ESG Compliance in M&A: Due Diligence Guide

ESG compliance is no longer optional in M&A. It directly impacts valuations, deal terms, and long-term success. Over 75% of dealmakers report encountering ESG issues, and more than half have canceled deals because of them. Strong ESG practices can protect up to 10% of deal value and even command premiums of 3% or more.

Key takeaways:

• Risks: Environmental liabilities, labor violations, and governance gaps can erode deal value.
• Opportunities: Companies with mature ESG practices attract higher valuations and lower financing costs.
• Actionable Steps: Conduct thorough ESG due diligence, identify risks early, and integrate findings into contracts like warranties, indemnities, and purchase price adjustments.

With stricter regulations like the EU's CSRD and California’s SB 253 coming into effect, ESG due diligence is critical for safeguarding investments. The guide offers a step-by-step framework to identify risks, quantify impacts, and align ESG practices post-closing.

ESG Academy: ESG considerations in an M&A transaction

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Main Objectives of ESG Due Diligence in M&A

ESG due diligence plays a critical role in M&A transactions by addressing three key goals: identifying hidden risks, uncovering potential value, and aligning with stakeholder expectations. These objectives directly shape deal terms, pricing, and long-term outcomes. Let’s break down how each one impacts the overall transaction.

Identifying and Reducing Risks

ESG due diligence helps uncover risks that could jeopardize a deal. Environmental risks might include contamination, waste mismanagement, or high carbon emissions, all of which could lead to expensive cleanups or regulatory penalties. Social risks involve issues like labor violations, human rights concerns, or inadequate diversity policies. Governance risks cover weak anti-corruption measures, ethical lapses, and insufficient board oversight.

These risks aren’t just theoretical - they have measurable financial consequences. For instance, ESG due diligence can safeguard up to 10% of a deal's value, with the average preserved value being 5.4% ^[2]. A case highlighted by KPMG showed a private equity buyer reducing its bid by $10 million after uncovering environmental liabilities, poor working conditions, and governance shortcomings at the target company ^[7]. Such findings enable buyers to negotiate protections like indemnities or purchase price adjustments before closing the deal.

By addressing these risks, companies not only protect the deal’s value but also create a foundation for uncovering opportunities to enhance it.

Creating Value and Improving Deal Terms

Once risks are mitigated, ESG due diligence shifts focus to identifying ways to improve the deal. Companies with strong ESG profiles often benefit from lower operational costs, such as reduced energy expenses, and may access favorable financing options like green bonds or sustainability-linked loans. These advantages can directly enhance the financial appeal of a transaction.

Research shows that 77% of dealmakers believe companies with mature ESG practices command higher valuations. Additionally, 83% of M&A buyers are willing to pay at least a 3% premium for strong ESG credentials, while 14% would pay 6% or more ^[2][7].

"We can only achieve economic success in the long run if we also consider ecological and social aspects and anchor them firmly in our company... sustainable products and a reduced carbon footprint are increasingly becoming value-enhancing factors for which customers and investors are willing to pay a premium."
– Henning Schmischke, Head of M&A, Altana AG ^[2]

Meeting Stakeholder Expectations

ESG due diligence has evolved into a necessity for meeting the expectations of investors, lenders, employees, and customers. With 65% of M&A executives predicting a stronger ESG focus in the next three years ^[4], companies that fall short risk losing access to financing or investor confidence. Shareholders are also holding directors accountable for managing climate-related risks, with some even voting out board members over inadequate strategies ^[4].

This focus extends beyond large corporations. Smaller private companies are increasingly required to comply with ESG standards, especially when part of the supply chain for larger entities subject to regulations like the EU's Corporate Sustainability Reporting Directive (CSRD) ^[6]. Strong ESG credentials also help attract and retain top talent, particularly in industries where skilled employees are a key asset ^[8][6].

