The "S" in ESG in the context of M&A transactions

What are the criteria behind the "S"?

Recently, it can be observed that social criteria are increasingly the subject of legislation. For example, the Act on Corporate Due Diligence in Supply Chains (Supply Chain Act) (Lieferkettensorgfaltspflichtengesetz - LkSG), which will come into force on 1 January 2023, also obliges companies based in Germany - usually with 3,000 or more domestic employees - to comply with human rights due diligence obligations. In addition, corporate social responsibility (CSR) reporting has been mandatory in Germany since 2017. This CSR reporting obligation also only applies to companies with a certain number of employees and does not necessarily mean that the respective contribution of the company within the corresponding ESG criterion can also be measured holistically. This is often not very meaningful because, despite the legislative activities for the assessment of social aspects, there has not yet been a uniform reporting standard so far and the majority of social criteria are qualitative or binary data that refer to contributions or mere intentions, whereas "E" criteria in particular can usually be quantified using concrete figures and are therefore measurable.

What is particularly difficult here is that the "social KPIs" cover a wide range of very different labour (protection) law, social, political and geopolitical aspects, such as reducing inequality, creating an inclusive working atmosphere and promoting greater diversity in the workforce. However, the "S" also regularly covers specific working conditions or the promotion of charitable causes. 

Typical topics and "social KPIs" are mainly:

• Working conditions and well-being: In particular, compliance with fundamental human rights and human dignity, but also the support of employees in their professional and personal development, a good work-life balance (e.g. through flexible working hours or mobile working) and the relationship between permanent and temporary employees. It is also relevant here whether there is collective bargaining coverage and the relationship with any employee representatives.
• Fair pay: In particular, the ratio between the remuneration of management and the average remuneration of employees (CEO pay ratio).
• Social responsibility: Assumption of social responsibility beyond the core performance of the company (especially in the context of donations and sponsoring activities for social, cultural and ecological projects (corporate giving)), but also the support of employees in taking on charitable activities (corporate volunteering).
• Supply chains: Observing socially responsible conditions along the entire value chain and implementing a corresponding risk management system.
• Occupational health and safety: In particular, the safe and ergonomic design of workplaces and the implementation of safety instructions and training.
• Equal treatment and diversity: In particular, indicators on the gender quota in management positions as well as the implementation and practical application of equal treatment and diversity policies.

Consideration of industry-specific and geographical features

It should be noted that these "S" criteria are based on general standards and should therefore not be understood as a rigid catalogue of checks. In the context of an "S" due diligence it is much more important to specify these rather general requirements with a view to the specific concerns of the target and to tailor them to the needs of the respective transaction. The general catalogue of criteria thus serves as a "construction kit", whereby the weighting or significance of the respective "social KPIs" depends in particular on the industry and the geographical characteristics of the respective target company (target).

While topics such as diversity or occupational health and safety play a particularly important role in Germany, this is completely different in other countries, for example. A company operating in the manufacturing sector may have a particular focus on risks in the supply chain (especially forced labour and child labour), whereas a company operating in the financial sector will not regularly be exposed to these risks to the same extent. Here, on the other hand, there may be an increased focus on flexible working time arrangements and work-life balance.

The OECD Guidelines for Multinational Enterprises, the ILO core labour standards (for an extension of the ILO core labour standards and their impact on ESG, see here), the ten principles of the UN Global Compact and ISO 26000 can be used for guidance in the "social assessment" of a company. Also, the draft ESRS S1 ("Own Workforce") of the European Financial Reporting Advisory Group (EFRAG) is particularly suitable. This contains criteria and performance indicators for reporting as well as corresponding application instructions. Based on this, a tailor-made catalogue of "S" criteria can be developed, using relevant industry experience and comprehensive knowledge of geographical features.

Carrying out an "S" due diligence as part of a legal due diligence

Many investors shy away from additional due diligence processes, such as an "S" due diligence, as they fear that this will result in further (high) transaction costs or delays in the transaction process. However, practical experience shows that the due diligence phase of a transaction is not significantly extended when "S" criteria are also taken into account. The risk assessment can be carried out on the basis of a tailor-made catalogue of "S" criteria, whereby it is often possible to use data and documents which have already been made available in the course of the legal due diligence anyway. For example, for the purpose of an employment law related legal due diligence, relevant HR policies on equal treatment and diversity as well as information on temporary workers and working time arrangements are usually provided. In addition, it is a good idea to address company-specific issues using the "S" criteria catalogue in an "ESG Expert Session" with the management (especially with regard to "soft" issues such as the company's social activities). Subsequently, the insights gained from this can then be processed for a comprehensive "S" report.

This (usually insignificant) additional effort associated with conducting an "S" due diligence is regularly compensated by the numerous advantages of a comprehensive social valuation of the target company, as the results from the "S" due diligence can be directly integrated into the M&A transaction process and any valuation issues. Any identified "S" risks, e.g. a risk of critical working conditions at a supplier in the supply chain, can be addressed and measures can be initiated, either before signing by the seller or after closing by the buyer. The latter can then also be taken into account during the purchase price negotiation, if the buyer has to budget resources for corresponding post-merger integration (PMI) measures. Another option are ESG-specific indemnities, for example from any future fines or contractual penalties that may result from a breach of the Supply Chain Act (sec. 24 Supply Chain Act).

Conclusion

The "S" criterion has so far been unfairly left in the shadows in the ESG universe and will gain - lasting - importance in the future. Particularly against the background of the threat of reputational damage that can result from social risks, a comprehensive "S" due diligence should always be carried out in the context of a transaction. In doing so, it is important to gain a transparent and meaningful picture of the social structure of the target company by means of an individual "S" criteria catalogue, taking into account industry-specific and geographical characteristics. In this way, corresponding risks can be identified in good time and taken into account in the context of company valuation and contract negotiation.