ESG Due Diligence for Company Acquisitions

Environmental, social and governance (ESG) criteria have become increasingly important in corporate transactions, as they carry considerable liability and reputational risks. Therefore, identifying ESG-related chances and risks is a must in due diligence.

ESG stands for environmental, social, and governance and relates to the planning and implementation of sustainability goals and responsible corporate governance. Specific requirements vary, depending on the size of a company, on the industry and the local focus of its activities. Mostly, these aspects have been considered merely in passing in the legal due diligence before a corporate transaction. However, in view of the looming risks and the growing relevance for investment and financing decisions, it is preferable to also take ESG-relevant aspects into account.

What is an ESG Due Diligence?

ESG due diligence is not yet a market standard, even though a number of ESG issues are covered by the traditional due diligence, such as environmental damage, compliance, data protection and risks from contractual relationships. However, the pressure to investigate sustainability aspects of the target company in the run-up to a corporate transaction is increasing: Social pressure is growing just as much as the expectations of customers and employees. More and more often, ESG issues are the subject of legal proceedings. ESG considerations are also of growing importance for the financing banks and financial investors.

Insofar as regulatory requirements already exist, for example when it comes to packaging and emission regulations or equal rights mechanisms, in the area of the German Act on Corporate Due Diligence Obligations in Supply Chains (LkSG), the EU taxonomy as well as the EU Corporate Sustainability Reporting Directive (CSRD), these topics are part of every legal due diligence. For reputational reasons, many companies "undertake" not only to comply with the legal provisions, but also to voluntarily submit to certain rules of the so-called soft law. These include, for example, internal climate protection due diligence obligations based on the Paris Agreement of 12 December 2015 and taking into account the steady increase in climate protection lawsuits filed by associations and private individuals against companies in civil courts. In conformity with core labour standards of the International Labour Organization (ILO), many companies prohibit labour grievances.

Such declarations based on soft law are not strictly binding on the companies concerned. Instead, the "obligation" is created by the expectations of potential investors or business partners whose disappointment might result in reputational damage and possibly a reduction in the value of the company. Many CEOs see compliance with ESG criteria as an opportunity to set themselves apart from competitors and to build a corresponding corporate culture.

Subject of an ESG Due Diligence

What exactly needs to be investigated in an ESG due diligence largely depends on the risk profile of the target company and on whether the transaction is ESG-driven, i.e., whether it (also) serves to improve the ESG profile of the investor. Principally, it should be asked to what extent the company is sovereign in terms of environmental, social and governance aspects and whether government sanctions, loss of reputation, further required investment costs or loss of market share should be expected. In general, it is recommended to look at the following factors:

Environmental

• Environmental management systems
• Emissions/waste management/hazardous substances
• Ecosystems
• Climate change resilience
• Procurement/use of resources (water, raw materials, energy)

Social

• Product safety/product stewardship
• Occupational safety and working conditions
• Diversity
• Equal opportunities
• Code of conduct in the supply chain
• Anti-discrimination policy

Governance

• Risk management systems
• Structure and remuneration of the board
• Implementation of ESG in the business strategy, for example when selecting suppliers
• Cyber security/data protection
• Anti-corruption policy
• Reporting standards

Advantages of an ESG Due Diligence

Sellers preparing for the sale of their company may polish it up with a "vendor ESG due diligence" and avoid potential liability due to lack of disclosure or subsequent breaches of warranty.

From the buyer's perspective, ESG due diligence helps to identify risks of compliance violations and reputational damage, to reduce financing costs and - last but not least - to avoid personal liability of the acting management. Findings from an ESG due diligence will be integrated into the purchase price determination and the list of warranties. In some cases, exemption clauses will be necessary - for example, if there is a threat of fines or exclusion from public assignments; in other cases, so-called post-closing covenants, i.e., obligations to be fulfilled after the transaction has been completed, may be appropriate. If a transaction is designed to improve the ESG profile of the buying company, identified risks may also be grounds for walking away from the deal altogether.

Conclusion

ESG principles are becoming increasingly relevant at the private sector and institutional level in the context of corporate transactions. Findings from an ESG due diligence can have a significant impact on the company valuation and the design of an SPA. In order to adequately consider ESG-related opportunities as well as liability and reputational risks, any due diligence should - also - examine the target company's risk exposure, taking into account relevant ESG issues.

Dr Barbara Mayer