Companies must consider environmental, social and governance (“ESG“) factors in their mergers and acquisitions (“M&A“) transactions to achieve maximum value and monitor risks. ESG matters are becoming increasingly significant in M&A transactions as businesses are facing mounting scrutiny and pressure for transparency on climate risk, social justice, sustainability, and corporate governance. To address ESG considerations in the context of an M&A transaction, buyers, including private equity funds and strategic acquirers, should conduct ESG-focused due diligence, allocate ESG risk in the transaction agreement, and perform post-close ESG integration.
Following the uncertainty of 2020, it was a record-breaking year for corporate acquisitions in 2021. We are seeing that picture continue into 2022, with leading financial data analysts citing valuations reaching new highs, plentiful investment capital, strong equity markets and cheap debt. Meanwhile, the HR world has seen significant changes, what with the impact of Covid, the increasing importance of sustainability and other environmental, social and governance (ESG) issues and ever-stronger regulation on issues such as diversity and gender pay gap reporting. How are those trends affecting the way in which buyers approach pre-acquisition HR due diligence on the target company? This article explores the position in the UK and some of the key jurisdictions in Europe, starting with a look at how the new EU Directive on Corporate Sustainability Reporting forms the backdrop to these trends.
UPCOMING EU CORPORATE SUSTAINABILITY REPORTING DIRECTIVE
The EU Directive on Corporate Sustainability Reporting (CSRD) aims to further the European Green Deal adopted in 2019, the EU’s strategy to achieve climate neutrality by 2050. It is expected to apply to financial years as early as 2023. The CSRD expands the scope of the existing Non-Financial Reporting Directive (NFRD), brought in nearly 8 years ago, and will require all large companies to report on environmental matters, social and employee issues including gender equality and equal pay, human rights, bribery and anti-corruption, and diversity. Under the CSRD, as well as large companies, all companies listed on EU-regulated markets will also be obliged to report on those ESG matters (albeit that SMEs will have an initial grace period of 3 years).
The CSRD introduces more detailed reporting requirements compared to the existing regime. Companies must provide information which covers their strategy, targets and the role of the board and management. They must report on the principle adverse impacts connected to their value chain. Information should be both qualitative and quantitative, forward-looking and retrospective. Reporting must be done in the management report (it cannot be buried in some other report). It must meet European sustainability reporting standards; and companies must engage auditors to audit their reports.
The CSRD reflects the significant increase in demand for corporate sustainability information in recent years, especially from the investment community, given the changing nature of risks to companies and heightened investor understanding of the financial ramifications of those risks. It sets the tone for a shift in approach when buyers are assessing a target company’s performance in the pre-acquisition due diligence process. While the legal remit of the CSRD may not extend beyond the EU, it will clearly have practical ramifications in global M&A. Notably, EU-based subsidiaries of US-based multinationals will fall within its scope.
Against that background, we take a closer look below at how the HR due diligence scene is evolving in the UK, Spain, France and Germany.
Recent years in the UK have seen a fundamental shift in due diligence relating to ESG, especially on larger transactions. Whereas in previous years a buyer might have included a few questions on ESG in its due diligence enquiries, ESG is now a more integral part of both investee/target business planning and investor/buyer value profiling. Positive requirements on investees to maintain minimum standards are increasingly common, as well as implementation of ESG strategies within integration plans (commonly covering the first 90 days).
All businesses are under a collective pressure to slow the rate of climate change and buyers want to know whether a target company’s policies, workplaces, and ways of working are environmentally sustainable. Increasing expectations on businesses to demonstrate good social and ethical behaviour has also led to an increased focus on a target company’s values as part of due diligence.
For many buyers, assessing the target company’s diversity and inclusion performance will be a key factor. This is unsurprising given research which shows that companies with greater diversity perform better than their competitors. Gender pay reporting remains a useful tool for buyers to assess equality across genders within a business. Buyers carrying out their due diligence want to ensure the target company has complied with its reporting obligations, shows an understanding of those obligations, and has committed to take appropriate actions where there is a gap. Whilst the UK government has announced that ethnicity pay gap reporting won’t be mandatory, many employers are choosing to do it anyway and a buyer may want to assess these statistics as part of its due diligence enquiries. Areas such as positive action initiatives and diversity-related policies will also be in scope.