"Organizations that take initiative and embrace ESG in M&A will be better positioned to achieve sustainable growth and adapt to constantly evolving expectations."
– Myron Mallia-Dare, Partner, Dentons Canada LLP ^[4]

How to Conduct ESG Due Diligence: A Step-by-Step Framework

The first step in ESG due diligence is conducting a materiality assessment. Using frameworks like SASB or GRI, identify the ESG factors that significantly influence financial performance within the target's specific industry and region. This approach ties ESG insights directly to deal terms, bridging the gap between risk management and financial outcomes. From there, proceed through red-flag screening, deeper investigations into specific topics, data verification, and financial quantification. The ultimate goal? To turn ESG findings into measurable impacts on the deal.

When evaluating ESG governance, review board minutes and committee oversight to check for clear, time-bound ESG targets. As Charles Russell Speechlys explains, "Good ESG governance is often an indicator of good governance and effective management more generally" ^[6]. This early analysis reveals whether the target provides investor-grade data or will need significant post-closing work to meet exit requirements.

For mid-market firms, where ESG reporting can be underdeveloped, combine management interviews, site visits, and supply chain sampling with media scans and data analytics. This approach helps verify disclosures and uncover potential red flags, such as human rights violations, labor disputes, or environmental issues that might not appear in formal reports ^[9]. Notably, over half of global dealmakers have either canceled a transaction or adjusted the purchase price due to material ESG issues found during diligence ^[5].

To quantify risks, translate findings into financial terms - such as reserves for remediation, capital expenditures, or adjustments to EBITDA or the purchase price. For instance, carbon certificate costs per ton of CO₂ are expected to more than double between 2022 and 2029, which could significantly affect valuations for industries with high emissions ^[3]. These financial implications should directly influence deal terms, including representations, warranties, indemnities, and integration plans. With this framework in place, the next step is to focus on environmental due diligence.

Environmental Factors to Review

Start by assessing carbon intensity across all three scopes: Scope 1 (direct emissions), Scope 2 (purchased energy), and Scope 3 (supply chain and product use). This is crucial as carbon certificate costs continue to climb, and buyers face growing pressure to align with net-zero goals. Conduct Phase I and Phase II environmental assessments to uncover any legacy contamination. Be especially vigilant about emerging risks like PFAS (per- and polyfluoroalkyl substances), which can lead to costly cleanups and regulatory penalties.

Resource use and waste management are also critical. These practices directly impact operating costs and compliance. For example, about 65% of traditional plastics remain in the environment a year after disposal, driving a shift toward bioplastics in the packaging sector ^[3]. Review waste disposal contracts, recycling efforts, and any history of environmental violations. Additionally, map out climate-related physical risks - such as facilities located in flood zones or supply chains vulnerable to extreme weather. These risks often translate into capital expenses for retrofitting, remediation reserves, or exposure to carbon taxes, all of which can influence the bottom line.

Social Factors to Examine

Social factors require a close look at labor practices, including wage compliance, working conditions, and safety records. Investigate past labor disputes, union negotiations, and workplace accidents. Employee retention and satisfaction metrics can shed light on workplace culture and governance challenges. For example, in 2021, 37% of private target deals included a "#MeToo Representation" related to sexual harassment or misconduct, up from 13% the previous year ^[11]. This trend highlights the increasing importance of addressing social risks in deals.

Supply chain ethics are another priority, especially for consumer goods companies. Map Tier 1 and Tier 2 suppliers to identify risks like forced labor, which could lead to customs detentions or reputational harm. Data privacy and cybersecurity also fall under social factors. Review the target's compliance with regulations like GDPR or CCPA and check for any history of data breaches. These issues can carry significant financial penalties and damage the company's reputation, undermining its "license to operate" with customers and employees.

Governance Factors to Analyze

Governance due diligence starts with examining board composition and oversight. Look for diversity, independence, and relevant expertise among board members. Determine which committees - such as audit, nominating, compensation, or ESG-focused committees - oversee sustainability issues and assess the quality of information they receive. As Cooley LLP points out, "A culture that doesn't permit dissent or value the feedback of employees of all levels is at risk of having more hidden issues" ^[11]. Strong governance is the backbone of effective ESG integration.

