ESG central to M&A

As its importance continues to grow in the corporate and private equity space, investors also face increasing regulatory pressures to uphold higher ESG standards across all industries and sectors. When assessing target entities in an M&A context, their ESG credentials are now a prominent transaction factor and a potential value enhancer for deal makers, as well as a key focus for diverse stakeholders, financial institutions and regulators.

Redefining the concepts of value and risk, ESG is a paramount concern for any business acquiring another business in the CEE region. In any potential M&A deal, the first key consideration is risk. Given the multiple compliance matters to be considered, ESG-related risks can be legally difficult to quantify when analysing them from the perspective of a potential transaction.

Döne Yalcin, partner at CMS in Istanbul and Vienna, says, “ESG considerations in M&A transactions are no longer ‘optional’ or ‘nice-to-have’, but constitute relevant value drivers in deal-making, growth propositions and the proper framing of risk profiles.”

It is therefore imperative for acquirors to have an in-depth understanding of a target’s risk profile, including its propensity to be affected by specific ESG risks. This not only requires a proper risk assessment of relevant ESG issues, but also a sound understanding of where future challenges may arise, especially those that are relevant to the sector in which they operate.

Tetyana Dovgan, partner at CMS in Kyiv, comments, “ESG compliance introduces a fresh perspective on the assessment of M&A transactions. Investors are not only focused on assessing the risks associated with a target’s historical non-compliance with, primarily, environmental and social legislation, but are also taking into account the nature-related risks related to the target’s direct operations, as well as its impact on climate and social aspects.”

On the issue of actual and potential compliance costs, she notes that they can vary depending on the size and nature of the business, the extent of its supply and value chain, and the current state of ESG compliance. These elements determine the extent of due diligence necessary to confirm the business’s ESG compliance according to ESRS standards (Sustainability Reporting Standards within the EU).

Accordingly, investors have to evaluate where the target is positioned on the sustainability spectrum and explore potential strategies to align its activities with the EU’s ESG taxonomy: a classification system that defines criteria for economic activities that are aligned with a net zero trajectory by 2050 and broader environmental goals other than climate.

Rodica Manea, partner in CMS in Bucharest, points out, “ESG regulations have become a cornerstone in creating a regulatory framework that ensures companies are held accountable for their impact on the environment and society, and investors have access to the information they need to make informed investment decisions. They are an important market transparency tool helpinig investments to the economic activities most needed for the transition, in line with the European Green Deal objectives.”

For example the EU has introduced the Corporate Sustainability Reporting Directive (CSRD) and proposed the Corporate Sustainability Due Diligence Directive (CS3D).

The CSRD sets the framework for sustainability reporting, requiring companies to identify, prevent, remediate, mitigate and report on potential and actual adverse impacts on human rights and the environment, while the CS3D aims to improve the regulatory framework on human rights and sustainability due diligence, and ensure responsible corporate conduct so that companies take responsibility for the impact of their activities.

According to Rodica, ESG considerations can motivate M&A (e.g. divestment of “dirty” businesses) or, on the contrary, prevent M&A from happening (e.g. because of withdrawal from a transaction due to the related environmental liabilities), as they may ultimately affect the valuation of the target.

Yalcin adds, “As some ESG risks take time to emerge, companies can actively engage in scenario planning, monitor emerging regulations, and promote open dialogue with key stakeholders to mitigate future ESG risks and increase flexibility to respond to a changing regulatory environment.” Key elements include operational agility, collaboration with industry peers and technology investments for effective data management, supported by regular internal audits and engagement with legal and regulatory advisory services.

From an M&A perspective, post-deal agreements are very pertinent because “they emphasise the need to ensure sustainable compliance with specific ESG requirements by the target company, with a focus on climate-related issues,” says Alexander Rakosi partner at CMS in Vienna. “This requires a closer examination of the target company’s expected ongoing commitment to ESG compliance in its business practices beyond completion of the transaction.”

By definition, ESG encompasses a broad range of legal and regulatory requirements. Although some aspects such as data privacy, diversity and governance considerations are equally relevant to all market participants, the relative significance of certain factors may vary according to the specific industry or sector. Proper corporate governance and the handling of social matters undoubtedly form a strong foundation for ESG compliance across all sectors, at various levels, and from multiple perspectives. “None of the ESG elements should be overlooked,” says Dovgan.

All three elements of ESG are therefore equally relevant across every sector. But based on sector specifics, she adds, one can take precedence over another. “For example, in energy, heavy industry, and infrastructure, the environmental aspect is crucial, given these business’s significant contribution to global carbon emissions. Whereas in IT, social issues such as workforce diversity, data privacy and protection, and the ethical use of artificial intelligence take precedence.” Compliance with labour standards and human rights concepts on supply chain issues can also be especially important for some companies.

Effective compliance with ESG regulations in the CEE region requires a keen awareness of the complexity of the regulatory framework, according to Rakosi. “This particularly applies in sectors where regulations are perceived to be more stringent or insufficiently developed or established, which often leads to problems in implementing cross-border sustainability standards for companies and operations,” he says.

At a practical level, sellers should calibrate their ESG compliance at an optimum level before commencing the sale process. Setting concrete sustainability goals that align with the business, alongside clear and measurable KPIs, is crucial for enhancing a company’s value and resilience, as well as creating new opportunities. “Achieving these goals requires developing a strategy, promoting it among all stakeholders (including management, employees, and counterparties), and getting everyone engaged in its implementation through best ESG practices,” says Dovgan.

For buyers, there is also a need for future-proofing: being able to assess what is likely to apply and ensuring that the target has complied, or has the capacity to comply, with these requirements when they become effective.

A primary objective of ESG compliance is to maintain adaptability in order to navigate future changes and challenges, thereby ensuring resilience and business continuity. Consequently, ESG compliance itself functions as a strategy to proactively address potential risks that may arise in the future. The development and implementation of long-term ESG strategies, beyond mere compliance, play a pivotal role in mitigating these risks and fostering sustainable business practices.