Increasingly Important Role of ESG in M&A Outlook

Ayşe Yüksel Mahfoud, William L. Troutman and Aara Tomar of global law firm Norton Rose Fulbright co-authored this article

In light of recent social, climate and sustainability shifts, ESG has become more important than ever. Businesses are being evaluated based on their environmental and social impacts, as well as their approaches to governance, due to the potential risks and costs associated with these factors. Those that are lagging in their contribution to ESG are facing economic, legal and reputational risks. As reported in the Global M&A Trends and Risks (2024) report by Norton Rose Fulbright, ESG is also emerging as one of the key factors impacting deal activity.

It has become common to see shareholder activists’ efforts to promote ESG strategies drive divestures and breakups, and ESG has the potential to derail deals, especially in cases where the target poses a risk exceeding the acquirer’s appetite.

Still, as highlighted in our survey, ESG remains a key driver of M&A. ESG-oriented goals have led to strategic partnerships, and many businesses are motivated to enter into partnerships to integrate ESG goals in their operations.

ESG shaping the deal process

Not only does ESG have an impact as a driver of M&A activity, it has also drastically affected the process for ongoing deals. Because of potential ESG-related risks, deals are taking longer to close and may even be completely derailed. 

Traditional due diligence processes are undergoing updates to serve the growing need to measure ESG performance. More lawyers, consulting firms and ESG experts are being brought into the deal process to facilitate the risk assessment and identify value that the target is expected to create. On the other hand, target companies are motivated to develop their ESG profile.

Parties are facing dragged-out deal negotiations. Buyers are pushing for deal terms with broader indemnities, closing conditions and favorable purchase price arrangements, such as earnout mechanics and price adjustments.

Deal closings are likely to get even more dragged-out if there are third parties involved. In addition to the extended due diligence process, deal parties should be prepared for more expensive representations and warranties insurance (RWI) due to ESG concerns. For parties that are able to negotiate down the cost for RWI, they face a prolonged due diligence process run by insurers, further slowing the deal process.

Financial institutions are closely monitoring ESG performance of potential borrowers. As a result, businesses that lack attention to ESG may have limited financing options. These businesses face increased cost of capital and less favorable financing terms.

Post-closing, buyers should use caution while reconciling targets’ ESG policies with theirs. It is advisable for buyers to review targets’ ESG policies, risk management codes and procedures to ensure effective integration and identify and mitigate gaps in compliance. 

This is especially applicable for deals involving targets that are either private or new businesses. Buyers need to use caution to not become a target for compliance issues and disputes as a result of the deal. Buyers also need to assess whether their own ESG disclosures and other related public statements need to be qualified, revised or updated to account for the effects of the acquired entity, especially during transition.

The continued popularity of ESG illustrates the need for effective identification of ESG blind spots. Businesses face an enhanced risk of ESG-related disputes. There is a need for businesses to be informed and equipped to face less-predictable outcomes. As part of their toolkit, some have begun to rely on artificial intelligence as one of the resources to gather data and frame ESG-oriented metrics for targets. As noted by respondents of the Norton Rose Fulbright survey, there is a need for top-quality ESG data.

ESG as a regulatory obstacle

The increasing significance of ESG stems from the ever-evolving legal and regulatory landscape. As the survey notes, all markets are expected to feel the burden of stricter regulation, and a majority of such future regulation is expected to be related to ESG. Several jurisdictions are witnessing new ESG regulations and rise in enforcement actions against companies not in compliance with such regulations. Nearly a quarter of the survey’s respondents cite ESG regulations as one of the top two factors most likely to suppress M&A in 2024.

In addition to its recently finalized climate disclosure rules, the SEC recently introduced changes to the Investment Company Act, or as it’s more commonly known, the Names Rule, requiring every registered investment company to adopt a policy if the company’s name indicates its focus on investments or issuers with specific objectives, such as ESG. As per the rule, covered investment companies are required to adopt a policy to invest a minimum of 80% of the total value of their assets in investments meeting the objectives.

The recent ESG-focused actions by the SEC are not limited to rules, as the agency has initiated multiple enforcement actions related to ESG, including bringing charges against a mining company, alleging it disclosed false and misleading information about human safety in connection with its infrastructure projects and issuing a $19 million fine against an investment manager for failing to effectively incorporate ESG factors into its investment decision-making despite its ESG claims.

We expect such enforcement actions against greenwashing and other aspects of ESG to continue. These actions, coupled with the new laws and regulations, indicate that ESG will continue to dominate the business landscape. 

As regulations continue to sputter into force, internationally recognized standards are proving to be helpful for businesses struggling to navigate the ESG regime. The International Sustainability Standards Board (ISSB) introduced a set of guidelines for businesses to facilitate consistent standards for ESG-related disclosures. These standards — commonly known as IFRS S1 and S2 — continue the efforts of the Task Force on Climate-related Financial Disclosures, simplifying disclosure requirements and aiming to equip businesses to effectively track and report ESG performance. The IFRS standards are especially crucial for multinational companies and businesses operating in jurisdictions with inconsistent regulatory regimes.

When it comes to multinational businesses, the inconsistent regulatory regime in the U.S. is not their only worry. They are grappling with the lack of consensus in regulations brought in place in other jurisdictions. It is becoming difficult to integrate such regulations as part of business practices. Given the increase in actions against greenwashing and other anti-ESG practices, compliance risk is becoming more of a priority.

ESG regulations facing backlash

We are also now seeing frequent attempts to oppose ESG-focused initiatives and regulations. Both the SEC and the state of California are facing lawsuits over climate-related rules they’ve recently enacted. Other states have witnessed new laws and regulations that seek to limit consideration of ESG factors in investment decisions by public authorities and entities. While citing the fiduciary duties of investment managers, these states are inclined to safeguard industries that do not promote ESG, such as fossil fuels. These laws largely impact public funds and expenditures, but efforts are underway to extend them to commercial ventures.

While ESG as a concept increasingly faces pushback from certain corners, it continues to evolve and remain prevalent. As the Norton Rose Fulbright survey reports, a majority of respondents predict that ESG-related scrutiny will increase in 2024. In this context, it will be interesting to see how the legal regime in different jurisdictions shape out for multinational businesses. With the current inconsistency in rulemaking, companies should exercise caution and have resources in place to identify risks driven by ESG factors, both in operational strategies and investments.