible concept in both the corporate and private equity space, and is considered key to companies’ growth prospects. ESG is no longer just about the investment case and the core pricing itself, but target companies are subject to demands by their suppliers or contractual counterparties (such as government/ government-like organizations) to adhere to certain ESG requirements. Divestments may now also be driven by concerns that a certain business line might be incompatible with long-term ESG and sustainability goals.

Our survey suggests that these changes are only a start. The vast majority (90%) of respondents say they expect scrutiny of ESG issues in deals to rise in the next three years.

A cross-sector phenomenon

The importance of ESG considerations has increased across all sectors. We see that for industrial companies, displaying evidence of being ahead of the sustainability curve can be a core differentiator, not only in attracting lucrative supplier relationships or catering to increased customer demands, but also in appealing to acquirors who themselves are aiming to improve their ESG scorecards.

Owners of real estate assets meanwhile are faced with growing pressure to offer solutions for energy-efficient management and ESG commitments of their own.

In a nutshell, those targets which can credibly prove they are at the forefront of ESG developments are able to generate significant market interest and achieve higher valuations from acquirors who are seeking to boost their own ESG credentials.

And then, of course, there is M&A activity in industries more explicitly linked to ESG goals. Take the recycling sector, which aims to close the loop in circular economy considerations for other industries such as packaging. In our view this explains the high level of M&A activity in the recycling sector. Market participants are cognizant of the fact that there will be high demand in the market for recycled material. Despite virgin material currently being cheaper to produce than gathering recycled material, they expect this price gap to narrow or disappear entirely, and, perhaps more importantly, they expect that legal and regulatory rules will provide for minimum requirements of recycled components to be used in manufacturing. As a result, market participants are intent on gobbling up recycling capacities now to be fit for the future and to make their model more commercially sustainable, catalysing M&A activity in this sector.

Globalisation of standards

This mantra of “keeping up with the times” has an impact even in jurisdictions where there currently is no specific ESG legislation in effect, such as in certain Central and Eastern European countries.

In such situations, whichever standards will eventually influence the definition of the gold standard in specific industries will have a huge impact on how deals are valued and completed. In several instances, sophisticated market participants such as private equity funds and/or international corporates are bringing along a new set of rules and requirements in the context of their inbound investments, identifying ESG standards as a baseline and important driver in the value creation equation.

Impact of ESG on legal work

From a legal practice perspective, ESG ramifications can be felt in several ways. In capital markets, ESG matters add to risk factors in prospectuses. Other pending initiatives such as the EU Green Bond Standard may result in further impact, providing additional clarity and guidance on standards. Additional standards will also serve external reviewers who assess ESG and sustainability measures.

In the context of M&A due diligence, an increasing focus is being placed on ESG in the material agreements review, on target companies’ ESG policies and initiatives, and on the assessment of compliance models. In this respect close alignment, between the various legal disciplines as well as with non-legal experts (such as financial or technical advisors) will be needed. Additionally, we would expect ESG considerations to become more relevant in the negotiation of transactional documentation (e.g. sale purchase agreements, asset purchase agreements), in particular with respect to the representations and warranties and covenants relating to pertinent standards, similar to the way anti-money laundering processes are handled.

In summary, we expect M&A activity will place an increasing importance on ESG. ESG-driven deal activity will continue to enter new geographic regions, affecting new and old industries alike, further cementing it as an element not to be ignored by both commercial and legal decision makers in the M&A industry.

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