Sustainability criteria in M&A transactions

Sustainability criteria are becoming an increasingly important factor for institutional and private investors in choosing companies to invest in. Especially the so-called ESG criteria play a significant role in this context. The acronym "ESG" stands for "Environmental", "Social" and "Governance". These ESG criteria should indicate on an aggregate basis how sustainable a company’s strategies are in environmental and social terms and in terms of (good) corporate governance. Recently, they have also had growing influence in M&A transactions and are more than just a short-term trend because they sustainably affect company value. It is therefore advantageous to have a look at how they can affect the transaction process.

Function and objectives of the ESG criteria

The development of the criteria over time can be analysed in quantitative terms using various ratios. In addition, qualitative factors can be considered using a scoring system. This includes the ability of a company to anticipate future strategic adjustments, e.g. making the production process more environmentally sustainable. With various weighting of the three main categories and after aggregating the partial results, the use of such a scoring system enables allocating the company an ESG score which can be later compared with that of its competitors.

ESG factors can influence the value of a company directly and indirectly. Directly in that a company can save costs if its employees receive competitive and fair pay and thus employee turnover is low, or in that the company has a low level of emissions and energy costs due to high energy efficiency. ESG aspects can influence company value indirectly in that they have an impact on the company's reputation and thus e.g. its ability to win new customers. The fact that the better the ESG score, the higher the company's value is confirmed by numerous studies. It is therefore logical that this point of view is also taken into consideration in due diligence.

ESG criteria in the transaction process – "Due Diligence is the key"

In addition to classic financial, legal, tax, commercial and IT due diligence, sustainability aspects are increasingly being analysed before a transaction is concluded. In particular, they are analysed as part of ESG due diligence which brings together experts (and their knowledge) from areas such as transaction, IT, legal and energy consulting as well as audit and compliance. Depending on the branch of industry and the specialty of the company to be analysed, this requires specifying various areas to focus on during such due diligence and involving various experts.

For example, a company from the automotive sector might want to switch to innovative, more sustainable drive technologies, which is an existential business transformation and therefore requires a fundamental strategic and financial analysis of economic and ecological sustainability of this project. By contrast, for a textile manufacturing company, aspects of employment and environmental law will be of crucial importance. Legal advisors and experts in energy and compliance analyse such a company, for example, in terms of energy efficiency and costs, the level of carbon neutrality achieved, and a possible loss of reputation or market share due to ethically and legally questionable (labour) conditions within the supply chain. In addition to an intensive exchange of information with the company being analysed, ESG due diligence relies on internal and external data such as the company's sustainability reports, expert assessments and an ESG rating from a rating agency, if available. Additionally, in an effort to compile the most comprehensive review of the company, an initial screening for controversies investigates publicly available specialists’ analysis and news reports.
 
The findings obtained from these analyses should therefore also have an impact on financial due diligence and company valuation as regards the future development of the net assets, financial position and results of operations of the company. Explicitly, this would include, for example, increases or decreases in forecast cash inflows/outflows or the growth rate, which can be determined based on the target's current sustainability level and the associated future integration or transformation costs. This new multidimensional transparency also makes it possible to address sustainability aspects at an early stage during acquisition agreement negotiations and post-merger integration.

Conclusion

The analysis of sustainability or ESG criteria as part of the transaction process, ideally in the course of ESG due diligence, should always be case-by-case, as the same criteria will have a different impact across different branches of industry. For example, the "environmental" component will play a greater role in the manufacturing industry than in the case of an investment company. Furthermore, it is essential that the complex interrelationships and impacts of sustainability aspects on the future development of the company are adequately taken into account by developing a systematic and interdisciplinary approach.