The Basics

As most are familiar with, ESG is an acronym for ‘Environmental’ (for example energy efficiency or environmental protection), ‘Social’ (for example occupational safety or promoting diversity) and ‘(Corporate) Governance’ (for example avoiding corruption or implementing sustainable corporate governance). These three factors are being taken into consideration by a growing number of entrepreneurs and investors in various decision-making processes, such as (acquisition) target selection and the structure of acquisition financing.

The increasing relevance of ESG factors has been anticipated for several years, and in 2021 over 40% of acquisition financing syndicated in Europe included ESG criteria. The growing number of signatories to the Principles of Responsible Investment in particular reflects the increasing interest of entrepreneurs and investors. Recently, there has been a continuous increase in the legally required disclosures on how a company deals with ESG factors. The most recent stricter statutory requirement under national law came into force on 1 January 2023 with the German Act on Corporate Due Diligence Obligations in Supply Chains (Lieferkettensorgfaltspflichtengesetz, or LkSG for short).

Reporting requirements for companies

CSR, ESG, NFRD and CSRD

While Corporate Social Responsibility (CSR) provides a framework for the general social responsibility of companies in the sense of sustainable business practices, ESG aims to make the results of CSR efforts and compliance with the required framework measurable. However, in order for ESG factors to be used in acquisition financing, they need to be accessible.

As a result of the Non-Financial Reporting Directive (NFRD), which has been implemented in §§ 289b-e and 315b-d of the German Commercial Code (HGB), some companies are currently obliged to disclose ESG factors. In particular, this covers the development of their environmental, employee and social concerns, respect for human rights, and the fight against corruption and bribery. Due to difficulties in practical application and imprecise definitions, the NFRD was replaced by the Corporate Sustainability Reporting Directive (CSRD) in 2024, which in particular extended the scope of the NFRD to all corporations, banks and insurers and underlined the principle of double materiality. However, both directives pursue the same goal of creating a Europe-wide uniform standard for sustainability reports.

EU Commission Action Plan

With its action plan: Financing sustainable growth, the EU Commission has now set its sights on a much larger goal. At its core are the EU Taxonomy Regulation, which has already been adopted, and the closely related Sustainable Finance Disclosure Regulation (SFDR), often also referred to as the Transparency Regulation. The former extends the annual reporting requirement to include information on economic activities that are deemed environmentally sustainable in accordance with the regulation's extensively defined annex. The central point of this regulation is the definition of the six environmental objectives: climate change mitigation and adaptation, protection of water and marine resources, transition towards a circular economy, pollution and biodiversity.

The SFDR is intended to create transparency in the financing of sustainable economic activities by obliging professional investors to publish information on the ‘sustainability’ of the financial products they offer (excluding shares and bonds). Ultimately, this will put financial and non-financial reporting on an equal footing, which in turn will increase the relevance of environmental and social objectives.

The German Act on Corporate Due Diligence Obligations in Supply Chains

In addition, the German Act on Corporate Due Diligence Obligations in Supply Chains (LkSG) came into force on 1 January 2023. From this year onwards, companies with at least 3,000 employees, and from 2024 companies with at least 1,000 employees, are obliged to become more accessible and transparent in the area of human rights and environmental protection with regard to their supply chains. Affected companies must identify, assess and prioritise risks in their supply chains and publish the data they have collected in a policy statement. In addition, appropriate measures must be taken to minimise the risks identified. After producing such a policy statement, reporting on supply chain management must take place at regular intervals. Non-compliance with due diligence requirements can result in fines and exclusion from public procurement. The amount of these fines can be up to EUR800,000 (§ 24 (1) LkSG) or, for companies with an annual turnover of more than EUR400 million, up to 2% of global turnover (§ 24 (3) LkSG). From the point of view of the regulated companies, with regard to certain locations, this often means nothing more than a legislatively imposed compulsion to exit economically vital markets if they do not want to come into conflict with national or European requirements and face drastic sanctions. It is rather doubtful whether such an exit by European companies would be accompanied by an improvement in working conditions locally. The controversial nature of this legislation is reflected, among other things, in a legislative initiative by the German Christian Democratic Party (CDU/CSU) dating 14 June 2024, by which the party has submitted a bill "to repeal the Act on Corporate Due Diligence Obligations in Supply Chains completely".

