ESG’s impact on M&A, investment and finance

Regulations concerning ESG and sustainability are increasingly affecting the M&A transactions, investment and financial sector. The scope of the due diligence process, the shape of transaction documentation, the target’s valuations, the structure of investment portfolios, and finally the source, form and structure of financing are all affected.

The ESG strategies adopted by companies in the EU prove that ESG factors are now becoming one of the key elements of the reporting and due diligence process. This is due to legal regulations at the EU level, including the CSRD (Corporate Sustainability Reporting Directive) together with European Sustainability Reporting Standards – ESRS, and the SFDR (Sustainable Finance Disclosure Regulation). SFDR regulates the disclosure of information related to sustainable development in the financial services sector – also based on the Regulatory Technical Standards (RTS) to the SFDR regulations.

This practice is also reflected in other regulations at the EU level – especially, in the recently adopted Directive (EU) 2024/1760 of the European Parliament and of the Council of 13 June 2024 on corporate sustainability due diligence and amending Directive (EU) 2019/1937 and Regulation (EU) 2023/2859 (the CSDD Directive). On 5 July 2024, the CSDD Directive was published in the Official Journal of the EU and entered into force on 25 July 2024. The CSDD Directive provides for specific obligations on obliged entities, including:

• Mandatory due diligence in order to limit negative effects will apply to the business’s own activities, activities of subsidiaries and the so-called ‘chain of activities’
• Increasing the responsibility and accountability of businesses for the negative effects of their activities
• Due diligence obligations in relation to respect for human rights and environmental issues for specific groups of companies
• Civil liability of the companies for adverse effects (applicable under certain conditions), and subject to fines for breaches of due diligence obligations
• Increasing access to legal remedies for persons and entities affected by negative effects resulting from the activities of enterprises. The objectives of the CSDD Directive should also be achieved considering the activities of companies/entities belonging to capital groups of obligated entities.

From the business perspective, the correct identification of factors and risks related to ESG aspects is currently one of the key transaction issues. Due to its complexity (including climate issues, carbon footprint, human rights, labour rights, impact on the local community, supply chain issues, data protection, business ethics, tax transparency, etc), detailed analysis of ESG factors during due diligence requires a multidimensional, interdisciplinary approach and in-depth, practical knowledge of regulatory areas related to sustainable development. Some of the factors and parameters related to sustainable development are difficult to measure in current conditions and require the use of appropriate analytical instruments. As part of the study, the existing regulatory framework (at the EU level) concerning ​​ESG / Sustainability should be taken into account (such as regulations, directives, delegated acts, technical acts, guidelines and recommendations of European supervisory authorities, etc.).

The impact of ESG factors on M&A transactions is also a matter of preparing appropriate transaction documents, reflecting the risks identified during ESG due diligence. Conducting due diligence ought to be perceived as a potential benefit for both parties to the transaction (both the sell-side and the buy-side). Quick and correct identification of risks allows, in most cases, to mitigate them before the signing phase, or to address them appropriately in the prepared transaction documentation. Proper management of ESG factors also allows for building the value of portfolio companies and significantly affects the valuation of these companies, which is noticed and appreciated by entities professionally operating on the investment market, in particular ​​private equity and venture capital funds. These actions should include ESG risk management while creating and implementing an ESG strategy and taking appropriate actions within the adopted strategy that significantly increase the valuation of a given portfolio company. In this context, ensuring an appropriately organised management structure in a given company or capital group, requires determining the appropriate division of competences and responsibilities in this area in relation to management bodies. This includes preparing key corporate acts in this regard, creating a procedure for monitoring ESG risk management in the companies from the same capital group and ensuring compliance of business ethics. These activities should also include an analysis of ensuring full tax transparency, from the perspective of counteracting BEPS (Base Erosion and Profit Shifting) and proper performance of tax reporting obligations.

In the investment sector, a natural consequence of adopting an ESG strategy (and adopting specific investment policies that take into account the issues of sustainable development) is the impact of ESG factors on the structure of investment portfolios. Regulations on sustainable development and non-financial reporting have a significant impact on entities from the investment sector, including managers of the investment funds. Strategies and investment policies consistent with ESG policies are widely implemented in the private equity sector, especially in Europe. From this perspective, entities seeking capital or investment support and not adapting to the sustainable development / ESG policy, significantly limit the possibility of obtaining the above-mentioned support – either in the form of an industry investor operating based on the ESG strategy, or in the form of, for example, a dedicated private equity fund. In the longer term, such entities may also have difficulty obtaining attractive financing, because financial institutions (especially banks) are subject to analogous regulations in the ESG area (such as ultimately, the obligations to report the so-called ‘green-asset ratio’).

There are some differences in the approach to the ESG (and sustainability) from a transatlantic perspective. The US presents a more flexible approach compared to the EU, both in terms of implementing regulations and ESG guidelines, as well as in terms of reporting these factors. In the US, being subject to ESG reporting obligations is, as a rule, related to a prior choice made by the company and its owners as to the legal form of the business conducted and as to the intention to be subject to these regulations or obligations. It is worth referring in this regard to dedicated programmes in the field of Sustainable Business Strategy conducted at Harvard Business School and to the interesting case studies presented there, regarding companies operating globally and their flexible and dedicated approach to the elements constituting Sustainable Business Strategy. It is also worth pointing out that at the federal level there is, in principle, no obligation to report ESG factors (apart from certain exceptions in the field of regulations adopted by the US. Securities and Exchange Commission for public companies).

ESG and sustainability issues are now becoming one of the fundamental elements shaping the international financial market. One of the most attractive forms of sustainable financing are green bonds. A very important benefit related to the issue of green bonds is the ability to release the issuer’s encumbered assets and encumbered assets in the issuer’s capital group. The legal documentation related to the issue of green bonds, including the terms and conditions of the issuance of the green bonds, may enable the refinancing of existing debt and lead to the release of securities originally established on the assets of the issuer or on the assets of companies from the issuer’s capital group (resulting, for example, from previously concluded facility agreements). An issuance of green bonds constructed this way may allow for a significant increase in the issuer’s free (unsecured) asset ratio.

Companies that are at the beginning of their transformation path and cannot use instruments such as green bonds, may consider instruments dedicated to transformation projects, such as transition bonds or sustainability-linked bonds. Loans and bonds related to sustainable development were very popular on the international financial market in 2023 and 2024. In this context, it is worth pointing out that sustainability-linked bonds, in accordance with International Capital Market Association guidelines, do not have to indicate a specific purpose of its issuance and, in principle, they can finance the general business activities of the issuer. This means that the funds obtained from the issuance of these bonds do not have to be allocated for a precisely described goal regarding positive environmental or social changes. However, a necessary element is the definition of precise measures (KPIs) regarding the issuer’s activities and the business’s impact on areas related to sustainable development (ESG). This mechanism allows firms to make the amount of interest (within certain limits) dependent on the issuer’s fulfilment of a KPI (such as increasing the share of renewable energy sources, reducing greenhouse gas emissions, increasing energy efficiency, etc.).

Summary
ESG factors and regulations concerning ​​sustainable development have an increasingly significant impact on the M&A transactions, investment and financial markets. The enormous development of sustainable financing instruments is an excellent opportunity for both entrepreneurs (and the financial sector) to seek modern and tailor-made forms of financing. This trend will now be further reinforced – and the role of advisors is to notice these circumstances, and to support clients in building a competitive advantage in this area.