Imogen Armstrong identifies some of the current issues in green due diligence and why it is an increasingly important part of M&A work
On 23 February the EU announced its long-awaited, mandatory due diligence proposals for environmental and human rights risks. It is one of the latest close-to-home developments coming out of an increasing global focus on ESG, the impact of which is already being seen across M&A trends.
The EU’s “Corporate Sustainability Due Diligence” proposal currently directly impacts only very large companies, being those with i) 500+ employees and €150 million+ in global net turnover in the previous financial year (regardless of whether or not the company’s industry is considered “high impact”), or ii) so-defined “high impact” companies with at least 50% of turnover generated in a high-risk sector (this includes industries such as the manufacturing of basic metal products, textiles, or metal extraction), and with 250+ employees and at least €40 million in net turnover in the previous financial year. UK companies are caught by the proposals where their turnover meets these same thresholds through their business in the EU alone. Therefore whilst the post-Brexit UK sits outside of this regime, it still applies to some British companies operating within the EU. Given the often nebular geographical nature of technology, this legislative pressure is something of which Big Tech companies will be increasingly aware regardless of the jurisdiction in which it sits.
Companies who feed into the supply chain of the organisations subject to such reporting regimes will certainly feel the effects of the scrutiny trickling through ISPs, for example, or manufacturers of the technology used by these businesses. The proposal recognises this, as it references the necessity of accessible and practical support being made available for supply chain SMEs (although we will have to wait and see what this actually entails).
This delicate ESG ecosystem is in turn going to impact who will be willing to do business with, or even invest in, the smaller players, all feeding into the “deal or no deal” nature of M&A due diligence.
The ESG Effect Across M&A
Even as the EU’s proposal takes shape, organisations such as techUK already consider it an “imperative”1 that tech companies achieve, or work towards achieving, Net Zero as those without ambitious climate change targets are inevitably going to be seen as less investible.
A quick look at investor commentary from the last year will tell you that ESG factors are increasingly being used to drive down deal prices. Working conditions, environmental liabilities and ethical sourcing of raw materials all play a part, as does employee-relevant data such as gender pay gap reporting. Grant Thornton in its investor survey last year found that “the time allocation spent on ESG, technology and data and information factors in assessment of a potential investment’s value has risen from 28% three years ago to 40% today”.2 Bloomberg estimates that ESG assets under management could climb to a third of all global assets under management – projected to be worth $53 trillion by 2025.3
The effect is real and measurable, and whilst it may be a cynical approach to take towards the green element of ESG in particular, tech companies as both polluters and innovation enablers would do well to take action to safeguard their future investment potential. By managing their own footprints, and in turn solving some supply-chain issues for their customers, SME tech companies could find themselves in an excellent position to ride the wave of ESG investment.
And whilst a company gearing up for sale or investment is usually a very different beast to a company happily ticking along, considering the potential due diligence a company could be subject to down the line is a useful way of analysing gaps in a business plan or focus. The following could therefore be relevant not only to corporate lawyers, but to commercial and in-house advisors too.
So what comprises Green Due Diligence?
ESG covers a huge range of ethical considerations; modern slavery, ethical data practices, diversity and institutionalised bias to name just a (very important) few. It is not at all limited to the environment alone, however for the sake of accessibility we are only focussing on environmental elements here.
Lawyers love a good definition, but “Green DD” is a new and evolving concept and is not yet universally defined. It constitutes a range of factors, and is currently being picked up as part of directors’ duties and corporate responsibility (e.g. the EU’s proposal above) as well as the M&A specific way we’re using it here.
The following are a few suggested areas of focus, which will no doubt be rapidly improving in sophistication over the coming months and years.
1. Supply Chains
Perhaps the most obvious area of focus, and one that spans both contractual and regulatory considerations. What sort of commitments are supply chain companies giving when it comes to their own environmental or sustainability credentials? Can these be verified?
Arguably one of the most important factors to ascertain is whether the target company has recourse against their suppliers in the event that they fall short on their green commitments. In particular this means having adequate auditing or supplier reporting obligations on environmental elements, and ensuring there are remediation or compensation rights in favour of the target, or in more extreme cases termination rights for environmental breaches (beyond the minimum legislative obligations). If the supply chain companies are subject to reporting regimes such as the EU’s proposal above, the investor/buyer might consider it important to see contractual commitments to comply.
