M&A Transactions through an ESG Lens
This is an Insight article, written by a selected partner as part of Latin Lawyer's co-published content. Read more on Insight
ESG is an essential tool in mergers and acquisitions (M&A) for mitigating risk and optimising value creation. When incorporated into the M&A process, ESG considerations help buyers understand the ESG implications of potential acquisitions, including risks presented by the target and the impact on the buyer’s own ESG obligations, so that appropriate measures can be implemented. Considering ESG factors also helps buyers advance their own ESG goals, such as to enhance the sustainability of their businesses and address the concerns of their customers and other stakeholders. Sellers, likewise, can optimise and promote their ESG status, increasing their value to buyers.
Latin American M&A is commonly perceived as presenting additional risks for several reasons, including political instability, foreign exchange volatility, uncertain monetary policies, corruption and complex regulation. But Latin American M&A also presents significant opportunities for a prospective buyer to expand into dynamic markets, with an underserved and rapidly expanding customer base, and potentially achieve outsized returns on such investments. Assessing M&A transactions through an ESG lens can provide valuable insight otherwise overlooked in a traditional transaction due diligence process.
The keys to maximising buyer ESG value in M&A
To understand how a target’s performance on ESG factors impacts the risks and value of a potential transaction, a buyer needs to consider:
- the ESG factors that are material to the buyer’s operations;
- the ESG goals and opportunities that the buyer wishes to maximise with the transaction;
- the applicable regulatory and disclosure requirements of the buyer and the target (including any voluntary disclosure regimes the buyer or target has elected to follow); and
- the ESG-related regulatory requirements or regimes of the buyer’s shareholders and other stakeholders.
Understanding ESG goals, risk exposure and disclosure obligations (including those pursued by its shareholders and other stakeholders) should inform the buyer’s diligence efforts as well as the reps and warranties, covenants (pre- and post-closing), and other terms the buyer seeks from the sellers. Having a clear sense of the buyer’s ESG-related goals and commitments and of the target’s ESG profile will also help the buyer appropriately value a transaction and assess whether the transaction will help or harm the buyer in achieving its own ESG agenda.
The context: the state of ESG in Latin America
While ESG legislation in Latin America is not as robust as, for example, what we see in Europe, it would be a mistake to assume that there is no such legislation in the region. In fact, many existing laws regulate ESG activities and impact – though Latin American ESG legislation is much less uniform than that in Europe – with differences in scope and focus between jurisdictions. Additionally, companies organised in or operating in Latin America may also operate in (or be in the supply chain or otherwise transact with companies organised or operating in) other jurisdictions with more developed ESG regulations. As a result, buyers also need to be attentive to the requirements of the countries in which they and their stakeholders operate.
Statutory framework in Latin America
Increasingly, different jurisdictions are recognising the importance of environmental regulations and the importance of reducing negative environmental externalities. Latin American countries have approached regulating corporate environmental impacts in a number of ways. For example:
Brazil has enacted Act No. 9,605, which provides criminal and administrative penalties relating to behaviour and activities harmful to the environment.
Argentina introduced the Law on Minimum Budgets for Adaptation and Mitigation to Global Climate Change, which establishes minimum environmental protection commitments related to adaptation to and mitigation of climate change.
Chile’s General Bases of the Environment Law created an ‘Environmental Impact Assessment System’ and designates projects that fall into its scope, including nuclear reactors; oil, gas, and mining pipelines; and forestry development or exploitation. Such projects require prior approval from the relevant Chilean authority.
These regulations, among others, signal an understanding by regulators of the role that companies play in increasing environmental risks and opportunities.
Latin America has a range of laws falling under the ‘social’ branch of ESG. These laws commonly incorporate or reference international standards, though this influence comes from a wide variety of different regional or multinational organisations. For example:
- In Brazil, under Federal Decree No. 9,571/2018, the National Guidelines for Business and Human Rights incorporate international standards into government policy, including the United Nations Guiding Principles on Business and Human Rights.
- Argentina relies on international agencies, including the International Labour Organisation (ILO), and has approved ILO Agreement No. 29: Convention concerning Forced or Compulsory Labour, which condemns the use of forced labour.
