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ESG due diligence and M&A transactions – deal maker or deal breaker?
Executive Education / 9 January 2023
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Professor in Finance & Accounting, Munich Business School | Head of M&A, Bayerische Landesbank
Prof. Dr. Johannes Hofinger ist Professor für Finance & Accounting an der Munich Business School. Zudem berät er Banken in den Bereichen Risikomanagement, Nachhaltigkeit, ESG-Offenlegung. | Jens Schulte ist Head of M&A im Bereich Sparkassen bei der Bayerischen Landesbank. Außerdem ist er an den Sparkassenakademien Bayern und Baden-Württemberg als Dozent tätig.

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Experienced M&A specialists are well aware of the principle… “Always check to see whose livelihood is on the line” is a sensible premise in many walks of life, but most especially when you’re acquiring or merging with another company. The due-diligence process – a standard tool in the M&A toolbox for many years now – is an in-depth investigation of the target company that aims to provide deeper insights into the latter’s business conduct and financial strength prior to signing a contract. But is it enough to confine due diligence to such traditional criteria as business models, accounts, law and taxation? When engaging in a merger or acquisition, does it make sense to overlook another increasingly weighty criterion: the sustainability of the company’s operations and business activities [1]? Clearly, the answer to both questions is “no”. What’s right for your company should also apply to your M&A transactions and all stakeholders involved. What’s more, in much the same way as “sustainability” has become a broader societal issue, it has long since ceased to apply exclusively to “mega deals”. Sustainability is becoming increasingly relevant to the SME sector as well – at impressive speed.

More stringent than ever: sustainable conduct and duty of disclosure

In the EU, large companies that interact with the capital markets must already comply with the provisions of the Non-Financial Reporting Directive (NFRD), which has been in force since 2014 [2]. And now, having entered into force in January 2023, the new Corporate Sustainability Reporting Directive (CSRD) [3] and its accompanying technical standards [4] will add even more stringent requirements that are intended to embed ESG due diligence [5] in corporate practice [6]. One standout feature is the requirement to identify Principal Adverse Impacts (PAI) [7], specify the measures taken to mitigate them, and monitor the outcomes.

Is it conceivable that a company that has successfully completed all its own ESG homework should wish to incur hidden ESG risks when acquiring another business? Not really, no. It makes much more sense to obtain an in-depth impression of the target company’s ESG compliance in advance, as part of the due-diligence process. The danger of carelessly incurring environmental and climate-related risks should – especially in retrospect! – highlight the wisdom of taking this course of action and thereby avoiding claims for ESG-related liability and damages.

Does ESG due diligence focus too much on the buyer?

The M&A business is driven by numerous stakeholders with a multitude of interests. The seller might appear as the outright winner of a beauty contest, while the buyer might come across as a hypercritical “controller”. And of course there’s a third party – the commercial bank financing the deal, with an interest in (at the very least) ensuring that any outstanding debts are repaid. If the seller performs a “vendor due diligence” exercise, they could identify existing ESG risks before entering into the transaction. Ideally, the risks could then be eliminated – with a correspondingly positive impact on the company’s selling price.

More often than not, however, ESG risks first come to light during the buyer’s due diligence, especially as buyers become more sensitive to (hence critical of) any exposure of potential acquisition candidates to claims for ESG-related liability and damages. According to a survey of global private equity projects published by PwC [8], 56% of respondents said that in 2021, ESG issues were discussed more than once a year in management board meetings with PE investors (2019: 35%). This growing interest in ESG is also reflected by the fact that 72% of respondents claimed to always screen target companies for ESG risks and opportunities during the pre-acquisition phase. And 56% of respondents indicated that they have even put their investment projects on hold for ESG-related reasons.

As financing partners, banks play a key role in acquisitions. In the future, the ESG scores on which they base their decisions could turn them into deal makers or deal breakers. Loans would be granted on the basis of the bank’s own rating (think: Green Asset Ratio) as well as the borrower’s ability to meet specific ESG targets. In turn, this could mean that the worse a new company’s ESG rating is, the more costly the bank’s financing conditions will be. In worst-case scenarios, the bank could refuse to grant the loan, or failure to comply with ESG requirements would drive up the cost of the loan agreement by a very significant margin. On the other hand, this would also mean that buyers who have good ESG ratings themselves, and/or invest in companies showing positive ESG performance, may reasonably expect to obtain more favourable financing terms.

ESG is also impacting M&A projects in the SME segment

Now, one could still argue that ESG criteria are only relevant to M&A transactions by “large” enterprises. And in the past, this argument did have (some) validity. But the new CSRD will significantly expand the number of companies subject to ESG reporting requirements. Whereas only around 550 companies in Germany were affected by existing legislation, the directive’s lowering of disclosure thresholds [9] means that this group will grow to embrace some 15,000 companies – including medium-sized businesses [10].