EU-wide Supply Chain Directive

In addition to the LkSG, the European Union enacted the EU-wide Supply Chain Directive, the Corporate Sustainability Due Diligence amending Directive (CSDDD), in the summer of 2024. This goes further than the existing LkSG, because the directive already applied to companies that employ more than 1,000 people and generate a turnover of at least  EUR450 million . The directive requires a double materiality check and stricter accountability, which must also be met by non-EU companies if they generate more than EUR450 million net sales in the Union. In addition, the directive requires disclosure of the entire supply chain, as well as users and disposers of products. The LkSG currently only requires transparency with regard to direct suppliers. The consequences of non-compliance are also more far-reaching: under the directive, those affected could claim damages against the company in European courts. The CSDDD is to be transposed into national law by the member states within two years of its entry into force.

Two standards have been established to improve comparability and to verify the quality of these reports and data: (1) the German Sustainability Code (DNK) and (2) the Global Reporting Initiative (GRI). In addition, sustainability rankings are prepared by various providers, mostly on behalf of investors. In order to extract reliable data from this multitude of information, various key figure systems have been developed that enable the calculation of ESG scores.

Areas of application in acquisition financing

ESG in target selection

These developments in the ESG area have also found their way into acquisition financing. On the one hand, they can be used in the selection of the target and, on the other hand, they can have an impact on the financing margin. While a traditional valuation system mainly takes into account the growth potential of the target company, ongoing charges (eg additional acquisitions or expensive research and development work) and the secured market position and market potential of the products when selecting the target, ESG factors enable a more extensive risk assessment. Taking ESG factors into account makes it possible to better assess a company's reputation and predict its development. The company reports described above provide data that can help to anticipate possible scandals and a company's social recognition. Since 2022, the EU taxonomy can be used to assess when a company can be classified as ‘sustainable’ or ‘environmentally friendly’. A risk assessment with regard to the ESG factors is or should also be carried out, as this allows the default risk of a loan to be assessed from a different perspective and a corresponding response to be made.

ESG in the design of the facility agreement

Potential responses to the evaluated risks can be reflected in the specific design of the financing. The core element here is the adjustment of the margin through the achievement of contractually agreed ESG-related performance indicators or a certain sustainability ranking. Such an agreement can go in either direction. An adjustment is possible both downwards (so-called ‘margin step-down’) and upwards (so-called ‘margin step-up’) as a result of achieving or not achieving an agreed ESG target. Based on current market observations, the margin can be adjusted within a range of 2.5 to 15 basis points. Agreements of this kind, as a condition subsequent, are increasingly being found in contractual documents. However, no guarantee can be given for such a specific arrangement, as no market standard has yet been established. It can also be observed that the credit period can be influenced by ESG factors, with companies with a negative ESG level being granted shorter periods. In addition, ESG components can play a role in the case of accession obligations. Nevertheless, such agreements do not constitute hard obligations, and non-compliance does not usually justify termination.

Conclusion

The relevance of ESG in acquisition financing arises in particular from the fact that these apply at various points in the financing process. Since the entry into force of the LkSG, it is no longer possible to avoid dealing with the ESG goals that one has already achieved and those that still need to be achieved, and to establish a compliant monitoring system in the companies concerned. It should be noted that both the German and the European legislator are planning even more far-reaching provisions. Dealing with the now hard legal reality of ESG is unavoidable.

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To discuss the issues raised in this article in more detail, please contact a member of our Banking and Finance team in Frankfurt.