Due diligence processes in Spain have been heavily impacted in recent years by increasing regulation on diversity. All companies in Spain are now required to prepare a detailed gender pay report. Companies with 50 or more employees have to negotiate an equal treatment plan with their workers’ representatives or trade unions. Due diligence focuses both on compliance with the obligations and on the impact the corporate transaction might have on those obligations - including whether the deal will trigger certain requirements and how it will impact equal treatment indicators or agreed measures to reduce inequality.
Another main area of concern to buyers is how the target company is coping with the requirement to keep an accurate working time register and with Spain’s restrictive legal regime for working time. Again, the analysis focuses both on the target’s compliance with the law and on whether the business would be feasible or provide the same level of profitability if changes needed to be implemented to ensure full compliance.
The current economic situation also means that buyers need to be concerned about any limits on their scope for restructuring the target company’s business after the acquisition. The past three years have seen restrictions and checks on dismissing employees aged 50 or above. This can increase the cost of collective dismissals, as a company must pay compensation if employees in that age bracket are disproportionately impacted by dismissals. Collective agreements may also limit a company’s freedom to implement restructuring measures. Due diligence enquiries also currently include an analysis of the Covid-related support schemes the company might have claimed under, primarily to assess whether dismissals had taken place when it was a condition of grant that employment was maintained – which could result in a company being required to make repayments.
In France, new trends can be seen across the sorts of due diligence enquiries prospective buyers are raising.
Since August 2021, employee representation in France has formally extended to environmental issues. Employers must inform the Social and Economic Committee about the environmental consequences of the company’s actions or proposals. This was a significant elevation of the SEC’s role; and due diligence increasingly examines compliance, which might be demonstrated through written documents and minutes of meetings with the SEC.
More recently, at the end of 2021, France passed a new law obliging large French companies (those with over 1000 employees across the past 3 years) to ensure at least 30% representation of women and men across management committees and at the senior executive level. Buyers are seeking specific information on gender breakdown as part of their due diligence to assess compliance – not least because there are financial penalties for failing to meet the quotas.
In 2017, a Corporate Duty of Vigilance Law was introduced in France, obliging companies to create a comprehensive plan to identify, mitigate and prevent serious violations of human rights and the environment. Since then, there has been a heightened focus on the target company’s compliance with international standards relating to the human rights of workers, including the OECD Guidelines for Multinational Enterprises (a set of recommendations from governments to multinational enterprises on responsible business conduct). A more in-depth assessment is anticipated once the CSRD comes into effect.
Last but not least, Germany is also experiencing a number of new trends impacting the due diligence process.
Risks arising from “union-busting” or other anti-employee representation practices in other group companies or along the supply chain are now being examined more closely. Good employee relations are also likely to become a selling point in the future. The CSRD will require companies to disclose more information about how they ensure that human rights and fundamental freedoms are respected, including the right to form and join a trade union, as enshrined in the EU Charter of Fundamental Rights. It is anticipated that due diligence in Germany on a target company’s approach to trade unions will therefore expand even further.
There are also risks arising from low ESG ratings, limiting access to capital markets. “Dinosaur” businesses as they are colloquially known (i.e. those businesses producing lots of waste, emissions, non-sustainable products, etc.) are increasingly finding it difficult to source financing and investors.
For regulated industries in Germany (such as financial services) ESG criteria must typically be reflected in remuneration systems to some extent and there has been increased effort during due diligence enquiries to ascertain how and whether criteria are met.
Gender pay gap reporting does not play a significant role (yet) in due diligence in Germany. However, that will almost certainly change once the CSRD is in force.
Due diligence, the key to the closet hiding the secrets, always moves with the times in M&A. Increasing numbers of investors see ESG as a fundamental driver of financial success, meriting a closer analysis of ESG key performance indicators. Meanwhile, the evolving international legal framework continues to promote greater corporate transparency and accountability. “Green” due diligence is, without a doubt, on the up.