Mexico’s General Law on Forced Disappearance of Persons takes inspiration not only from the UN Committee and Working Group on Forced or Involuntary Disappearances, but also standards established by the Inter-American Commission on Human Rights and its Inter-American Court counterpart.
Chile’s Decent Work Country Programme imposes obligations on employers to provide better working conditions for employees, with the overarching priorities of eradicating child labour, addressing gender inequity in the workplace, and creating a national policy for security and health in the workplace.
As with other regions, Latin American governments have an array of laws regulating corporate governance. These range from laws relating to anti-corruption, like Mexico’s General Law of the National Anticorruption System or Brazil’s Clean Company Act, to other requirements related to ESG considerations more generally, like the 2019 rules requiring Mexican pension funds to include ESG factors in their risk and credit assessments.
In terms of actual disclosure and ESG reporting, in December 2021, Brazil introduced a requirement that publicly listed companies disclose information on ESG indicators on at least an annual basis using a ‘comply or explain’ approach that is similar to the approach the European Union has adopted through its Sustainable Finance Disclosure Regulation and CSRD. The way in which the information has been collected, audited and reviewed also must be reported, as well as the use of any benchmarking standards, such as the United Nations Sustainable Development Goals (SDGs) or the recommendations of the Task Force on Climate-Related Financial Disclosures. Companies that misrepresent compliance may be subject to investigation or administrative penalties.
Latin American businesses also may be impacted by the general rise in ESG-related legislation around the world. For example, the EU has passed a wide variety of laws in this area, which frequently impact not only companies organised or operating within the EU, but also companies organised or operating in third countries that are part of the supply chain of an EU company.
On 5 January 2023, the Corporate Sustainability Reporting Directive (CSRD) entered into force, which strengthens the rules concerning ESG reporting. CSRD applies to a wide swathe of EU companies based on revenue and employee headcount, and imposes reporting obligations on in-scope companies. Companies will have to report on how sustainability matters impact them, as well as how they impact sustainability matters (a concept known as ‘double materiality’). Reporting obligations will extend beyond these companies’ own operations to their broader value chains. Specific reporting requirements are further defined by the European Sustainability Reporting Standards (ESRS), which cover topics that companies will be obligated to report on if material to their operations.
In addition to CSRD, the Corporate Sustainability Due Diligence Directive (CS3D), which is currently being considered by the EU Commission, will aim to foster sustainable and responsible corporate behaviour and anchor ESG considerations in companies’ operations and corporate governance. As currently drafted, the directive will apply to third-country companies active in the EU that exceed certain thresholds. Further, while not directly covered by the law, companies deemed to be within a value chain of an in-scope company will likely find their sustainability practices assessed by their customers and other counterparties.
In the United States, the SEC has proposed rules that would require public companies to disclose climate-related information, including greenhouse gas emissions and climate-related risks, targets, and financial metrics. States also may require disclosures by certain categories of companies, such as the climate disclosure laws passed by California in September 2023.
Business partners of the target, and of the buyer as well (including, among others, the buyer’s stockholders or other investors), may require compliance with ESG steps reflecting the legal obligations or other objectives of those partners. Sellers and buyers thus need to understand the contractual commitments that they owe to their partners as well as the sensitivities of those partners that may affect their future business relations.
Regardless of regulations in Latin America, companies in Latin America that have customers or otherwise do business with parties outside the region must have the processes and controls, and requisite compliance infrastructure, to allow them to comply with, and respond to requests for information pursuant to, the regulations imposed on those customers and other parties. Buyers of businesses in Latin America must be prepared to provide disclosures and otherwise comply with regulations imposed by the buyers’ home countries and other jurisdictions in which they do business and to respond to questions from their stockholders and other investors (including the limited partners of a private equity company).
High ESG-risk industries in Latin America
Industry-specific risk factors also are important in M&A. For example, due to its abundance of natural resources, Latin America has established strong agricultural, mining, and forestry industries, which bring unique ESG risks.