Yet according to the “S-Mittelstand Fitness Index 2021” survey published by the Association of German Savings Banks (DSGV) [11], Germany’s SMEs are actually driving the transformation to include sustainability criteria, because the majority of respondents regard this area of activity as a positive opportunity to burnish their sustainability credentials – and are already taking steps to do so. The savings banks themselves are heavy users of ESG criteria and use a scoring model (S-ESG Score) to systematically analyse a company’s level of sustainability and the associated risks [12].

Recommendations for building up ESG expertise

This article shows why ESG aspects should now be considered an integral part of the M&A due-diligence process, and how they will impact more and more SMEs in the future. It makes sense for buyers, sellers and lenders alike to prepare themselves to tackle ESG-related issues. This does, of course, mean that the employees of all stakeholders concerned should be adequately trained, and should seek to involve banks as financing partners at an early stage. While their initial interests may differ, both parties share a common goal: neither of them wishes to be surprised by undesirable ESG risks once the transaction has been successfully completed!

Dr Patrik Buchmüller is co-author of this blog post and lectures on Frankfurt School’s Risk Manager – Non-Financial Risks certification course.


Quellen:

1 EU Taxonomie Verordnung (EU) 2020/852

2 Nicht-finanzielle Berichterstattung, NFRD 2014/95/EU. Die Umsetzung dieser Richtline in nationale Gesetze erfolgte in den darauffolgenden Jahren, in Deutschland bspw. 2017 mit dem CSR-Richtlinie-Umsetzungsgesetz (CSR-RUG), in Österreich durch das Nachhaltigkeits- und Diversitätsverbesserungsgesetz 2016 (NaDiVeG).

3 Richtlinie (EU) 2022/2464

4 European Sustainability Reporting Standards (ESRS). Die (finalen) ESRS wurden von der European Financial Reporting Advisory Group (EFRAG) termingerecht Ende November 2022 an die EU-Kommission zur weiteren gesetzgeberischen Behandlung zur Verfügung gestellt.

5 Environment, Social, and Governance (Umwelt, Soziales und Unternehmensführung)

6 [Draft] ESRS 1 – General Requirements, Punkt 4 Sustainability due diligence

7 Negative Auswirkungen der eigenen Geschäftstätigkeit auf die Umwelt.

8 PwC, „Global Provate Equity Responsible Investment Survey 2021“

9 Art. 5 CSRD

10 KPMG, https://home.kpmg/de/de/home/themen/uebersicht/esg/corporate-sustainability-reporting-directive.html, Zugriff: November 2022

11 Deutscher Sparkassen- und Giroverband, Diagnose Mittelstand 2021

12 Sparkassen Rating und Risikosysteme (SR), Nachhaltigkeit messbar machen

Experienced M&A specialists are well aware of the principle… “Always check to see whose livelihood is on the line” is a sensible premise in many walks of life, but most especially when you’re acquiring or merging with another company. The due-diligence process – a standard tool in the M&A toolbox for many years now – is an in-depth investigation of the target company that aims to provide deeper insights into the latter’s business conduct and financial strength prior to signing a contract. But is it enough to confine due diligence to such traditional criteria as business models, accounts, law and taxation? When engaging in a merger or acquisition, does it make sense to overlook another increasingly weighty criterion: the sustainability of the company’s operations and business activities [1]? Clearly, the answer to both questions is “no”. What’s right for your company should also apply to your M&A transactions and all stakeholders involved. What’s more, in much the same way as “sustainability” has become a broader societal issue, it has long since ceased to apply exclusively to “mega deals”. Sustainability is becoming increasingly relevant to the SME sector as well – at impressive speed.

More stringent than ever: sustainable conduct and duty of disclosure

In the EU, large companies that interact with the capital markets must already comply with the provisions of the Non-Financial Reporting Directive (NFRD), which has been in force since 2014 [2]. And now, having entered into force in January 2023, the new Corporate Sustainability Reporting Directive (CSRD) [3] and its accompanying technical standards [4] will add even more stringent requirements that are intended to embed ESG due diligence [5] in corporate practice [6]. One standout feature is the requirement to identify Principal Adverse Impacts (PAI) [7], specify the measures taken to mitigate them, and monitor the outcomes.

Is it conceivable that a company that has successfully completed all its own ESG homework should wish to incur hidden ESG risks when acquiring another business? Not really, no. It makes much more sense to obtain an in-depth impression of the target company’s ESG compliance in advance, as part of the due-diligence process. The danger of carelessly incurring environmental and climate-related risks should – especially in retrospect! – highlight the wisdom of taking this course of action and thereby avoiding claims for ESG-related liability and damages.

Does ESG due diligence focus too much on the buyer?

