Introduction
In recent years, companies have started to place more weight on Environmental, Social, and Governance (‘ESG’) considerations rather than solely concentrating on the financial performance and achievements. ESG considerations promote sustainability and ethical business practices among companies by assessing company’s environmental, social and governance aspects. As the information spreads instantly in the current digital era, reputational risks have increased. A single misstep or failure to meet ethical considerations can result in significant public backlash, consumer distrust, and an irreversible loss of brand value. Consequently, companies have begun to place increasing emphasis on transparency, ethical sourcing, and environmental sustainability, all of which resonate strongly with today’s socially conscious consumers. For instance, for many corporates across the world, climate sustainability has become an indispensable practice. Companies are increasingly adopting practices like reducing carbon footprints, recycling, and improving waste management to align with climate sustainability goals.
The integration of ESG considerations in Mergers and Acquisitions (‘M&A’) has also become an integral part of recent business transactions. ESG due diligence extends beyond traditional financial and legal evaluations, focusing on sustainability, ethical practices, and regulatory compliance. As global regulatory frameworks and market expectations evolve, ESG considerations have transitioned from being optional to being pivotal in assessing the viability and value of M&A deals.
The amalgamation of ESG regulations in the process of due diligence
ESG considerations play a key role in determining the valuation and outcome of mergers and acquisitions. Acquirers are inclined on investing in companies which prioritise ethical practices, sustainability, and transparency. It has become paramount for the acquiring company to perform thorough ESG due diligence in order to determine the target’s compliance with various regulatory standards. Not only does this ensure regulatory compliance but also serves as a checklist for marking potential ESG risks that are associated with the transaction. This proactive approach helps in avoiding costly surprises post-merger, ensuring smoother integration and alignment of sustainability objectives.
Businesses involved in manufacturing, or dealing in plastics, hazardous substances etc. are exposed to environmental and social risks due to their operational nature. These businesses often involve emissions, hazardous waste and are required to adhere to stringent occupational health and safety regulations. Particularly, ESG due diligence plays a more significant role in transactions involving these categories of businesses. By conducting ESG due diligence, acquirers identify compliance gaps in environmental permits, waste management and assess the target’s adherence to labour laws and workplace safety measures. ESG due diligence is critical in manufacturing-focused M&A transactions, safeguarding acquirers against substantial legal, financial, and reputational risks.
Though ESG factors have become an integral part of due diligence process in M&A transactions, certain practical challenges are faced by the acquirers while conducting ESG due diligence.
Practical challenges
ESG considerations find their enforcement in India through various legislations. The fragmented structure of ESG regulations pose a significant challenge to the acquirers to secure relevant data from the target company. Mergers often involve businesses operating in multiple states, each with its own legal and regulatory nuances. This further amplifies the hurdles due to the presence of different laws in different states. Acquirers can address this challenge by providing the target company with a tailored requisition list designed to align with the specific industry and jurisdiction.
This challenge is expected to improve further as the ESG reporting requirements in India are evolving and a more precise and standardised ESG reporting norms are being laid down. Business Responsibility and Sustainability Reporting (‘BRSR’) being one, whereby Securities Exchange Board of India has mandated the 1,000 largest listed companies by market capitalisation to file BRSR reports as part of the annual reports from financial year 2022-23 onwards.
Another challenge faced by the acquirers is that the documents and data provided by the target company in itself may not reflect the true picture of the target. As the company may be compliant with all the laws and regulations on paper, however the real risks may come to light only through a site survey. Therefore, a thorough site assessment may also be required to ensure environmental compliance at the ground level. These challenges and hurdles make ESG due diligence a long and time-consuming process often delaying the transaction.
Despite these challenges, ESG due diligence remains crucial to the success of M&A transactions especially in transactions involving businesses which have greater environmental impact.
ESG due diligence findings and transaction documentation
Identification of risks via ESG due diligence is just one step, the critical task lies in negotiating acquisition terms and integrating the material findings into transaction documents. Acquirers typically seek standard representations and warranties on matters such as regulatory, legal, and environmental compliance. Besides standard representations and warranties, acquirers may seek tailored warranties with respect to ESG issues. These representations and warranties are further customized based on the target’s industry to mitigate sector-specific risks effectively.
Acquirers may consider seeking certain warranties with respect to ESG issues as fundamental, ensuring greater coverage. This is specifically beneficial for acquirers investing in industries where businesses tend to have greater environmental and social risks. Apart from seeking representations and warranties, acquirers often consider material ESG non-compliance to be resolved as a condition precedent to the transaction or impose post-closing covenants requiring compliance/ rectifications by the target companies within stipulated time periods.
Post Merger Integration
Post merger integration is regarded as the most critical stage of the M&A transaction. Policy and governance integration, value creation, forming synergies are few of the cumbersome tasks at hand once the entities merge. ESG due diligence helps ease the burden of post-merger integration by offering a framework for assessing compatibility. It enables companies to evaluate whether their social, economic, environmental, and ethical corporate values align, providing a foundation for smoother integration.
Conclusion
Incorporating ESG due diligence in M&A transactions is no longer optional but a strategic necessity. As global standards for ethical governance and sustainability evolve, businesses must focus on transparency and compliance. By aligning corporate practices with ESG principles, companies can ensure regulatory adherence, foster investor confidence, and build trust with stakeholders. The integration of ESG due diligence in M&A safeguards the financial health of transactions. Beyond that, it promotes long-term societal and environmental well-being, reinforcing businesses’ roles as responsible global citizens.
Written By Nidhi Arora (Partner) and Drishey Chugh (Associate)