Anti-corruption policies and internal controls also demand attention. Review whistleblower programs, ethics hotlines, and records of reported violations. Evaluate executive compensation structures to see if they align with long-term ESG goals or incentivize short-term gains. Additionally, check for any history of regulatory fines, litigation, or stakeholder activism. Strong governance can lower the cost of capital, as rating agencies increasingly factor ESG into credit ratings ^[6]. Weak governance, on the other hand, signals higher risks of penalties and loss of investor trust - key considerations when determining valuation and deal terms.

Adding ESG Findings to M&A Agreements

Incorporating ESG findings into deal documents is a smart way to safeguard your investment and ensure the target company aligns with future regulatory or exit requirements. A survey by BCG found that addressing ESG concerns can help preserve 5.4% of deal value ^[2]. By turning ESG due diligence insights into enforceable commitments, you can minimize hidden risks and maximize deal outcomes.

Many ESG standards are voluntary guidelines, often referred to as "soft law", rather than binding regulations. This means traditional "compliance with law" clauses won't cover these areas. Instead, tailor provisions to directly address the risks identified during your review.

"ESG due diligence findings can have a significant impact on the drafting of share purchase agreements. Buyers need to ensure that the targets they acquire correspond to their ESG profile by identifying the key risks and opportunities prior to signing." – Dominique Gottret, Partner and Head of Corporate & Business Law, KPMG Switzerland ^[1]

Representations and Warranties

Craft specific representations to address risks like supply chain vulnerabilities or social issues. For example, if due diligence highlights supply chain problems, require the seller to confirm that Tier 1 suppliers comply with standards such as the German Supply Chain Duty of Care Act or the OECD Guidelines for Multinational Enterprises.

"Care should be taken to ensure that references to any standards and/or regulations identify the specific soft-law provisions the buyer would want to rely on to ensure they are considered binding on the target company." – Norton Rose Fulbright ^[13]

For social risks, include clauses addressing issues like sexual misconduct. In 2021, 37% of private target deals included such provisions, compared to just 13% in 2020 ^[12]. If the target has public ESG commitments, such as achieving "Net Zero by 2030", include warranties ensuring these goals are actively pursued.

Use your due diligence findings to set measurable baselines. For instance, if the target reports 50,000 metric tons of Scope 1, 2, and 3 CO₂ emissions, include this figure in the warranty to ensure transparency. This approach turns vague ESG commitments into concrete obligations. Beyond warranties, specific indemnities can address known ESG liabilities.

Indemnities and Risk Allocation

Negotiate indemnities to cover potential losses tied to ESG risks like soil contamination, PFAS exposure, or regulatory violations. According to BCG, 30% of deals with material ESG findings included indemnities, escrow arrangements, or required remedial actions by the seller ^[2].

You can also adjust the purchase price to account for assumed risks or remediation costs. In 15% of cases where ESG issues were identified, buyers reduced the purchase price accordingly ^[2]. Alternatively, escrow or holdback arrangements can reserve a portion of the purchase price to cover future losses if ESG problems arise within a specified timeframe.

While Warranty & Indemnity (W&I) insurance covers unknown breaches of codified ESG standards, contingent liability insurance may be necessary for known risks. Be precise in defining triggering events and damages in indemnity clauses to avoid disputes. For instance, instead of vaguely mentioning "environmental liabilities", specify "costs arising from PFAS contamination at the Springfield facility exceeding $500,000."

Once contractual safeguards are in place, focus shifts to integrating ESG standards post-closing.

Post-Closing Integration Plans

After the deal closes, align the target's ESG practices with your own standards. Create clear action plans that might include forming a sustainability committee at the board level, appointing ESG-focused directors, and ensuring the target can produce high-quality data to meet reporting requirements under frameworks like the EU's Corporate Sustainability Reporting Directive (CSRD) or California's SB 253, which mandate consolidated reporting between 2026 and 2028.

Look for operational improvements that can deliver both ESG benefits and financial returns. For example, upgrades like energy-efficient systems, waste heat recovery, or transitioning vehicle fleets to electric models can reduce emissions while cutting costs. If supply chain risks like forced labor or child labor were flagged during due diligence, audit and renegotiate contracts early to avoid reputational damage.