Mining, a key supporting element of the rising focus on renewable energy and electric vehicles, has historically been associated with unsafe working conditions, forced labour and the displacement of local populations. Forestry and agriculture have their own suite of potential issues, whether poor forest management and lack of sustainable practices when carrying out the former or clearcutting sections of forest to enable the latter. Agriculture and mining can involve the use of hazardous chemicals, resulting in accidents like the spill of millions of gallons of toxic substances into the Sonora river from a copper mine operated by a large mining company. Poor planning of mining or agriculture projects can lead to the destruction of the local environment, air pollution and intrusion on indigenous cultures and communal land. So, while these major industries present great opportunity for growth, they must also be approached with caution by buyers.
Incorporating ESG considerations in the M&A diligence process
While the idea of incorporating ESG considerations into M&A due diligence may seem like a recent phenomenon, certain ESG-related factors have long been the subject of diligence. For example, diligence into such topics as safety records, human capital, litigation and investigations, employee policies, board governance, anti-money laundering, anti-corruption and other compliance issues is not uncommon. What is ‘newer’ is the idea of thinking more generally about the risks and opportunities that an acquisition target presents through an ESG lens. Assessing targets through an ESG lens will help to cast light on potential risks and circumstances that may not be uncovered through a more traditional approach to corporate due diligence.
Generally speaking, the best way for a buyer to incorporate ESG into the M&A diligence process is to integrate ESG into the already-existing areas of due diligence investigation – be that legal, operational or financial. Most ESG factors or questions fit within or are adjacent to existing areas of inquiry. This approach avoids adding a whole new, stand-alone set of diligence questions, which could frustrate buyers and sellers alike, create a barrier to efficient deal-making, and cause push-back or minimalisation of such inquiries as overbroad, overreaching or unduly burdensome.
One challenge in incorporating ESG into the diligence process is the lack of a uniform standard. This is, however, somewhat by design. ESG is not a one-size-fits-all idea. Rather, what is material to a given target (or a given buyer for that matter) will be not only industry-specific, but also company-specific. This is why, as noted above, it is important for the buyer to understand the ESG factors that are material to its operations and its objectives in the transaction and to consider the factors material to the target’s operations. An initial step, then, is to conduct a high-level ESG-focused risk assessment of the target to identify the key areas of risk, as well as opportunities, and thus focus, for ESG diligence.
Conducting such a risk review will include considering the target’s markets, industry and business operations, and identifying relevant ESG-related data that is publicly available. This high-level assessment can help the buyer identify key areas of potential ESG focus for the diligence process. Once the key risk areas are identified, relevant diligence areas of focus can be incorporated into a traditional diligence approach. An extremely helpful tool to help identify key areas of ESG risk for a given target is the Sustainability Accounting Standards Board (SASB, which is now part of the IFRS Foundation) industry-specific ESG factors. SASB has identified material factors for 77 industries, and these can be used as a starting point for understanding which of the many ESG-related factors are likely most material for an acquisition target.
Ultimately the goal of incorporating ESG into the diligence process is to identify potential areas of ESG risk for the buyer, including:
- Reputational risk, which may deter customers from a company and its products and services, harm its global profile, generate boycotts, or reduce investors’ appetite for the buyer’s capital stock (particularly if publicly traded) or other offered investments (such as LP interests offered by a private equity fund). Buyers whose stock is publicly traded are increasingly seeing activists who engage companies privately and publicly to discuss ESG and other issues.
- Litigation risk, which included climate change, labour claims, use or diversion of natural resources (such as water rights), overuse of utility resources, encroachment upon indigenous rights, as well as greenwashing claims and even shareholder claims.
- Regulatory risk, including whether the target by virtue of its operations or otherwise is exposed to ESG regulation in other jurisdictions with more active regulation, and whether the buyer itself is subject to such regulations that would extend to acquired businesses.
The due diligence stage thus presents a key opportunity to understand a target’s exposure to ESG-related risks. Due diligence also allows a buyer to consider whether a proposed acquisition target will impact (either positively or negatively) the buyer’s ability to achieve its own ESG-related goals or commitments.
Key areas of ESG focus
While the specific areas of focus for any given transaction will depend on the specific target and its risk profile, we set forth below a high-level overview of common areas of focus for ESG-related diligence.
