Sehrish Siddiqui
Sehrish Siddiqui is a member with law firm Bass, Berry & Sims and focuses on ESG.
Davis Mello
Davis Mello is a member with law firm Bass, Berry & Sims.

Mergers & Acquisitions recently announced the inaugural PE Innovators in ESG list, and this week, the publication is bringing the industry together for the PE Innovators in ESG Speak virtual event.

Private equity sponsors are coming under increased pressure from limited partners to develop more robust practices around environmental, social and governance (ESG) matters. They are being pressed to expand the scope of their traditional due diligence efforts to consider in a structured way ESG factors that might have previously been thought to be outside the scope of typical diligence for private middle market companies. Private Equity International’s LP Perspectives 2021 study indicated that ESG factors are gaining greater weight in due diligence, with 88 percent of investors taking a manager’s consideration of ESG factors into account while conducting due diligence.

As attorneys at Bass Berry & Sims, we share our insights on ESG due diligence, below.

Challenges and Benefits of Addressing ESG in the Middle Market

This increased focus on ESG presents a challenge for the middle market, where acquisition targets may not have robust internal governance and compliance infrastructure or the resources to dedicate to ESG-related matters. Additionally, PE firms face a unique mandate to produce substantial returns quickly, leaving little time to address a broad range of ESG matters in addition to pursuing growth opportunities and building out more basic compliance functions.

In many middle market deals, especially those involving high-growth targets, it is common for targets to have devoted relatively little attention to ESG. In these instances, ESG diligence often becomes primarily an exercise in identifying items for monitoring and follow-up as part of an extended post-closing process. 

Even for those targets that have dedicated significant resources to certain ESG initiatives, ESG diligence findings may be difficult to evaluate without clear criteria to measure against. While standard-setters have begun consolidating industry-specific frameworks for evaluating targets and managing portfolio companies, many middle market sponsors have been left to develop their own policies and processes around ESG matters, a task made even more challenging given the lack of public disclosure regarding how other private entities implement ESG initiatives. 

However, despite the challenges of addressing ESG in the middle market, the increasing focus presents opportunities for sponsors. First, as limited partners continue to place more emphasis on ESG, effectively addressing ESG matters in transaction diligence will help sponsors attract capital. Second, identifying ESG concerns in diligence can enable sponsors to reduce potential legal, reputational and other risks through strategic legal and/or accounting measures ahead of closing. Third, enhanced focus on ESG in the diligence process can improve portfolio company performance following closing. The diligence process can raise awareness within the target organization of important ESG considerations, and management and other employees may be energized by an enterprise’s attention to these matters. 

Engaging with Advisors to Identify ESG Concerns

In addition to retaining counsel with experience conducting ESG-related diligence, sponsors should consider retaining other relevant specialists to assist. Depending on the nature of the target’s business, this may include environmental, cybersecurity, human capital or other specialists. When retaining ESG professionals, sponsors should consider which would be more helpful: an ESG specialist working alongside staff or a general consultant that also has ESG expertise. If the former, sponsors should be sure the ESG specialist understands the general corporate and investment landscape as it is difficult to separate ESG from other corporate matters.

A sponsor desiring to cultivate a particular focus on ESG investing may consider hiring dedicated ESG investment professionals. Often, ESG-focused firms hire dedicated analysts who identify ESG issues relevant to specific regions and industries. These professionals are responsible for staying abreast of evolving regulations and policies, evaluating ESG data providers and systems, and educating the sponsor’s internal investment professionals.

In all cases, it is important to take into account relevant experience when retaining an ESG professional. Consider the working knowledge and experience of the industry and region the company operates, familiarity with competitors of the business and their related practices, and knowledge of the various ESG metrics to help measure where companies stand against these standards. 

How to Prepare for a Diligence Process that Includes ESG

Sponsors should establish ESG guidelines that include a list of ESG matters that must be addressed in transaction diligence. Many ESG diligence factors, such as labor practices, corruption and regulatory compliance, will already have been part of traditional legal due diligence, but others may be new, such as a company’s impact on biodiversity, cybersecurity or approach to human capital risks.

A formal policy and ESG diligence checklist will help ensure consistency across the portfolio and satisfy limited partner requirements. Sponsors should solicit input from legal advisors and relevant subject matter experts to ensure this ESG diligence checklist is appropriately scoped. This process can also help identify risks specific to industries. For financial technology companies, for example, data breaches can damage their financials and reputations, so sponsors can focus their research on the adequacy of data privacy and security programs. For consumer companies, ESG risks often lie within the supply chain, so the focus could be on balancing cost with quality as part of the ongoing dialogue with company management.

Once a formal ESG diligence checklist has been developed, sponsors should work with legal counsel and other third-party advisors who will be involved in the diligence process to ensure that due diligence request lists submitted to a seller include all appropriate inquiries necessary to satisfy their ESG imperatives. A sponsor might also meet with a target’s key stakeholders, including employees and customers. These meetings can give a better sense of how the management team operates and whether the company is being thoughtful about things like talent retention, which can be integral to a private company’s future success and can provide a better sense of a target’s corporate governance – which can impact the success of a private company’s exit strategy.

Best Practices in ESG Due Diligence

In addition to identifying legal and other risks to address in the context of a transaction, a robust ESG diligence process can help improve post-closing portfolio company management. Middle-market sponsors already dedicate substantial resources to transaction diligence – as they continue to take a more proactive approach to ESG, they should leverage that diligence process to generate a post-closing roadmap to integrate ESG best practices.

Sponsors should be thoughtful about engaging appropriate advisors and developing a relevant ESG due diligence policy and checklist. Sponsors should consider asking legal and other advisors to specifically address ESG in their due diligence reports – or, to prepare supplemental reports specifically focused on ESG. Following closing, sponsors should follow up on issues identified in these reports to create a plan to implement improved processes and policies around ESG matters. If dedicated internal resources are not available, sponsors should rely on experienced legal counsel and other third-party advisors to develop a post-closing checklist and navigate a multi-disciplinary implementation plan.