In recent years, investors and customers alike have been gung-ho about ESG, so much so that it has found its way into day-to-day commercial lingo. The term ESG stands for Environmental, Social and Governance and refers to three key factors when measuring sustainability and the ethical impact of an investment in a business or company.
ESG indicators help evaluate an organisation’s ability to retain customers, employees and bring growth opportunities as they cover a wide range of issues, including but not limited to shareholders rights, board management and decision making, environmental risks and regulation, climate change resilience, HR issues, etc.
Hence, ESG considerations have become a key tick box item in shareholder meetings while considering potential M&A transactions. This inclination is only predicted to increase over a three-year period, as more and more organisations come forward to incorporate ESG norms in their systems as a means to create future value.
Currently, there is no standard reporting requirement that has been adopted by countries globally. However, most of them have placed reliance on sustainability standards, published by the Global Reporting Initiative. In India, while ESG norms have been in play since 2009, through voluntary compliance, it is only recently that the Securities Exchange Board of India (SEBI) came up with mandatory ESG disclosure requirements for the top 1000 listed companies. Further, financial institutions have also been asked to rely on voluntary guidelines on ESG risk management, issued by the Indian Banks’ Association (IBA), while providing finance to companies.
This article, therefore, aims to dig deeper into the impact of ESG on global acquisitions involving an India leg, while suggesting ways of factoring it into the deal making process for buyers, and highlighting measures that can be taken in transaction documents, both pre- and post-closing.
ROLE OF ESG IN DUE DILIGENCE FINDINGS:
Since ESG compliance has become the foremost priority for long-term investors, a thorough assessment of risks forms a crucial part of any deal to avert reputational damages, lawsuits, and fines.
For instance, in 2015, a car manufacturing company had admitted to pushing defective devices in the market by misleading testing authorities. The incident led to unearthing of major corporate governance issues within the Board, bringing to light ineffective management structures. Similarly, labour law issues related to delay in wage payment, correct calculation of gratuity and provident fund, safe working conditions, etc., bring issues in cash flow to light or in some instances damage the reputation of the company.
It, therefore, becomes crucial to have a detailed ESG strategy that goes beyond the acquisition process and assists the buyer in analysing if the target generally complies with the standards prevalent in the sector, whether any claims have been made that might point to greenwashing and what other risks the acquirers might face.
Our transactional experience indicates that the ESG due diligence exercise should be focused on the following key factors:
- compliance with data protection regulations;
- decision making process within the Board;
- incentive and retention schemes for employees;
- disclosure and reporting obligations;
- supplier onboarding policy, including contracts entered into;
- operational efficiency in crisis management;
- compliance with anti-corruption regulations;
- commercial and financial engagement with related parties;
- compliance with employee health, benefit, and safety regulations; and
- liability risks associated with environmental issues.
Apart from the above, we note that it might also be beneficial to take stock of both long-term and short-term loans taken by the company to determine if any loan provided by financial institutions was based on the company’s ESG compliances.
Further, some clients also commission a separate exhaustive environment diligence report for manufacturing units located in India to map their adherence with local environment and labour regulations.
ESG PROTECTION IN TRANSACTION DOCUMENTS
Once the due diligence exercise highlights the ESG risks, buyers can then proceed to negotiate the acquisition terms in the transaction documents. Typically, representations and warranties included in any M&A transaction only seek to cover standard matters such as regulatory, legal, and environmental compliance. While tailored warranties may be included in the deal documents, depending upon the industry in which the company operates, ESG specific risks relating to modern slavery, greenwashing, maintenance of financial risks and sustainability policies, etc., may not be covered under narrowly drafted warranties.
Accordingly, buyers may push for ESG-focused representations and warranties, which for instance, focus on compliance with generally required ISO standards or codes, specific compliance with import laws where the business primarily relies on imported raw materials, compliance with foreign exchange regulations where risks pertaining to overseas direct investment are involved, or climate change matters when manufacturing plants form the primary asset.
It is, however, also to be noted that there might be practical difficulties in enforcing very specific warranties. In fact, in some cases, it becomes tough to establish the loss flowing through a specific breach. In such instances, buyers may look towards including detailed pre-completion requirements, requiring sellers to put in place a specific standard, undertake a data privacy and security audit, enter into written agreements, address liabilities in supplier agreements, etc.
Further, since warranties are only provided for a limited time, they may cover risks that may accrue over a period of time and arise after the limited period. For M&A transactions focussing on manufacturing facilities, environmental warranties should be made fundamental as risks associated with it may be hidden for an extended period. Furthermore, breach of fundamental warranties may allow the buyer to invoke event of default to effectively exit from the company in case the breach has substantially bled through the company value.
For private equity investors, where the deal is structured in a manner that the seller is appointed at a critical management position, owing to his expertise in the industry, comprehensive employment agreements could be executed wherein incentive is linked to the EBITDA percentage of the company and termination on account of fraud, mismanagement, corruption, etc., is linked to termination of transaction documents. This could address potential governance issues in decision making by the Board.
DISCUSSIONS WITH R&W INSURER
While the above measures may primarily be able to allocate risks between parties, onboarding an R&W insurer helps pass over the risks to a third party. R&W insurance is an additional protective measure taken to cover unknown risks and liabilities. Subject to deal specific exclusions that an R&W insurer may propose, we note that R&W insurers generally take extensive analysis of the due diligence findings, including governance mechanisms, Board and quorum rights, reserved matters and proposed business plans under the transaction documents. Since typically R&W insurers cover known issues, they force both the seller to make an extensive disclosure schedule and buyer to have a deep knowledge of the target’s operations, including its compliance with laws.
With investor activism at its peak in the US and Europe, we have seen growing inclination towards ESG focussed metrics in all major transactions, even in the India leg. For instance, companies providing backend software services have had substantial ESG issues in terms of compliance with data protection laws of India, related party transactions and employment related policies. Since the businesses of the Indian subsidiaries bring substantial value to the global deal, it will be pertinent to ensure that effective evaluation of ESG considerations are made to provide adequate protections in the transaction documents and any other financing agreements.
As the economy becomes volatile, only organisations that create holistic shareholder value through sustainable growth and adjust to the dynamic demands of the investors may survive.