Ethical business practices, compliance and risk management
A key ESG area of focus in most Latin American transactions will be ethical business practices, compliance and risk management, particularly given the history of corruption in the region. This generally involves a review of the target’s bribery, corruption, sanctions and money laundering risks, as well as the sufficiency of the target’s risk management and compliance programs to mitigate those risks. Focussing on ethical business practices, and the target’s ability to identify and manage risks, aligns with ESG principles by promoting ethical behaviour, good risk governance, and responsible business conduct.
Cybersecurity and data privacy
Latin America has been the target of cyber attacks in recent years. For example, a ransomware attack on 27 Costa Rican government institutions in 2022 led to the declaration of a ‘national emergency’ due to the disruption. These attacks affect the operations and damage the reputation and stakeholder trust of targeted companies. They also may infect the systems of a buyer during the integration of a target company following an acquisition. In light of these risks, comprehensive due diligence on cybersecurity and data management infrastructure should be undertaken. This involves evaluating data protection measures, defence mechanisms to cyber attacks, compliance with privacy laws, and risks associated with past and ongoing cyber incidents that may involve regulatory investigations and enforcement action. The target company’s disclosures in this regard also should be reviewed to confirm compliance with applicable requirements and to confirm that the disclosures themselves do not add a basis for complaints or other litigation. Addressing cybersecurity and data privacy in the due diligence process will safeguard data integrity and ensure smooth integration of technology and operations post-acquisition, as well as align with responsible and robust business practices.
Environment, climate and use of resources
Another ESG-related area on which buyers should focus diligence is environmental impact, given the growing recognition worldwide, particularly in Latin America, of the impact of a range of human activities on the environment as well as the accompanying rise in reporting obligations and other requirements. In addition to reputational risk, an acquisition target’s climate track record and environmental practices are increasingly likely to result in legal exposure for a buyer, ranging from shareholder suits in the United States based on sustainability-related statements, to enforcement actions for failure to comply with mandatory reporting or other requirements. This is in addition to the long-term risk posed by a target whose climate impact and use of resources does not consider the sustainability of certain business strategies, and the risk that target’s practices in this area could impact the buyer’s ability to achieve its own sustainability-related goals and commitments.
When assessing the climate-related impact of an acquisition or investment target, a buyer should initially identify what policies and commitments the target has developed, as well as what reporting or other regulatory obligations it has. Climate-related diligence will likely encompass many areas, including climate impact potential, climate risk management, noncompliance issues and an evaluation of the management team’s commitment to climate-related goals. The buyer should confirm whether the target company has ever assessed the risks it faces due to climate change, whether transition risk (i.e., risks related to the transition away from a carbon-intensive economy) or physical risk (i.e., risks related to the actual changing climate). The buyer should look at the target’s past reporting and other climate- or sustainability-related communications to gauge the risk of ‘greenwashing’ claims and otherwise identify compliance gaps that will need to be addressed following closing. If shortcomings are identified, the buyer should develop a plan to remediate those specific issues post-close.
Buyers should also consider requiring climate-related representations and warranties along with those for more traditional compliance areas. Buyers should evaluate climate risk through a similar lens as other traditional risk areas: drilling down on what they are acquiring and ensuring that the benefit outweighs the potential risks.
Social impact and supply chain risks
While sometimes difficult to evaluate, a company’s social and community impact should be a core concern for buyers. This is increasingly so due to the proliferation of human rights and supply chain diligence and transparency-related legislation being adopted around the globe, as well as consumers’ and investors’ growing awareness of the impact of business on local communities and their considerations of these impacts when making business decisions. Areas of focus for diligence include labour and human rights-related policies and practices. For example, does the target prohibit forced labour, modern slavery and human trafficking? Does the target prohibit harassment, bias and discrimination? Does the target have appropriate workplace safety mechanisms and pay a living wage to its employees? Does the target employ migrant workers, directly or through third parties, and are they treated fairly?
Understanding the target’s history of stakeholder engagement is particularly important when those stakeholders are members of historically marginalised, oppressed or disenfranchised populations, such as minorities or Indigenous populations. This is of particular relevance in Latin America, where the targeting of Indigenous environmental and human rights defenders has been a significant problem.
