In addition to traditional due diligence areas such as legal, tax, finance, commercial, technology, and others, the ESG due diligence process will play a significant role in corporate transactions going forward.
ESG Criteria in the Company
Due to legislation (e.g., under the CSRD Directive, the LkSG, the DCGK, or the 7th MaRisk Amendment), ESG is becoming an integral component of a company’s value and should be fully taken into account by companies in the future. This applies in particular to M&A transactions, as ESG factors can give rise to compliance and, consequently, liability risks for investors. Factors that influence the purchase price are typically identified during the due diligence process. For this reason, it is worthwhile to incorporate ESG due diligence as a supplement to traditional due diligence (legal, tax, financial, commercial, etc.).
ESG due diligence examines environmental, social, and organizational factors. The focus is on uncovering reputational costs, identifying liability risks, and determining potential for value creation. In order to appropriately identify sustainability-related risks with potential negative consequences for corporate value or opportunities, it is crucial to consider the company’s individual risk profile and classify the target in terms of risk (e.g., based on size, industry, and business activities), which results in a customized questionnaire for that company.
The following test areas may arise from the individual categories:
- Environment: The impact of a company or target on the environment, as well as the influence of sustainability issues on the company (known as “double materiality” as defined by the CRSD Directive). This includes the company’s CO2 emissions, waste management, energy and water consumption, and the (uncontrolled) release of chemicals or toxic substances.
- Social: Interactions with employees (e.g., through analysis of the turnover rate), customers, and suppliers; supply chain management; and compliance with human rights and occupational safety standards.
- Governance: The quality, effectiveness, and efficiency of corporate management and organization. This also includes transparent and proper accounting (risk: vulnerability to fraud and noncompliance with laws), measures to prevent corruption—including the independence of supervisory bodies—and a functioning IT infrastructure.
Recommendations for Action Regarding the M&A Process:
- Buy-Side: ESG criteria should be reviewed and evaluated as part of an ESG due diligence process.
- Sell-Side: ESG criteria should be identified and documented ex ante—ideally as part of vendor due diligence—after a risk management system has been established or integrated into the compliance management system.
Conclusion:
ESG criteria are becoming increasingly important for companies and investors. Accordingly, it is crucial to examine the most significant criteria through ESG due diligence during a transaction. In the future, the results of an ESG due diligence will also be increasingly factored into corporate valuations, as the cash flows to be discounted can be determined more accurately following an ESG due diligence and may be influenced or reduced by the resulting outflows. For this reason, too, ESG will form a core element of every company’s future corporate culture and must be incorporated into business initiatives and financial reporting.
