Mastering a Purposeful Approach to ESG Due Diligence in Mergers and Acquisitions

There’s no denying that 2021 was a year of significant growth in M&A, and global M&A activity is poised to climb even higher in the year ahead. M&A can be a tremendous tool for companies looking to adopt more resilient business strategies, but failing to account for the critical ESG elements can undermine success and lead to negative outcomes for business. Investors and regulators are placing more emphasis on corporate ESG performance and disclosure, including in M&A activity and financing terms. In addition, a lack of alignment around ESG topics (e.g., related to labor, governance, and corporate values) can substantially disrupt the post-merger integration process. As a result, interest among M&A teams in ESG is steadily growing, with requests to sustainability teams for guidance and frameworks on effectively integrating ESG considerations into standard due diligence.

To help our members meet this demand, BSR has built upon the guidance offered in our 2019 paper Key Considerations in Managing ESG Through a Merger and developed a set of simple steps that companies can follow to conduct effective ESG diligence in M&A. We hope that the guidance below will help our members to better evaluate the potential impact of ESG issues on business value while embracing purposeful sustainability leadership to better navigate these turbulent times.

Each company will need to develop its own approach to diligence that appropriately integrates ESG into each stage of the deal flow. The diligence process should help a company consider any potential impact of the merger or acquisition on their sustainability strategy and the long-term value of the combined entity. There are several basic elements to consider:

A red-flag check.

The objective of this step is to understand any major ESG-related opportunities or risks as part of the initial target identification process.

Consider the “future fitness” of the core business and relevant assets. For example, do the target’s products and services appear to be compatible with the net-zero economy? Do they support or erode individual rights to privacy? Do they heavily rely on commodities with fragile supply chains (e.g., in conflict zones, reliant on current geopolitical conditions, or susceptible to extreme weather)? Does the business model present significant risks to human rights or a revised social contract (e.g., working hours, living wages and access to basic benefits, emerging legal requirements)?
Conduct a media scan to understand any major ESG related risks. Searching for media coverage of human rights violations, serious privacy or data breaches, harassment, labor disputes, corruption, or environmental degradation can help to identify any major liabilities or cultural concerns that should be investigated upfront. Tools such as BSR’s partner Polecat perform big data analysis of online and social media, which are specifically focused on ESG.

A set of basic ESG governance questions.

The goal is to understand a target’s overall maturity related to ESG and ability to address current and emerging ESG issues:

Does the company have a dedicated person or function responsible for management of ESG? What is their level of seniority? What type of oversight mechanisms govern ESG? Does the board play an active role? Is the CEO part of a regular ESG review cycle? What is the training program for the C-suite and board to understand ESG?
Has the company conducted an assessment to determine its material ESG issues?
Does the company have an ESG strategy or policy that addresses material sustainability topics and impacts from assessment results?
Does the company have measurable timebound targets related to material ESG issues?
Does the company publicly report performance on material ESG topics in line with relevant ESG reporting standards and regulatory requirements? Which regulatory frameworks for ESG disclosure is the company bound to according to jurisdiction?
Does the company actively engage with external stakeholders, for example through an advisory group?

A shortlist of potentially material ESG topics based on industry, business model, and geography and evaluation of the inherent risk or opportunity level.

As a starting point, review material issues identified for your own business. Complement this list of issues with information from tools like the SASB, MSCI, or GRI industry profiles in combination with a standard set of publicly available geographic indices (e.g., Transparency International’s Global Corruption Index), and industry- or topic-specific guidance from organizations like CDC.
It may help to develop a standard list of topics reviewed in any deal (e.g., climate, human rights, and business ethics) alongside a list of possibly relevant additional topics (e.g., hazardous waste).
Ask yourself how big the risk associated with each issue might be if it went unmanaged. Consider impacts across the full value chain, from raw material sourcing through product use and disposal across all relevant geographies.
Be sure to take a double materiality approach that considers both possible impacts to business value and the environment, society, and economy associated with the target company.
Consider dynamic issues that could be relevant in the next 5-10 years for the post-merger organization alongside issues for the individual business today. It may help to have a standard set of scenarios to evaluate performance across a range of possible future operating environments and to regularly monitor emerging issues.

Due diligence to understand risks and opportunities for each material topic.

Pull together an information request for the company based on material issues identified and tap experts as needed to help evaluate performance. Consider the following elements:

Related policies and commitments: Do policies exist, and are they relevant to the new company?
Governance: Is there clear ownership and accountability for performance?
Performance management systems: Do management systems exist and are they certified to relevant external standards? Have goals been set, and are KPIs regularly tracked?
Track record: Review performance data (e.g., GHG emissions), do a deeper dive on media coverage, consider litigation, and targeted stakeholder activism.

While it is ideal to have as much information as possible early in the process, in practice some of the components can come together after a deal is announced and before it is finalized. It’s worth noting that there are many reasons why M&A deals proceed even against significant ESG challenges. In fact, deficiencies in effective management can offer opportunities to create tremendous value and positive impact. Either way, it is essential to devote resources to defining sustainability strategy, governance, management, and disclosure protocols during and immediately following a merger. It is essential to have a clear and complete picture of the deal by both parties and a defined action plan to realize the potential of every business to maximize its long-term value and contribute to a more just and sustainable world.

This article was first published here: BSR | Our insights | Blog | Mastering a Purposeful Approach to ESG Due Diligence in Mergers and Acquisitions