These risks extend beyond the target’s own operations to the target’s supply and value chains. Does the target have a holistic approach to managing third-party risk? Has the target vetted its key suppliers so that the buyer can be confident that the target’s products are not manufactured using forced labour or child labour? Supply chain risk (and third-party risk generally) transcends far beyond human rights risks and encompasses virtually every risk we have discussed, including climate (e.g., carbon emissions), corruption and bribery, health, safety, cybersecurity, data privacy, money laundering, and sanctions.
Understanding the target’s supply chain and other key third parties, as well as how the target has conducted diligence and monitored the activities of its suppliers or third parties, will help the buyer ensure that it will not be buying significant third-party issues through acquiring the target. And if the target has not appropriately vetted and managed the risks in its supply chain or value chain, the buyer should have a plan to take such action as soon as practicable after sign or close.
Assessing a target’s governance, while a distinct exercise, is something that will touch on all other aspects of diligence and the target’s ESG infrastructure. Some key areas to consider when assessing governance include board composition, structure, and level of experience (including the existence of independent directors); management incentive structures; the presence and quality of codes of conduct and other behaviour-focused policies such as health and safety, antidiscrimination and harassment, crisis management, and anti-bribery and corruption; and the resourcing for compliance matters, whether that is a dedicated compliance officer or split across multiple positions or teams.
Family-owned businesses, particularly when extending across multiple generations, often present unique challenges. For example, shareholding within such an entity may be structured for the family members to maintain control, even when selling their interests or soliciting outside investment. There may also be a conflict between family control and the need to formalise management to attract further investment or simply to adapt to an organisation growing in size and complexity.
Beyond diligence: incorporating ESG into pre- and post-close risk management
To be most effective, buyers and sellers can embed ESG considerations into the whole M&A process, from the initial solicitation for bids to post-closing covenants and governance, depending on the structure of the transaction deal (including whether the sellers are likely to continue to participate in the business or are selling all their interests), the parties’ respective objectives, risks uncovered during due diligence and other factors. The tools available to buyers and sellers range from informal and non-binding tools to formal, enforceable, legal commitments.
At the pre-bid stage, sellers can highlight for potential buyers the ESG commitments and achievements of the business and the potential value to the buyers. Sellers can also conduct reverse ESG diligence on potential buyers to assess the level of value alignment, including the buyers’ ESG practices, prior acquisitions, and disclosures. Sellers can focus on buyers for whom the target business can offer the most value and emphasise the benefits of the target company’s ESG profile.
As discussed above, buyers should conduct diligence through an ESG lens, focussing on the key ESG-related risks and opportunities of the target company, both on its own and as a part of the buyer’s enterprise and business relations.
Buyers also need to be prepared to respond to the ESG concerns of their own investors and other stakeholders, as well as other potential participants in the transaction, such as financing sources and representations and warranty insurance providers.
If a seller wants to ensure that the buyer after closing will continue the ESG commitments of the business, there are tools available that are best effectuated through actions in the pre-bid stage. For example, valuable IP can be held by a mission-aligned founder or affiliated entity (e.g., for-profit, non-profit or trust) and licensed back to the company with ESG-related covenants. Holding IP outside of the company may have a negative impact on valuation and can be very difficult to reverse if the IP is held by a non-profit. However, if IP is held by a founder, there is more flexibility to change the ESG covenants. Royalties can be paid on a sliding scale to incentivise mission alignment – if a company adheres to the ESG covenants, royalty payments can be lower.
Other examples of mechanisms to promote continuation of a target business’s mission are noted below, though many mechanisms and tools may be available to sellers, depending on the structure of the transaction.
Terms of definitive documentation
Buyers and seller can reflect ESG considerations in the terms and conditions of the acquisition agreement and other transaction documents.
Buyers may ask the seller or the company to make ESG-related representations and warranties. Certain specific ESG-related representations, such as those related to workplace harassment and misconduct (the ‘MeToo’ reps), are already seen in many deals, but there’s no one ‘ESG rep’ that covers all or even most ESG issues. Customary representations may already address certain ESG concerns (e.g., compliance with law and anti-corruption compliance) to some extent, but buyers may also request additional or enhanced representations regarding ESG considerations identified in due diligence or otherwise prioritised by the buyer, for example, with respect to monitoring of ESG issues in the target’s supply chain or the accuracy of the target’s ESG-related public communications (to mitigate concerns about greenwashing risks).
