ESG Dealmaking

Environmental, social and governance (ESG) concerns are driving businesses globally to re‐calibrate their merger and acquisition (M&A) transactions. This article contends that, despite a growing ESG backlash in the United States, for many businesses undertaking an acquisition transaction, ESG issues will continue to be salient. In a 2023 industry survey of senior executives, for instance, ‘96% expect ESG scrutiny in deals to increase over the next three years, including 48% who expect it to increase significantly.’

The rise in ESG scrutiny in deals is not unexpected. Over the last decade, numerous actors and institutions, including investors, stakeholders, governments, international and transnational organizations, and academics, have pressed companies to address ESG issues in their business decisions. Accordingly, there are multiple factors for ESG’s prominence in M&A. These factors include regulatory changes, financing and contractual pressures on buyers in M&A deals, investor and other stakeholder demands, as well as companies’ own internal policies, practices and procedures. In addition to affecting the business rationale for some M&A deals, these factors incentivize parties in M&A deals to enhance ESG due diligence and transaction planning.

ESG’s impact has been most acutely felt in the due diligence process. M&A due diligence is an integral part of dealmaking, influencing every aspect of a transaction from deal structure, pricing, and documentation to whether a deal closes. Risk assessment, including with respect to non-financial factors, has long been an important focus of M&A due diligence. The emphasis on ESG has broadened and modified both the scope and reporting of risk assessment in M&A due diligence, adding increased complexity to an already complex process. For example, with companies increasingly exposed to risks from climate change and extreme weather events, it is crucial to evaluate any real estate holdings for such risks. Similarly, a target’s supply chain may be severely disrupted due to extreme climate events. Additionally, M&A due diligence now regularly encompasses diligence on sexual harassment or misconduct issues at target companies. Buyers are also often advised to conduct diligence on workplace culture and workforce composition at a target company. As experts note, ignoring the ‘S’ part of ESG can have significant negative ramifications—including lawsuits, investigations and negative media attention—for a buyer after a deal closes.

Enhanced ESG due diligence will likely also expand the reporting and analysis of due diligence in M&A deals. An expanded diligence scope may require amendments to information request lists, additional questions in the due diligence question and answer process, new areas of focus at expert sessions and wider research in public sources. Moreover, enhanced ESG due diligence will likely involve multiple advisors and advisory firms. The expanded need for expertise may also lead to a proliferation of documents prepared during the due diligence process, along with an increase in transaction costs.

Despite the uncertainties and costs associated with expanded due diligence, for buyers in M&A transactions enhanced due diligence may prove to be valuable in the long run. Not only may enhanced due diligence allow for better integration management, but it may also allow buyers to avoid substantial post-closing liabilities. For example, the U.S. Department of Justice’s M&A Safe Harbor policy, announced in October 2023, provides incentives for companies to invest in strong compliance programs, to conduct due diligence, and timely self-disclose misconduct by the acquired entity.

Yet, the complexities of ESG due diligence are significant. My article’s case study of human rights due diligence in M&A illustrates some of the challenges facing dealmakers in a new era. Legislation mandating human rights due diligence has proliferated around the globe, especially in the European Union. Furthermore, even prior to the proliferation of laws mandating human rights due diligence, leading organizations, including the United Nations Global Compact and the International Bar Association, had issued guidance for businesses to follow when conducting human rights due diligence in M&A deals. Such due diligence would involve ‘the process of assessing a target’s human rights risks and impacts, as well as its compliance with applicable laws and international standards related to human rights,’ including anti-human trafficking and slavery policies, non-discrimination policies and anti-harassment policies. 

Despite laudatory goals, even proponents of human rights due diligence in M&A recognise the challenges with effective human rights due diligence in the M&A context.  The challenges posed by a quick moving M&A process are particularly salient in the human rights context where the broad and global nature of human rights due diligence laws and many companies’ reliance on complex global supply chains may require a human rights expert to analyze a large set of norms, standards, laws and risks implicated by a target’s business. Human rights due diligence may also impact the confidentiality of a deal and be difficult to conduct in the M&A context, where confidentiality is of utmost importance. And a diligence process that may result in significant costs and delays to dealmaking may be resisted by business dealmakers. There are also questions about whether M&A diligence teams possess sufficient human rights or local expertise in the dealmaking process. For M&A lawyers to appropriately assess the human rights risks of a deal, there may need to be additional interdisciplinary training for lawyers both in law schools and through bar associations.

ESG factors have also begun to affect transaction planning in M&A. As with due diligence, an ESG focus may serve as a critical tool for transaction planning and documentation. Many ESG issues overlap with and are captured by the broad representations and warranties traditionally included in M&A transaction documents, while others present opportunities for additional risk allocation through refinement of representation and warranties. An ESG-focus in M&A deal-making has also expanded beyond the fine-tuning of representation and warranties to other deal planning mechanisms such as closing conditions, indemnifications and other purchase price adjustments. However, to date there is little data on whether there are any established provisions or deal technologies that address ESG issues through the acquisition agreement. Future research should empirically explore the extent to which M&A contracts have shifted to address ESG risks.

The author’s complete article can be accessed here.

Afra Afsharipour is the Martin Luther King, Jr. Professor of Law at UC Davis School of Law.