2. Standard Terms
Rather than focussing simply on the usual suspects of term, liability caps and change of control provisions, attention could instead be brought to the existence (or lack) of any flowed-down environmental targets, or even how the company is holding itself accountable to its upstream customers for its own targets. Standard terms are an excellent indication of how seriously a target company is taking its environmental obligations, because these sorts of terms only make it into standardised documents if they’re perceived to be important.
Take for example whether there are termination rights for a breach of environmental standards, or even whether relevant environmental laws are contractually called out: is a tech manufacturer specifically obliged to comply with relevant environmental regulations or are we simply relying on an “all relevant legislation” clause (which arguably fails to focus the mind on any practical level)?
Any truly green/ESG focused business will have its premises at the front and centre of its credentials. There are a number of certification schemes looking to evaluate and reward the ESG performance of real estate; for those with a penchant for acronyms, the Royal Institute of Chartered Surveyors lists BREEAM, CRREM and GRESB amongst others. Some of these are UK-specific and some are global, but the real test lies in fundamentally understanding what these evaluations actually mean.
The chances are that sophisticated investors will have their own ideas about what they will and will not accept by way of certification, but if not then it’s certainly something that commercial real estate lawyers will be looking to up-skill in, while corporate lawyers will need to understand the basics.
4. Shareholder Agreements
It’s one thing for day-to-day management to talk about its environmental aspirations, but quite another for the shareholders of a company to have ratified their environmental aims in their shareholder agreement. Young, vibrant, innovation-ready tech SMEs are prime candidates for radical shifts in company ownership priorities. If a new data centre or software start-up is making big claims about its negligible environmental impact, it would seem to be an easy win for the shareholder agreement to reflect this – and a big tick win in an investor’s due diligence as it shows an institutionalised priority right up the corporate food chain.
At the due diligence stage, investors/purchasers could ask targeted questions about how the company has been held to account for its environmental targets by its current owners. Are the shareholders required to enforce a company’s approach to its net zero journey? What does the shareholder agreement provide for in the event that the company doesn’t hit its targets – does a portion of the dividends then go towards carbon offsetting as opposed to the shareholders’ pockets?
The bold might predict that shareholders who are willing to put long term sustainability and all the benefits this entails ahead of short term gains will be increasing in number in years to come. It’s therefore entirely possible that we’ll be seeing more of this in the medium to long term.
5. Reputational Risks
Reputational damage is a difficult risk to quantify, but one which can have a serious impact on an investor’s willingness to become involved in a company.
The Advertising Standards Agency (ASA) can be a good place to start for a feel of how successfully a consumer-facing business is living up to its green claims. The ASA is attacking green washing with increasing energy, even setting up a quick-reporting tool specifically for consumers concerned with advertising environmental claims. How is the business portraying its credentials, and does it know its carbon offsetting from its carbon reduction? Has it been subject to any ASA decisions?
For tech companies with a large energy consumption, care should be taken with “100% renewable energy” claims, as it has been possible for energy providers operating within Ofgem’s Renewable Energy Guarantee of Origin (REGO) certification scheme to purchase and trade REGO certificates without actually purchasing the underlying renewable energy.4
An understanding of the businesses’ internal environmental and sustainability policies and procedures can also give a good indication of its day to day running, and its ability to mitigate against issues which could become an environmental PR headache.
Finally, a word on that post-deal glow. Post-deal management plays a huge part in maintaining an ESG investment’s potential, and there will be varying amounts of control on the day to day running of the company by the new owners. There is however, for the right investment into the right business, the potential to have a serious impact on an acquisition’s long term sustainability and value regardless of where it sits on the ESG scale pre-investment. The company does not have to be perfect right now to see significant gains in sustainability in the future, and indeed future value generally lies in potential for improvement.
Flipping this around, tech SMEs looking to improve on their credentials and their ability to thrive in the long term will be looking for investment partners who can provide tangible expertise in this area. Understanding where both parties sit on the “real time” and “aspirational” scales from the start of their relationship, therefore, will pay (literal) dividends down the line.