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CFA, Senior Manager, Advisory
In recent years, there has been a silent revolution in the due diligence of corporate transactions. In addition to traditional due diligence - such as financial due diligence or tax due diligence - the examination of environmental, social and governance (ESG) aspects is establishing itself as the state of the art.
The driving forces behind this revolution are manifold. Society's expectations of corporate responsibility and sustainable behaviour have risen continuously in recent years. At the same time, the European Union's Sustainable Finance Strategy has increased the regulatory pressure for a transformation to a sustainable economy.1 As a result, not only banks and insurance companies now routinely obtain sustainability-related data from companies, but institutional and private investors are also increasingly incorporating ESG aspects into their investment decisions - partly for regulatory and partly for strategic reasons.
More and more companies are also recognising that sustainability issues are crucial for compliance, stakeholder trust and financial success. ESG due diligence is therefore not a passing trend, but it has become a new standard - it already influences financing aspects, contract design or up to an estimated ten per cent of the transaction value.2
Traditionally, due diligence has focused on transaction-specific risks and opportunities - such as the quality of earnings and assets - mostly from a financial and tax perspective. ESG due diligence expands the scope of the due diligence to include sustainability aspects that can directly or indirectly influence the transaction value. The focus varies from one transaction to the next, mainly due to sectoral differences. However, two overarching aspects are at the forefront: risk minimisation and value creation potential.
In the context of sustainability-related risk assessment, regulatory risks (e.g. a ban on certain materials), climate-related risks (e.g. weather-related effects on production sites), operational risks (e.g. resilience of value chains) or reputational risks (e.g. greenwashing) are traditionally considered. When identifying and evaluating potential for value creation, the main focus is on increasing sales, reducing costs, minimising government intervention, employee productivity and optimising investment strategy.3
However, risk minimisation and value creation should not be viewed in isolation. For example, a paper manufacturer in Brandenburg is significantly reducing its own water consumption through innovative technologies. In doing so, the paper manufacturer not only counters the potential risks of an expected water shortage, but also achieves a competitive advantage through lower production costs.
The process of an ESG due diligence is similar to that of a classic financial due diligence. For example, the procedure for a buy-side ESG due diligence is usually as follows: Firstly, a comprehensive data analysis is carried out, for which relevant documents are made available in a data room. In addition, AI-supported background checks are carried out, such as a media analysis of the company's reputation. This is followed by interviews and Q&A sessions with key individuals to clarify open questions. Finally, optional on-site inspections offer an independent review of sustainability standards and their practical implementation. The final step is an overall assessment, which is often visualised using additional graphical representations such as heat maps.
Although the process of ESG due diligence is relatively standardised, there are often challenges with regard to the practical implementation. One of these challenges is almost always the inadequate availability of reliable ESG data. A typical example for medium-sized companies is the lack of internal information on employee satisfaction. Here, an AI-supported analysis of publicly accessible social media data can provide indications of dissatisfaction among employees. In this way, measures can be taken at an early stage to minimise fluctuation costs. In addition, high staff turnover in fast-growing companies can indicate a risk in terms of scaling potential. A targeted increase in company value should then be critically scrutinised.
Another challenge is assessing the monetary impact of sustainability issues with regard to the transaction value or future company value development. Here, it makes sense to establish a link to turnover or certain types of costs. For example, if an increase in certain diversity criteria in top management is planned, the expected personnel costs for the restructuring of the top management team can be used.
Finally, a challenge that is frequently observed in practice is the integration of the results of ESG due diligence with the results of other due diligences. This is because many sustainability issues also affect financial due diligence or tax aspects. The modernisation of a production facility, for example, is not only relevant for operational environmental and energy management (ESG due diligence). The associated potential tax incentives through government subsidies for sustainable investments (tax due diligence) also have an impact on acquisition and operating costs, which in turn influences profit margins (financial due diligence). It is therefore advisable to carry out all due diligences from a single source. This ensures a holistic assessment of the corporate transaction.
Surveys by BDO show that 64 per cent of CFOs surveyed consider sustainability to be an important factor for long-term financial success.4 In addition, 95 per cent of the private equity companies surveyed consider ESG aspects to be an integral part of their due diligence.5 This makes it clear that sustainability can no longer be dismissed as ‘non-financial’. Sustainability information is ‘pre-financial’ information that influences the value of the company. It is therefore also important to link ESG due diligence with concrete measures after the completion of a transaction in order to further increase the value of the company. ESG due diligence is no longer a niche topic - it is increasingly becoming the market standard.
1 European Commission (2024): https://finance.ec.europa.eu/sustainable-finance/overview-sustainable-finance_en. [Status: 02.01.2025]
2 Jens Kengelbach, Jana Herfurth, Dominik Degen, Dirk Oberbracht, Ferdinand Fromholzer & Jan Schubert (2024): The Payoffs and Pitfalls of ESG Due Diligence. URL: https://www.gibsondunn.com/payoffs-and-pitfalls-of-esg-due-diligence/. [Status: 18 April 2024]
3 Witold Henisz, Tim Koller & Robin Nuttall (2019): Five ways that ESG creates value. https://www.mckinsey.com/capabilities/strategy-and-corporate-finance/our-insights/five-ways-that-esg-creates-value. [Status: 14 November 2019]
4 BDO (2022): The CFO's Role in ESG. URL: https://www.bdo.com/insights/advisory/the-cfos-role-in-esg. [As at: 02 November 2022]
5 BDO (2022): BDO Private Capital Pulse Survey - Spring 2022. URL: https://insights.bdo.com/spring-pe-pulse-survey.html. [As at: 2022]