Introduction

In South Africa and globally, the long-term implications of Environmental, Social and Governance (ESG) integration in due diligence processes on M&A transactions are yet to become fully apparent. However, as companies have progressively included ESG factors in their due diligence, these processes have been reported to cause the cancellation of more than half of all merger and acquisition (M&A) deals this year.

ESG is significantly more developed in finance and investment analysis, highlighting an opportunity to leapfrog the thinking of ESG in finance and investment analysis to M&A. By leaning on finance and investment analysis, this article unpacks how the evolving ESG landscape could influence future M&A activities and how this is likely to unfold, through enhanced assessment of litigation risk and the sourcing of funds for future M&A activities.

Background of ESG-related investing in South Africa

As a broad outline, South Africa’s investment environment is supported by a comprehensive legal structure that includes environmental protection, labour regulations, and takeover requirements. South Africa has also recently revised its anti-money laundering, terrorism financing, and financial sector regulations to align with international best practice. In the context of ESG factors, South Africa places a strong emphasis on governance frameworks, which are instrumental in sustainable and responsible investment practices. In particular, the King reports have played a fundamental role in shaping South Africa’s approach.

Foundationally, the King reports serve as a cornerstone for sustainable and responsible investment. King I established governance standards for listed companies and banks, which emphasized an integrated approach that considered social and environmental factors alongside financial ones. King II then brought sustainability into corporate governance discussions by introducing the triple-bottom-line concept. This trajectory in South Africa was further developed by the King III and King IV reports.

On the listed market, South Africa’s sustainable and responsible investment approach was solidified by the JSE’s Sustainable and Responsible Investment Index in 2004, a first in the emerging market context. Based on King II’s principles, this index identified companies that integrated responsible investment practices and provided investors with a comparative benchmark for companies.

The United Nations Principles for Responsible Investment (UN PRI) were developed in 2006, and assisted investors in analysing ESG characteristics more effectively through a common language for responsible investing. Signatories, including the (South African) Government Employees Pension Fund, committed to integrating ESG factors into their investment approaches. Finally, the Code for Responsible Investing in South Africa (CRISA) was developed after the UN PRI to offer practical guidance on analysing investments promoting sustainable development. The CRISA was updated in 2022. CRISA’s five principles have wide overlap with the UN PRI and encourage investors to incorporate sustainability considerations, including ESG, into their investment activities.

Collectively, the above serves as a framework of South Africa’s commitment to sustainable and responsible investment practices. Some of the impacts of these frameworks on the M&A space are substantial, including access to funding and litigation risk. Both impacts are unpacked further in the following section.

Investment analysis and impacts on M&A

Collectively, the framework outlined above articulates South Africa’s approach to sustainable and responsible investments. Beyond shaping responsible investment practices, these considerations are increasingly playing a role in the context of M&A transactions. In instances where M&A deals are backed by funders bound to the UN PRI, CRISA or other ESG-related codes, a due diligence process would need to give adequate consideration to ESG factors. The growing importance of ESG factors has led to investment decisions which align with funders’ ESG mandates, guiding capital away from projects with poor ESG ratings.

As ESG analysis in the finance and investment environment continues to evolve, progressively more rigorous reporting frameworks are governing sustainable and responsible investments. Beyond reporting, funders may be subjected to an increasing number of climate litigation cases. In the South African context, litigation against directors for breaches of fiduciary responsibilities is possible, among other potential claims. Funders should consider the risk of asset devaluation and the potential emergence of stranded assets that do not align with the transition to more sustainable economies.

By targeting acquisitions with a favourable ESG rating, M&A activity can provide opportunities for companies to improve their ESG practices and make their firms more marketable to ESG-inclined investors. By increasing a company’s ESG practices and scoring, boards may unlock easier access to funding. The heightened focus on ESG can also lead to greater transparency and accountability, fostering trust among stakeholders and, potentially, resulting in long-term sustainable growth.

For example, a company with a weaker ESG performance may seek to acquire a highly rated ESG company, bolstering its ESG performance and improving its overall ESG profile. Alternatively, a company may seek to divest from assets that have negative ESG impacts, improving the company’s ESG performance. This strategic alignment with ESG principles not only enhances a company’s reputation, but also positions it favourably in an evolving market where responsible and sustainable practices are increasingly valued by investors and stakeholders.

Conclusion

As M&A transactions involve the evaluation of target companies’ practices and potential risks, the principles of responsible investing provide a framework for the incorporation of ESG factors in the due diligence process. By considering ESG factors, investors can assess a target’s long-term sustainability, social impact, and alignment with company values, ensuring responsible decision-making in the M&A space.

Authored Shahid Sulaiman, senior partner and Davin Olen, an associate at Dentons in South Africa.