You might also tie part of the purchase price or post-closing bonuses to achieving specific ESG milestones. This keeps the seller engaged in addressing any gaps identified during due diligence.

"ESG diligence is not a moral overlay. It is a financial clarity tool. It helps you answer simple questions: Will cash flows show up as modeled? Will you need to spend more than you thought to operate legally and competitively?" – Ian, M&A and Post-Merger Integration Expert, E2E Deal Insights ^[5]

Common ESG Red Flags and How to Address Them

Seventy-five percent of dealmakers encounter material ESG issues that can chip away at deal value if not dealt with properly ^[8]. Taking a proactive stance can save an average of 5.4% of deal value, while ignoring these red flags often leads to post-closing liabilities that erode returns ^[8]. Using a solid due diligence framework, the following red flags highlight ESG risks that demand immediate attention. When caught early, these issues can be addressed with strong contractual protections.

Environmental Risks and Solutions

Legacy contamination can become a major financial burden in M&A deals. Under strict liability laws like CERCLA, buyers could face hefty cleanup costs for pollution - even if it occurred before the acquisition ^[5]. Conducting Phase I/II environmental assessments for all real property is a critical first step.

PFAS exposure is another growing concern. These "forever chemicals" are found in industries like manufacturing, textiles, food packaging, and semiconductors ^[5].

Climate transition risks also deserve a close look. High carbon emissions - whether Scope 1, 2, or 3 - could mean future capital expenditures for decarbonization or the risk of assets becoming obsolete. Assessing remediation costs, energy retrofit needs, and the target's ability to operate in water-scarce areas or sensitive biodiversity zones is vital ^[5].

To tackle these risks, consider tools like indemnities for known contamination, purchase price reductions based on cleanup estimates, and isolating contaminated assets into separate entities ^[1][5]. For urgent matters like permit transfers or cleanups, make their resolution a condition for closing ^[1].

Social Risks and Solutions

Poor labor practices can lead to lawsuits and tarnished reputations. Look for issues like wage violations, unsafe working environments, or supply chain problems involving forced or child labor.

Weak workplace culture and strained community relations often hint at deeper operational challenges. A disconnected management team or lack of diversity could signal trouble. Site visits and employee interviews can provide insights beyond what’s visible in the data room ^[12].

In addition to social risks, governance issues also require immediate attention.

Governance Risks and Solutions

Weak board oversight is often a deal-breaker. If the target lacks a dedicated ESG team, board-level involvement in sustainability, or executive training on ESG risks, there could be a significant management gap ^[8][9]. This becomes even more pressing with new regulations like the EU's Corporate Sustainability Reporting Directive (CSRD).

Data privacy and cybersecurity vulnerabilities are critical governance concerns. Poor protection of customer data or the use of biased AI can lead to fines and reputational damage. Review the target's incident response plans, breach history, and audit logs to gauge these risks ^[4][7].

Corruption and bribery allegations pose immediate legal and reputational risks. Watch out for violations of the U.N. Global Compact, lack of anti-corruption measures, or a history of enforcement actions. For example, in May 2022, AGL Energy, Australia’s largest emitter, abandoned a high-profile demerger plan due to governance issues and shareholder pressure over decarbonization misalignment ^[5].

Transparency and reporting gaps are becoming more critical as disclosure requirements grow stricter. If the target can’t provide measurable ESG data or clear targets, it risks falling short of investor and regulatory expectations ^[8][9]. Use media scans and big data tools to uncover "soft" governance risks like stakeholder activism or reputational controversies that traditional audits may overlook ^[9].

"Governance-related issues are often the primary reason for abandoning a deal." – Gibson Dunn / BCG ^[8]

To address governance risks, adjust the purchase price to reflect the cost of implementing stronger oversight structures ^[1][8]. Make it a closing condition for the seller to establish an ESG committee or appoint a Chief Sustainability Officer ^[1][4]. For compliance gaps, negotiate specific indemnities to cover past misconduct and potential future penalties ^[1][8].

