Why should a buyer consider ESG factors when performing an M&A due diligence?

A company's ability to add value is no longer solely linked to its ability to generate profits in the short term. Today, the creation of sustainable medium- and long-term value is becoming increasingly relevant. For this reason, the company's ESG strategy and how such strategy can add value to the stakeholders is fundamental.

The regulatory risk is not the only risk that matters in terms of ESG. Non-regulatory ESG factors, such as sustainability, carbon footprint, diversity, equity and good corporate governance, are key issues to be analyzed in the investment strategy in the context of a potential M&A. Compliance and implementation of ESG factors are now synonym of a financial health and implies that a company will be in good shape in the medium and long term. On the contrary, a company that does not take ESG factors into account represents a riskier and less financially sound investment. In fact, several studies have revealed a positive correlation between a company's ESG performance and its ability to generate profits.

All this indicates that ESG factors are and will be determining factors when closing an M&A deal, and this translates into numbers. There are many institutional investors who in one way or another decide to invest or to adhere to sustainability principles and who prioritize investing in companies whose principles are aligned with ESG factors. Without going further, it is clear that ESG factors are key when it comes to reaching consumers and to attracting the best talent that ultimately is reflected in a company’s performance.

ESG aspects to be considered in the context of a Due Diligence

The acronym ESG covers environmental, social and governance concepts. When applied to a company, they have to do with sustainability, by virtue of its social commitment, good governance and environmental practices, spawning a positive impact on the community. Incorporating these factors in a legal due diligence is not an easy task, and it is key to ask the right questions.

Here are some of the factors to take into account:

E - Environmental factor: this factor measures how and what are the tools the company uses avoids or minimizes negative impacts and generates positive impact in the environment. S - Social factor: this factor measures the company's impact on its social environment and covers both the company's actions in the community, as well as its respect for human rights, social and gender inclusion, among others. G - Governance factor: this factor measures the impact of a company’s governing bodies, such as shareholders and administrative bodies, and its management, ethics and transparency processes, among others.
E goals S goals G goals
  • Efficient power consumption
  • Efficient water consumption
  • Waste management (how much is classified, recycled/recovered and how much goes to final disposal).
  • Carbon emissions (from power generation sources, transportation, etc.)
  • Promote good labor relations.
  • Protect human rights in general.
  • Be aware of the employment relationship’s impact on the social aspect of the employee or collaborator.
  • Promote the health of employees and the community in general.
  • Promote diversity.
  • Prepare reports and promote transparency.
  • Increase diversity within governing bodies.
  • Integrate the shareholders and the administrative body so that they have common interests.
  • Set ethical criteria and internalize them as part of the company's processes.

ESG factors in a Due Diligence: Are we talking about hard or soft standards?

Many of the ESG factors mentioned are not set out in regulations. However, some of them, to a lesser or greater extent and depending on the jurisdiction, are regulated by environmental standards, emissions limitations, corporate parity and other rules, and thus entail the risk of fines or suspension of operations. Currently, increasing government limitations on carbon emissions in Europe are a clear example and we estimate that the volume of regulations applicable to ESG is likely to increase due to international pressure to comply with higher standards in this area.

At an intermediate point, beyond regulations, there is an increasing number of certifications and other standards that act as soft law that may allow or deny access to certain types of investors with an appetite for high-impact companies, even when these companies trade at heftier prices than their peers.

Challenges of measuring ESG performance in the context of a Due Diligence process

Beyond the importance that ESG factors have gained, there are still multiple challenges when incorporating them in the context of a due diligence.

Risk quantification and qualification mechanisms are uncertain and not uniform. There are multiple organizations that have attempted to provide a framework of principles and guidelines for ESG disclosure, but much remains to be done in terms of uniform criteria.

In addition, accessing a company’s information in the context of a due diligence process can be a complex task and, once the information is obtained, the challenge is how to quantify and assess ESG factors for the acquiring company, versus the target’s perspective.

Moreover, the companies’ level of sophistication, especially at a local leve may imply greater challenge to incorporate and report the incorporation of ESG factors.

Local practice: Uruguay, Paraguay and Bolivia

Foreign investors are increasingly interested not only in the local company’s economic performance but also in its impact, its sustainability and, of course, how the company applies ESG principles. Thus, ESG due diligence can be decisive when making the final decision on whether or not to invest in a local company.

While many of the regulations, permits and requirements whose compliance is verified in an M&A due diligence process refer to aspects included in the "E" for Environment (and, although to a lesser extent, also in the "G" for Governance and the “S” for Social), it is still not usual for “ESG” audits to be carried out separately from the regular legal due diligence process. It is rare for M&A processes to include an analysis of whether the company has incorporated ESG purposes in its definition of success, whether it makes its decisions (from daily to long-term) in light of ESG criteria, or how much of what it claims to do in terms of ESG is actually measured and verified.

However, the market is taking firm steps to bring the ESG concept to the table. More and more companies in our jurisdictions establish sustainability committees at the highest levels of their organizational structure, measure their ESG impact and issue sustainability reports. Therefore, companies seeking foreign investors, who want to retain the best talent and place their products and services, will be evaluated using ESG criteria, and for that, a due diligence process will be necessary.

The market ascribes importance to ESG factors beyond whether they are embodied in laws or not. Our countries are not isolated, they are home to many multinationals that are familiar with and have incorporated ESG factors in their internal policies, along with local companies open to foreign investment, which increasingly means incorporating ESG factors in the company's DNA.