Sellers, likewise, can require that the buyer make representations regarding its impact and ESG practices.
ESG concerns with respect to the target company can be addressed in part through pre-closing covenants and closing conditions requiring remediation or mitigation before closing and through special indemnities, though some target companies may not be willing to change their practices prior to closing. Buyers also can get representation and warranty insurance, where available, though such insurance generally does not cover known issues.
Buyers can tie earn-out payments or vesting acceleration for founders to post-closing performance and improvement on material ESG metrics or issues identified during diligence.
Sellers that want to ensure continuation of certain of their ESG practices can include covenants that require buyers take related actions, such as to maintain existing third-party certification and evaluation regimes, to establish or maintain ESG advisory boards with specified rights and powers, or to continue community activities. Sellers also may seek representation on the buyer’s board of directors, particularly if the sellers are taking a significant portion of the buyer’s stock as consideration in the transaction. Other mechanisms can also be used, depending on the structure of the transaction, such as vesting acceleration for founders, additional payments to sellers, or other penalties if the buyer causes, or allows, the company after closing to deviate materially from agreed ESG practices.
Integration and post-close monitoring
Even the best M&A process must be followed by effective integration of the acquired company into the buyer’s corporate family, with consistent policies and procedures, monitoring and enforcement mechanisms. Special efforts may be required with respect to a target until it is fully integrated and any identified issues must be addressed.
Post-closing requirements may include monitoring and reporting obligations to ensure continued alignment on agreed ESG considerations and metrics. To assess alignment, diverse reporting streams may be adopted to elicit information on ESG performance. Reporting can be made subject to materiality, which may be assessed from a single or double materiality standpoint.
Depending on the jurisdiction where the buyer operates, compliance requirements, or buyer preferences, materiality for reporting may be assessed on a double or single materiality basis, measuring how the target company’s overall value is impacted by ESG issues (single materiality) or how the company’s actions impact its ecosystem (double materiality).
Certain reporting regimes also define what information is material. For example, the EU’s Corporate Sustainability Reporting Directive requires reporting on a double materiality perspective, while the IFRS Foundation’s S1 and S2 standards on sustainability- and climate-related disclosures require disclosures on a single materiality basis. Increasingly, reporting regimes are aggregating to facilitate cost- and time-efficient reporting by ensuring that different reporting regimes elicit similar information. This development will help a buyer report across diverse jurisdictions and regimes while reducing duplicity that may overburden the integration of the target company into the buyer’s systems. For example, the IFRS S1 and S2 standards are designed to be integrated and interoperable with voluntary and mandatory ESG standards and frameworks such as the Task Force on Climate-Related Financial Disclosures, the Global Reporting Initiative standards, and the EU CSRD, among others.
Training and compensation
To bolster ESG resilience or performance, a buyer may provide training or resources to support the newly acquired business to improve strategy, operational alignment, and performance on ESG metrics. Training may be scheduled at the initial stage or on a periodic basis with milestones included to help facilitate understanding on how a company is performing on material ESG topics or issues. Training topics should be designed to facilitate the business’s alignment with the buyer’s ESG values, policies and compliance requirements.
In addition, the go-forward compensation of key executives and management can be tied to the achievement of ESG targets, including in connection with annual bonuses or the vesting of equity.
Ongoing risk and materiality assessment
ESG considerations and compliance requirements are constantly evolving. As part of postclosing and compliance requirements, a buyer may conduct periodic materiality assessments to provide a thorough understanding of a company’s position on material ESG risks, resilience, and readiness to address identified risks. Conducting risk assessment on a periodic and ongoing basis will help ensure an accurate understanding of risk exposure and proactive measures to bolster the company against ESG risks.
 Stacey Sprenkel and Randy Bullard are partners at Morrison Foerster.
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 For example, a buyer could obtain a list of industry-specific materiality standards for the metals and mining or agricultural products industries. SASB standards are available for download at https://sasb.org/standards/download/.
 The United Nations Permanent Forum on Indigenous Issues, United Nations (2016), https://www.un.org/development/desa/indigenouspeoples/wp-content/uploads/sites/19/2016/08/Indigenous-Human-Rights-Defenders.pdf
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