ESG due diligence is increasingly standard
As part of conducting due diligences, many buyers are now including ESG tracks in the due diligence process. This means that deals teams will now look at the ESG risk and opportunities that your company faces.
Buyers usually look at ESG records for at least the past three years. You can prepare by understanding your ESG position and incorporating ESG into your business as soon as possible, ideally at least three years before the transaction. Here it is important that your actions reflect the risk and opportunities that you have identified, so that the potential buyer doesn’t find major reg flags in the due diligence process.
So, what should you focus on when incorporating ESG into your business?
Provide credible ESG data
Investors increasingly expect companies to show credible ESG data from their operations in a similar fashion to their financials. The topic of credible ESG data is extensive and covers aspects including sourcing, quality, and use of data. Strong data sourcing and quality can be important due to the many uses of ESG data.
You will need to provide credible ESG data in a plethora of places, including:
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ESG due diligence
The data will serve as key input in the ESG due diligence process. You will be asked to provide ESG data during the transaction that the buyers team will be closely inspecting. It is therefore necessary for the data to be reliable, as it both will make the transaction easier for both sides. Likewise, lack of credible data will diminish a potential buyer’s trust in the transaction.
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ESG scores
ESG scores are increasingly being used as input in investments decisions. Historically ESG scores could be bought, and they would be constructed with proxies or through averages based on competitors. This is no longer the case. To be able to obtain a ESG score, you now need to be able to provide actual data from the source, which can be audited if necessary.
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Regulations and compliance
Almost all companies will be subject to ESG reporting in the coming years, if they are not already, due to different national and EU regulations such as the CSRD. If you want to be bought by a fund, you will additionally be subject to reporting requirements stemming from regulations that they are facing such as the SFRD and the EU taxonomy.
Demonstrate your ESG competences
Have ESG competences inhouse – or at least a credible plan to obtain them. We increasingly hear buyers mention that they look for proof that the seller has the competences to deliver on the company’s ESG strategy.
It is no longer enough to know what ESG stands for and have a glossy report with lots of pictures detailing ambivalent ambitions.
The buyer will ask you about the concrete actions that you will take to achieve those ambitions. They will expect you to come with educated answers regarding your approach to future ESG-related topics. Buyers are especially looking at how much management has been involved in the ESG efforts and how the governance of ESG is handled within the company.
Stay current on relevant legislation
Regulation is a big driver for investors’ preferences and requirements. EU and other government entities are increasingly approving and implementing extensive ESG regulations affecting most companies in the EU. You can determine which regulations are most relevant for you based on your company’s size and industry, as well as your potential buyer’s investment mandate.
You should be aware of these big directives and regulations (as of November 2022):
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Non-Financial Reporting Directive (NFRD)
A current EU directive that mandates large, listed companies to report on selected ESG topics. The NFRD is being replaced with the more extensive EU directive, CSRD.
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Corporate Sustainability Reporting Directive (CSRD)
An upcoming EU legislation requiring all large or listed companies to publish reports on their environmental, social and governance impact activities. The first companies in scope will have to report for the first time in 2025 based on their results for FY2024.
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European Sustainability Reporting Standards (ESRS)
The standards outline in detail the reporting requirements set out by the CSRD. The standards are extensive, containing 84 disclosure requirements across ESG topics. ESRS will require companies to have 1,144 datapoints.
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Sustainable Finance Disclosure Regulation (SFRD)
This European regulation aims to make the market for sustainable investment products more transparent. SFRD’s goal is to prevent greenwashing and to increase transparency around sustainability claims made by financial market participants. Depending on the investment focus, asset managers must live up to increasingly strict disclosure requirements. E.g., funds without a sustainability scope follow article 6, whereas funds that have sustainable investments as their objective follow article 9. Interestingly, the regulation is practically turning into a labelling device, with funds identifying themselves according to the articles that they live up.
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Regulatory Technical Standards (RTS)
These are consolidated sets of technical standards providing additional details for the disclosure requirements set under the SFRD and the Taxonomy Regulation. To live up to the regulations set out in the SFRD, firms will have to follow the methods detailed in the RTS.
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Principal Adverse Impacts (PAI) regime
This set of mandatory indicators and metrics under the SFRD aims to show financial market participants how certain investments pose sustainability risks. The PAI regime requires fund managers, financial advisors and other financial institutions to collect ESG data and disclose any sustainability risks associated with their investments and financial products.
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Task Force on Climate-Related Financial Disclosures (TCFD)
TCFD is a framework for disclosing climate related risks and opportunities. The UK has introduced a regulation requiring UK-registered businesses to disclose climate-related financial and process information in accordance with the TCFD framework.
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Directive on Corporate Sustainability Due Diligence (CSDDD)
The directive establishes a duty for companies to identify, prevent and mitigate the negative effects of their activities on people and the environment. Essentially, the CSDDD makes companies liable for their value chains, not just their own operations.
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EU Taxonomy
The EU Taxonomy is a complex classification system to define which parts of the economy may be defined as sustainable investments. It is created as a tool to redirect money towards sustainable projects. You will need to understand the system as many investors will need to calculate how big part of your firm value is sustainable according to the taxonomy.
Consider alignment with investor foci
Many investors have specific interests or areas of focus within ESG. Being a front runner in an area that investors are focusing on can increase your sales attractiveness.
Investor desire to decrease the average emissions of their portfolios was highlighted at Private Equity International’s Responsible Investment Forum in November 2022. This focus is positive for companies that can demonstrate alignment with the Science Based Targets initiative (SBTi), as these companies are significantly more attractive to investors. Aligning your company with SBTi will contribute favourably to you valuation.
In addition to climate targets, some investors have a big focus on ‘S’ issues, such as gender diversity. Identifying foci that are relevant to your company and formalising your commitments and actions in these areas and can be beneficial to your exit goals.
Be aware that your compensation may depend on your ESG results
We expect to see more ESG-linked performance metrics both in management numerations and earn-outs in future transactions. This means that part of the value you get from selling your company will be directly linked to your ESG results. Keep an eye on which indicators are being used in these compensation models, as it will help concretise which ESG topics investors are especially going to value in a transaction.
Do the work beyond reporting
Remember to do the actual work as you focus on your ESG reporting. With all the talk of ESG data and reporting, it may seem hard to focus on anything else. But ESG has gained cadence in the investment world as ESG-conscious companies have been performing better, so make sure you actually work with ESG and not just report it. Otherwise you will not reap all the benefits of your ESG efforts.
ESG is an opportunity for value creation
ESG is a broad area, and there will be multiple things for your company to consider and work with. But identifying relevant, value-generating efforts and starting early can help make sure the resources you spend on ESG are worth it. Working credibly with ESG can act as a value driver in your investor dialogues and increase saleability and/or valuations.
