Tax and Legal aspects of ESG in an M&A context – The deal Execution phase



In previous articles, we zoomed in on the importance of managing carefully the ESG (or at large “Sustainability”) hard and soft laws during the pre-deal phase of the M&A process. It was demonstrated that dealing/understanding the sustainability challenges during both the deal sourcing as well as the due diligence phase, actually contributes ultimately to value creation. 

In this follow-up article we will explore the role of ESG and share insights on how companies can effectively address ESG considerations to achieve their strategic objectives in the execution phase of an M&A transaction.

By adopting a strategic approach to ESG in the execution phase of M&A, companies can not only mitigate risks but also create value for stakeholders and position themselves for long-term success in this rapidly changing business & regulatory environment. 

ESG issues identified during the pre-deal phase impact a transaction usually on three levels:

(i) Financing

(ii) Deal fundamentals

(iii) Transactional documentation

(i) Financing

Lenders and investors are also conducting ESG due diligence to assess the potential risks and opportunities of their investment. ESG issues may reduce the attractiveness of the deal for financing sources. They may adjust their financing terms based on ESG factors. 

For example, a company with strong ESG practices may be able to secure more favorable financing terms, while a company with weak ESG practices may face higher interest rates or be required to provide additional collateral.

Companies that prioritize ESG considerations and have strong ESG practices will be better positioned to secure financing and achieve more favorable terms. This is especially true for high debt leveraged deals such as many of the private equity buy-side transactions. This somehow conflicts with what a recent survey indicated as a relatively low appetite for private equities to seriously incorporate ESG metrics in their deal structures and financing. The primary challenge is that ESG initiatives don’t yet have a clear, short-term financial ROI or value-creation story, given that the typical ownership timeline for a PE-owned portfolio company is approximately five years explains this at least partially.  

(ii) Deal fundamentals

ESG issues can impact the fundamentals of the transaction. Depending on the buyer’s ESG strategy and the gravity of the issue, such issues may indeed constitute actual deal killers, at least impact the business and cash flow plans, and hence the valuation of the target business. 

This can lead to situations where the Seller, in order to preserve the chances of landing a transaction with certain bidders which have high ESG demands, are forced to re-organise their group operationally in a pre-closing restructuring, either to carve out certain ESG “negative” parts of the business up for sale or on the contrary carve-in ESG “positive” divisions into the transaction perimeter. Remember from our previous newsflash that the ESG reporting obligations under the CSRD have quite some interconnections with the group structure, which means that any of such pre-closing restructurings need to take into account the impact on the ESG data collection points in the group.

The difficulty can also lie in projecting the relevance of the ESG issues or synergies in an ever-evolving ESG landscape and in quantifying the impact of the issue on the valuation of a business. Earn-outs and Management Incentive Packs may be a useful tool to capture future swings in valuation but the immediate challenge will be agreeing the ESG metrics of such earn-out

(iii) Impact on transactional contracts

In many instances, ESG risks and issues will not crucially change the fundamentals of the deal but certainly calls for further consideration in the transaction documents (SPA, APA or JV agreement) . To date, ESG aspects have not yet given rise to truly novel, widely used SPA clauses, let-alone established market practices. However, as the relevance of ESG risks and issues continues to increase, we expect them to be addressed in the transaction documents in a broader, deeper and possibly tailored manner.

ESG topics can be addressed multiple ways. If any ESG topics are of particular relevance to the buyer, but no issues have been identified in the due diligence, risks can generally be addressed using the customary SPA toolbox. If the topic is conditionally, the buyer can implement a condition precedent (CP) to capture any ESG issues between signing and closing.

Beyond the applicability of CPs, most ESG risks can be covered by the standard set of warranties, most notably the compliance with law and the no-litigation warranty. It is worth keeping in mind, however, that warranties are not only about damage claims, but also about disclosure. So, even if a buyer ultimately cannot claim damages, the disclosure may still prove to be helpful in the buyer’s quest to understand the ESG profile of its purchase.

W&I insurance can also offer a solution. It has become a customary feature on larger M&A transactions and is generally also available to cover ESG matters. W&I insurers will apply their usual criteria to ESG issues as well, e.g., the requirement to do proper due diligence of an area for which coverage is sought, standard exclusions, no coverage of known issues, etc. There is no reason to expect that coverage of ESG topics will come at a higher cost.

In conclusion, the integration of ESG considerations into the M&A execution phase is crucial for companies to successfully navigate the complex landscape of modern business. As investors, lenders, and regulators increasingly demand greater transparency and accountability from companies, it is clear that ESG factors will continue to play an important role in financing and structuring M&A transactions as well as in the underlying documentation.

Thanks to Sarah Van Leynseele (PwC), Pierre Queritet (lawyer), Jessica De Bels (lawyer) and Quinten Smits (lawyer) from PwC Legal for their contribution.