Key diligence and structuring considerations in ESG deals for private equity firms

Private equity firms are recognizing the increased societal focus on environmental, social, and governance (ESG) issues.  Like many for-profit organizations, private equity firms often struggle with what appears to be conflicting goals: generating returns for their investors while achieving broader ESG goals of their stakeholders. 

Despite these seemingly contradictory goals, a greater number of private equity firms may create “impact” funds as new platforms or seek to add impact-oriented companies as add-on acquisitions.  In 2021, a record 132 impact funds were started, and Bloomberg data shows ESG funds have raised $20 billion since 2015.  While a growing number of private equity firms have funds that put ESG at the heart of their business strategy, private equity firms new to this space or seeking to expand their presence with ESG-driven platforms should be aware of some key characteristics of these types of acquisitions. 

1.         Transactions focused on achieving ESG goals present unique challenges when performing due diligence

There is not one universally accepted set of ESG metrics, and ESG priorities differ by company and are heavily dependent on the industry.  Private equity firms in the ESG space typically apply the same or similar emphasis on ESG criteria that they apply to financial, tax, and other considerations in the diligence process.  Essential due diligence from a legal perspective includes reviewing a target’s performance on top-down government regulatory frameworks, including a review of the target’s compliance with: business ethics, bribery and corruption laws; occupational health, and safety laws; supply chain and waste management laws; environmental licenses, permits, and legislation; and mandatory disclosures. 

While the top-down regulatory framework for ESG can be aligned with more typical legal due diligence of “compliance with law” topics, ESG due diligence also requires a less standardized diligence process from the perspective of a bottom-up industry-driven self-regulation, including community and stakeholder issues and ESG voluntary disclosures.  For this aspect of ESG due diligence, fund managers should develop internal policies on ESG priorities that are accompanied by sufficient key performance indicators because a universal ESG measurement system does not yet exist to evaluate a company’s performance. 

Successful buyers will understand relevant ESG metrics in their industry of choice and have a strategy or vision for which ESG criteria are at the heart of their strategic plan.  Despite the lack of standardized ESG frameworks, private equity firms can compare the value and ESG success of target companies by assessing quantifiable information to find commonalities and compare targets within and across industries as a baseline tool for determining the value of an acquisition and, in turn, use such commonalities to set minimum ESG standards for target acquisitions.

2.         ESG deals require private equity firms to address unique considerations in deal documents

ESG-focused private equity firms may find greater success with post-closing transitions and overall performance by including certain risk mitigation factors in transaction documents.  In particular, private equity firms should consider provisions in transaction documents to deal with past, present, and future ESG issues for the target:

• Past: ESG-focused fund managers may desire to include additional contractual provisions that ensure the ESG profiles of their target companies have in the past been and will remain in line with their needs and expectations over the period of investment. 
• Present: Standard representations and warranties regarding compliance with certain aspects of law can be expanded to include compliance with additional ESG metrics, whether based on a recognized set of ESG metrics or based on specific key performance indicators. 
• Future:  To the extent that a target company cannot make certain representations regarding alignment with ESG standards prior to the closing, the parties can build certain covenants into transaction documents regarding post-closing remediation efforts, including the creation of internal frameworks and policies on ESG-focused issues (like gender equality, environmentally friendly office policies, or diversity initiatives) or covenants regarding entering into agreements with third-parties (such as power purchase agreements with the supplier of electricity from a renewable energy source) that would improve the target’s ESG profile post-closing.  Additionally, private equity firms may want to impose certain obligations on the owners of a target company that require the owners to provide certain information to the fund managers post-closing for the fund managers to be able to fulfill their ESG related reporting requirements, including any mandatory government disclosures and voluntary self-disclosures.

3.         It is important for ESG funds to work with knowledgeable advisors

While every acquisition requires knowledgeable advisors, buying a target company that focuses on ESG priorities or expanding an ESG platform as a private equity firm requires a team of lawyers and other professional advisors who understand various ESG metrics.  Ideally, the lawyers and professional advisors should specifically understand the ESG metrics that are applicable to a target’s industry and current market trends, including top-down regulatory frameworks and bottom-up industry-driven norms, and be able to apply these metrics in structuring the transaction.  Further, a team of ESG-focused lawyers and other advisors can help perform ESG legal due diligence and negotiate ESG principles in transaction documents to ensure cultural alignment of the target with the investor’s platform to maximize long-term success in the acquisition.  While private equity firms may initially perceive broader ESG goals of their stakeholders as being contradictory with maximizing financial returns for their investors, a skilled legal team can assist private equity firms with balancing these goals and, in many cases, achieving both goals simultaneously. 

To learn more about ESG in M&A deals, please register for our upcoming webinar on Tuesday, September 13 at 2 p.m. ET, Understanding the ABCs of ESG in M&A Deals.