Environmental, social and governance (ESG) issues are a growing concern for investors, consumers, governments and other stakeholders.
In the private equity sector, the rise of sustainable funds and sustainable investing shows the recognition of ESG’s role in value creation. Prominent global firms such as Temasek, Apollo Global Management, TPG and KKR & Co are foraying into ESG investing and have deployed and/or committed substantial funds to such investments, including decarbonisation technology. As ESG investing becomes more mainstream, companies which take proactive steps to address ESG issues will find themselves more marketable as an attractive target for investment.
ESG considerations in the deal life cycle
As negative ESG practices could lead to financial and reputational risks for the investor, there has been an increase in the use of ESG due diligence in transactions. As the specific ESG risks affecting a target will depend on several factors, including the industry in which they operate, the nature of their business and geography, the scope for ESG due diligence will vary. ESG due diligence may focus on a range of issues, including environmental degradation, human rights violations, data breaches, workplace misconduct and corruption. If the investor is subject to sustainability reporting requirements, it may wish to cover such matters under the ESG due diligence scope as well.
Investors may seek to address ESG risks in transaction documentation through ESG-specific representations and warranties. Although customary representations and warranties cover matters such compliance with laws and regulations, investors may wish to negotiate for additional protection through ESG-focused representations and warranties. This may include representations and warranties relating to policies and procedures in relation to financial crime or social matters which go beyond strict legal obligations or tailored representations and warranties depending on the industry or nature of business, such as compliance with international standards against slavery or child labour for supply chain companies.
Further, if an ESG risk identified during due diligence cannot be addressed pre-closing, investors may price in this risk by negotiating for a lower valuation of the target or restructuring the transaction. The investor may also seek an indemnity for any losses which it may suffer in connection with such risk. Notwithstanding that transaction documentation can provide protection for the investor, a report by Baker Tilly International and Acuris Studios found that 60% of the dealmakers interviewed have walked away from an investment due to a negative assessment of ESG issues in relation to a potential target.
Post-closing, an investor may aim to align the company’s ESG policies and values with its own as part of its process of integrating the company into its operations. The investor may achieve this by mapping out the material ESG risks identified and imposing post-closing obligations on the target to make the necessary rectifications within a prescribed timeframe. This may include an obligation to implement ESG policies which are aligned with the investor’s own policies and to communicate the same to the relevant stakeholders.
Managing ESG Risks
Given that ESG considerations may be present in every stage of the deal lifecycle, it is imperative that companies seeking to attract investors adopt good ESG practices to manage their legal and reputational risks. This may include:
- implementing the recommendations of the Task Force on Climate-related Financial Disclosures;
- implementing anti-corruption policies and practices;
- developing the company’s workforce, which includes investing in training, education, skilling and reskilling its workforce;
- considering the risks of child labour, forced or compulsory labour; and
- considering data stewardship risks, which includes “cybersecurity, the use and governance of artificial intelligence and machine learning, and privacy and data ownership issues associated with data collection, management and use”.
In Singapore, publicly listed companies are required to comply with guidelines for sustainability reporting. Although private companies have more autonomy than publicly listed companies in relation to governance matters, they may still be indirectly affected by ESG regulations or sustainability reporting requirements:
- Foreign ESG regulations may apply to the subsidiaries of Singapore companies which operate in those jurisdictions. These include the (i) Corporate Sustainability Reporting Directive, (ii) UK Modern Slavery Act and (iii) German Supply Chain Due Diligence Act, which focus on a specific size threshold, location, or revenue, and not ownership structure. Complying with the regulations in these jurisdictions may have knock-on effects on the global operations of the group.
- Private companies may be required by their customers or shareholders to adopt ESG practices for compliance purposes or to mitigate their risk. For example, a private company may be asked by a customer to adhere to certain codes of conduct in order to do business with them.
- Investors increasingly evaluate ESG risk factors as part of their investment decisions. Based on the Pitchbook 2022 Sustainable Investment Survey, 77% of non-VCs and 59% of VCs have plans to increase their attention to ESG risk factors in the coming year.
Embracing ESG and understanding its risks and opportunities should be part of any company’s multi-faceted strategy to grow its business and attract investors. As ESG considerations gain a foothold in private equity investments, companies which adopt good ESG practices from the outset will be in a better position at the fundraising stage, to provide any ESG-specific representations and warranties required by the investor and defend against price adjustments due to negative ESG factors.
Dentons Rodyk thanks and acknowledges Senior Associates Claire Tan and Rachel Tan for their contributions to this article.
November 14, 2022