The M&A business is driven by numerous stakeholders with a multitude of interests. The seller might appear as the outright winner of a beauty contest, while the buyer might come across as a hypercritical “controller”. And of course there’s a third party – the commercial bank financing the deal, with an interest in (at the very least) ensuring that any outstanding debts are repaid. If the seller performs a “vendor due diligence” exercise, they could identify existing ESG risks before entering into the transaction. Ideally, the risks could then be eliminated – with a correspondingly positive impact on the company’s selling price.

More often than not, however, ESG risks first come to light during the buyer’s due diligence, especially as buyers become more sensitive to (hence critical of) any exposure of potential acquisition candidates to claims for ESG-related liability and damages. According to a survey of global private equity projects published by PwC [8], 56% of respondents said that in 2021, ESG issues were discussed more than once a year in management board meetings with PE investors (2019: 35%). This growing interest in ESG is also reflected by the fact that 72% of respondents claimed to always screen target companies for ESG risks and opportunities during the pre-acquisition phase. And 56% of respondents indicated that they have even put their investment projects on hold for ESG-related reasons.

As financing partners, banks play a key role in acquisitions. In the future, the ESG scores on which they base their decisions could turn them into deal makers or deal breakers. Loans would be granted on the basis of the bank’s own rating (think: Green Asset Ratio) as well as the borrower’s ability to meet specific ESG targets. In turn, this could mean that the worse a new company’s ESG rating is, the more costly the bank’s financing conditions will be. In worst-case scenarios, the bank could refuse to grant the loan, or failure to comply with ESG requirements would drive up the cost of the loan agreement by a very significant margin. On the other hand, this would also mean that buyers who have good ESG ratings themselves, and/or invest in companies showing positive ESG performance, may reasonably expect to obtain more favourable financing terms.

ESG is also impacting M&A projects in the SME segment

Now, one could still argue that ESG criteria are only relevant to M&A transactions by “large” enterprises. And in the past, this argument did have (some) validity. But the new CSRD will significantly expand the number of companies subject to ESG reporting requirements. Whereas only around 550 companies in Germany were affected by existing legislation, the directive’s lowering of disclosure thresholds [9] means that this group will grow to embrace some 15,000 companies – including medium-sized businesses [10].

Yet according to the “S-Mittelstand Fitness Index 2021” survey published by the Association of German Savings Banks (DSGV) [11], Germany’s SMEs are actually driving the transformation to include sustainability criteria, because the majority of respondents regard this area of activity as a positive opportunity to burnish their sustainability credentials – and are already taking steps to do so. The savings banks themselves are heavy users of ESG criteria and use a scoring model (S-ESG Score) to systematically analyse a company’s level of sustainability and the associated risks [12].

Recommendations for building up ESG expertise

This article shows why ESG aspects should now be considered an integral part of the M&A due-diligence process, and how they will impact more and more SMEs in the future. It makes sense for buyers, sellers and lenders alike to prepare themselves to tackle ESG-related issues. This does, of course, mean that the employees of all stakeholders concerned should be adequately trained, and should seek to involve banks as financing partners at an early stage. While their initial interests may differ, both parties share a common goal: neither of them wishes to be surprised by undesirable ESG risks once the transaction has been successfully completed!

Dr Patrik Buchmüller is co-author of this blog post and lectures on Frankfurt School’s Risk Manager – Non-Financial Risks certification course.


Quellen:

1 EU Taxonomie Verordnung (EU) 2020/852

2 Nicht-finanzielle Berichterstattung, NFRD 2014/95/EU. Die Umsetzung dieser Richtline in nationale Gesetze erfolgte in den darauffolgenden Jahren, in Deutschland bspw. 2017 mit dem CSR-Richtlinie-Umsetzungsgesetz (CSR-RUG), in Österreich durch das Nachhaltigkeits- und Diversitätsverbesserungsgesetz 2016 (NaDiVeG).

3 Richtlinie (EU) 2022/2464

4 European Sustainability Reporting Standards (ESRS). Die (finalen) ESRS wurden von der European Financial Reporting Advisory Group (EFRAG) termingerecht Ende November 2022 an die EU-Kommission zur weiteren gesetzgeberischen Behandlung zur Verfügung gestellt.

5 Environment, Social, and Governance (Umwelt, Soziales und Unternehmensführung)

6 [Draft] ESRS 1 – General Requirements, Punkt 4 Sustainability due diligence

7 Negative Auswirkungen der eigenen Geschäftstätigkeit auf die Umwelt.

8 PwC, „Global Provate Equity Responsible Investment Survey 2021“

9 Art. 5 CSRD

10 KPMG, https://home.kpmg/de/de/home/themen/uebersicht/esg/corporate-sustainability-reporting-directive.html, Zugriff: November 2022

11 Deutscher Sparkassen- und Giroverband, Diagnose Mittelstand 2021

12 Sparkassen Rating und Risikosysteme (SR), Nachhaltigkeit messbar machen

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