"ESG diligence is not a moral overlay. It is a financial clarity tool. It helps you answer simple questions: Will cash flows show up as modeled?" - Ian, M&A Expert, E2E Deal Insights ^[5]

Spotting and addressing these red flags early not only safeguards your investment but also strengthens your negotiating position. By translating ESG findings into enforceable protections, you can help preserve deal value and avoid future liabilities.

Conclusion: How ESG Drives M&A Success

ESG due diligence has become a critical factor in M&A transactions. A striking 75% of dealmakers report encountering material ESG issues during deals, and over half of transactions have been canceled because of ESG red flags ^[8][5]. Proper ESG assessments can protect up to 10% of deal value ^[8].

The financial benefits are clear. Companies with strong ESG credentials often command premiums of over 3%, while those with poor ESG performance face similar discounts ^[7]. Beyond valuation, ESG compliance opens doors to lower-cost green financing, cuts operational costs through energy efficiency, and boosts relationships with key stakeholders like customers, employees, and regulators. In short, higher ESG maturity translates directly into a competitive edge.

Regulatory changes are accelerating this trend. Mandatory disclosure requirements in places like the EU and California are forcing mid-market companies to meet the same ESG standards as their larger counterparts ^[10][5]. By assessing ESG risks and embedding protections into contracts, as discussed in earlier sections, mid-market business owners can safeguard deal value and gain actionable strategies for success.

Key Takeaways for Mid-Market Business Owners

• Start early. Incorporate ESG red-flag checks during the target identification phase. Techniques like media scans and preliminary environmental assessments can help uncover potential issues early ^[9].
• Quantify findings. Translate ESG risks into financial terms, such as remediation costs or EBITDA adjustments, to negotiate better purchase price adjustments, indemnities, or escrow arrangements ^[5][8].
• Strengthen contracts. Use targeted indemnities for known ESG risks, broad representations and warranties for unknown risks, and ensure remediation commitments are secured as part of closing conditions ^[4][8].
• Bring in experts. ESG due diligence requires specialized knowledge to interpret complex regulations, apply industry-specific benchmarks, and catch risks that general audits might miss ^[8][10].
• Plan for integration. Post-closing, align the target’s policies with your corporate values and reporting structures. Misalignment can undermine expected synergies ^[4][9].

How Phoenix Strategy Group Can Help

Phoenix Strategy Group offers tailored support throughout the entire M&A process, helping growth-stage companies navigate ESG complexities. From initial target screening to post-closing integration, they bring expertise to every stage.

Their team specializes in quantifying ESG risks, translating environmental, social, and governance issues into financial models that guide valuation and deal structuring. With fractional CFO services and FP&A capabilities, they integrate ESG insights into cash flow projections, forecasts, and capital planning.

Whether you’re preparing for an exit or evaluating acquisition opportunities, Phoenix Strategy Group provides the clarity and tools needed to protect deal value and position your business for long-term success. Learn more at phoenixstrategy.group.

FAQs

What ESG issues are most likely to kill a deal?

Significant environmental liabilities, governance weaknesses, labor-related social risks, and supply chain violations are among the most frequent ESG issues that can disrupt deals. These challenges often lead to canceled agreements or major price renegotiations, as they carry serious financial and reputational risks for the parties involved.

How do you price ESG risks into valuation and the purchase agreement?

When evaluating a company's worth and structuring purchase agreements, ESG risks play a crucial role. During due diligence, potential liabilities, risks, and opportunities tied to environmental, social, and governance factors are thoroughly analyzed. If any material ESG issues are uncovered that could impact the value of the deal, the purchase price is adjusted accordingly. This ensures that these factors are properly reflected in the transaction, safeguarding the investment.

What should governance due diligence focus on first?

Governance due diligence starts with pinpointing and assessing gaps, risks, and compliance issues that could impact the transaction's value or reputation. Tackling these challenges early helps address potential problems and reduces the risks tied to governance weaknesses.

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