DealMakers - Q3 2022 (released November 2022)
Harness opportunities: ESG considerations at the forefront of M&A transactions
by Roxanna Valayathum and Shanna Eeson
Environmental, social and (ESG) review, in broad terms, refers to the examination of a company’s environmental, social and governance practices, their impact, and the company’s performance against benchmarks. The implementation of ESG practices has swiftly risen up the corporate agenda as a mainstream issue in the last few years, and has profoundly reshaped business models globally.
As a ripple effect of this, ESG factors are now steadily gaining importance in mergers and acquisitions(M&A) transactions, and are predicted to become embedded across M&A in the coming years. South African businesses are, therefore, advised to harness this global appetite for ESG by taking into account such considerations in their M&A transactions, as a means to achieve maximum value and monitor risks. In doing so, South African businesses will be set to unlock competitiveness and profitability, and attract investment.
An overview of ESG factors
The most prevalent ESG factors which have prompted many businesses worldwide to focus on environmental impacts and risk management practices include:
Environmental factors, such as climate change, energy, water scarcity and usage, biodiversity, destruction of natural habitats, environmental pollution and waste management;
Social factors, such as employment and labour issues, employee benefits, diversity, health and safety, human rights, community relations, and the manner in which broad- based black economic empowerment is advanced; and
Governance factors, such as corporate structure and management, strategic direction and oversight, compliance, anti-bribery and corruption, board composition and executive compensation.
Growing pressure to support the inclusion of ESG in M&A transactions
Investors believe that companies with strong ESG initiatives are more lucrative investments, pose less risk, and are better positioned for the long term. If a company fails to consider all important ESG aspects, it risks reputational damage. Globally, we have witnessed growing regulatory frameworks which now prescribe intensified accountability for ESG in M&A transactions, such as the new efforts to enhance disclosure of ESG factors in M&A transactions in the United States.
Locally, the regulation of ESG principles has already been adopted for pension funds, insurers and the Public Investment Corporation. However, recently, there have been widespread voluntary ESG initiatives, which indicate that South Africa has been taking steps to follow international ESG trends in M&A. These initiatives include:
the revised draft Code for Responsible Investing in South Africa (CRISA) 2.0, which stipulates that investment activities must reflect the integration of material ESG factors and which should also reflect in due diligence investigations; and
the Johannesburg Stock Exchange (JSE) Sustainability and Climate Change Disclosure Guidance document, which caters to the growing expectations from various stakeholders on businesses to report on respective impacts on the environment, people and financial performance, incorporating both global and local context to help companies understand how the various standards relate to one another.
Businesses also ought to take heed of the final guidelines on the considerations to be taken into account when considering the impact on the public interest, published by the Competition Commission in 2016. These guidelines consider the social aspect of ESG. It is typically a conscientious process. For instance, in the merger where ECP Africa Fund IV LLC & ECP Africa Fund IV A LLC sought to acquire Burger King (South Africa) RF (Pty) Ltd and Grand Foods Meat Plant (Pty) Ltd, the Commission initially prohibited the merger on public interest grounds that the shareholding of historically disadvantaged persons in Burger King would decrease from more than 68% to 0% as a result of the merger. The Commission prohibited the merger on such grounds for the first time ever. It saw parties having to go back to the drawing board to reconsider public interest concerns, which were later addressed by the parties and accepted by the Commission. This case serves as a pertinent example of the importance of considering social wellbeing and economic needs of South African communities in relation to ESG. Seemingly, investors are taking ESG risks into account now more than ever, due to global pressures as well as increasing shareholder, employee and consumer activism.
ESG considerations in M&A due diligence and M&A agreements
Due diligence allows the buyer in the M&A process to confirm undisclosed details about a selling company's financials, contracts, personnel and customers. The buyer is then able to derive a complete picture of the business or company being acquired. In light of the ESG-focused shift in the market, we urge buyers to broaden the scope of their due diligence to include performing targeted ESG investigations, in order to identify ESG-related risks which may influence a target's price and overall deal structure. Once fully aware of the potential liabilities and risks of a transaction, companies may mitigate ESG risk through the transaction agreement. A focus on ESG can be a competitive advantage for businesses, private equity funds and many other strategic acquirers. By integrating ESG considerations into each stage of the deal, this will inform the buyer of any potential impact of the merger or acquisition on its sustainability strategy and the long-term value of the combined entity.
Red flag checks may include assessing the future fitness of the target and relevant assets, and media scans to understand any major ESG-related risks. Thereafter, the buyer can look to address any ESG risks in the transaction agreement through specific indemnities, targeted representations and warranties addressing ESG matters, or through various pre-closing conditions or post- closing covenants by the seller/s. If an issue cannot be addressed pre- or post-closing, such as non-compliance with ESG-related regulations, the buyer may wish to negotiate a reduction in the purchase price to reflect the risk assumed.
Although ESG is still in its budding phase in South African M&A, it is critical that investors, companies, private equity funds and other strategic acquirers follow in the footsteps of global majors in the widespread incorporation of ESG factors in M&A. Any delay in doing so may result in companies risking reputational damage in the long run and losing out on access to capital and lucrative opportunities often offered by ESG compliance.
Valayathum is a Director and Eeson a Candidate Attorney | Cliffe Dekker Hofmeyr
(Peterdy, "A Framework for Understanding and measuring how sustainably an organisation is operating" 2022 (https://corporatefinanceinstitute.com/resources/knowledge/other/ esg-environmental-social-governance/) accessed on 20 October 2022)
(Deloitte, "Unlocking transformative M&A value with ESG" 2022 (https://www2.deloitte.com/us/en/pages/mergers-and-acquisitions/articles/unlocking-transformative-m-and-a- value-with-esg.html) accessed on 20 October 2022)
(Kim, Mallia-Dare "ESG: Creating value and mitigating risk in mergers & acquisitions" 2022 (https://www.millerthomson.com/en/publications/articles/esg-mergers-acquisitions/) accessed 20 October 2022
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(Gez, Pullins, Druehl, Ali "SEC Proposes Amendments to Rules to Regulate ESG Disclosures for Investment Advisers and Investment Companies" 2022 (https://www.whitecase.com insight-alert/sec-proposes-amendments-rules-regulate-esg-disclosures-investment-advisers-investment#:~:text=On%20May%2025%2C%202022%2C%20the%20US%20 Securities%20and,disclose%20extensive%20climate-related%20information%20in%20their%20SEC%20filings.2 (2022 accessed 20 October 2022)
(Davis, Kitcat, 2022)
(Second Code for Responsible Investing in South Africa, 2022 (https://integratedreportingsa.org/ircsa/wp-content/uploads/2022/09/CRISA2.pdf.) accessed 20 October 2022)
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(ECP Africa Fund IV LLC; ECP Africa Fund IV A LLC And Burger King (South Africa) RF (Pty) Ltd; Grand Foods Meat Plant (Pty) Case no. IM053Aug21 para 4)
(Kim, Mallia- Dare, 2022)