ESG Due Diligence in Nigerian Commercial Transactions
A traditional due diligence (DD) is performed to verify details in a transaction and detect potential defects in a deal or investment prospect. This process would usually include considerations of environmental, health, and safety (EHS) issues.
However, given the increasing emphasis on sustainability by stakeholders and regulatory bodies, it has become imperative to integrate Environmental, Social, and Governance (ESG) metrics into the due diligence procedures to steer clear of bad investments.
Consequently, investors are now inclined to allocate higher financial resources for sustainable targets. Unlike the relatively narrower scope of EHS, ESG introduces a more comprehensive array of sustainability risks and opportunities directly influencing transaction valuation.
Investors and creditors are increasingly employing Environmental, Social, and Governance (ESG) criteria to evaluate risks and opportunities for value creation. Businesses now face mounting pressure from various sources, including regulatory bodies, investors, and local communities, compelling them to adopt a proactive stance on ESG issues.
As said above, while the due diligence process traditionally encompassed Environmental, Health, and Safety (EHS) considerations, there’s a discernible shift toward a more comprehensive review utilizing ESG standards that span environmental, social, and governance topics. This shift is propelled by heightened expectations from stakeholders and growing concerns about the climate and environmental impact of business activities. In commercial transactions such as Mergers and Acquisitions (M&A), the integration of ESG due diligence is crucial during the negotiation phase, as significant ESG findings can exert a tangible influence on the valuation of the target company.
Conducting ESG due diligence serves several key objectives within the context of commercial transactions. Primarily, it aims to comprehensively grasp the risk profile and exposure of the company to environmental, social, and governance (ESG) considerations. This process involves a detailed examination of associated ESG risks and the identification of any red flags that may arise during the due diligence process. Additionally, it aims to ferret potential risk mitigation measures.
Given that a company’s ESG performance significantly influences its operations (its capacity to secure financing, maintain employee satisfaction and morale, capitalize on growth opportunities, and retain and expand its customer base), ESG considerations become crucial in decision-making. As a result, stakeholders such as investors, employees, customers, regulators, and others are increasingly holding companies accountable for their ESG practices.
In a comprehensive survey covering Europe, the Middle East, and Africa, a 2022 KPMG study found that over two-thirds of dealmakers expressed a readiness to offer a premium for a target exhibiting advanced ESG maturity in alignment with their specific ESG priorities.1 In another survey of 200 ESG practitioners including corporate investors, financial investors, and M&A debt providers, it was found that 74% of professionals are already integrating ESG considerations as part of their M&A agenda, with the identification of ESG risks and opportunities given as the top reason for conducting ESG due diligence, by 46% of respondents, followed by requirements by investors, cited by 19%, and preparation for regulatory requirements by 14%.2
Evaluating a company’s environmental, social, and governance (ESG) practices through due diligence provides insights into its value creation and sustainability. Beyond assessment, this process empowers investors to anticipate and implement post-closing strategies to mitigate identified risks. Investors often place a premium on sustainable targets, driven by the belief in a positive, long-term relationship between sound ESG practices and financial returns. Essentially, strong ESG performance is considered a proxy for effective management, recognizing its pivotal role in determining a company’s financial value.
Determining which ESG activity to scrutinize might be taxing because ESG is a broad term. I liken it to a skilled fisherman navigating the open sea. ESG, akin to a boundless ocean, teems with various sea monsters representing diverse aspects. Much like a fisherman’s cautiousness deepens with the water’s depth, the scrutiny of ESG factors intensifies depending on the specifics of the transaction and the nature of the company involved.
Close to the shore, where waters are shallower, a fisherman may only concern himself with a few threats. Similarly, in the realm of ESG, the level of scrutiny hinges on the subject of the transaction. ESG, being extensive and at times complex, encompasses different topics under each pillar. For instance, within the Environmental (E) pillar, considerations span biodiversity, climate change, decarbonization, air pollution, deforestation, water contamination, and more. The Social (S) pillar addresses matters such as minimum wage, child labor in the value chain, cybersecurity, data privacy, diversity and inclusion, and human rights. Governance (G) encompasses business ethics, corporate governance, responsible tax records, regulatory compliance, and anti-corruption measures.
During negotiations, it is evident that not all these issues would be equally applicable. Identifying the pertinent (material) ESG topics for scrutinizing a transaction represents the initial and significant challenge. There is no one-size-fits-all approach; hence, the scope of an ESG due diligence must be tailored on a case-by-case basis, considering the unique sustainability-related risks and opportunities associated with each transaction.
The Financial Reporting Council of Nigeria’s recent emphasis on sustainability risk disclosures, coupled with the proposal for a carbon tax and the escalating concerns about data privacy from both stakeholders and regulators, reflects a notable shift towards more rigorous ESG regulatory practices in Nigeria. This shift underscores the importance of conducting thorough ESG due diligence. Investors and financiers adopting ESG due diligence procedures enhance their readiness to navigate evolving regulatory requirements.
Incorporating ESG due diligence into the deal process not only distinguishes organizations in a competitive field but also positions them to secure deals successfully. This strategic approach demonstrates a commitment to long-term value creation, providing investors with a competitive advantage. Also, prioritizing ESG due diligence ensures a comprehensive understanding of the broader spectrum of sustainability risks and opportunities directly influencing deal valuation.
While ESG considerations have been around for many years, ESG due diligence is still a relatively new concept at its nascent stage of adoption. As a result, there is no uniform standard or guideline for organizations to comply with. The good news is organizations can develop their ESG due diligence template or framework aligned to their unique business needs.
It’s essential, however, for an organization to already have an established ESG strategy as a prerequisite for building a robust ESG due diligence framework. Before delving into the specific ESG considerations relevant to a transaction, it’s crucial to evaluate the ESG priorities that will shape decision-making processes. Subsequently, the ESG strategy can be seamlessly connected to the ESG due diligence process, enabling the development of a tailored ESG due diligence framework for the deal at hand.
I agree, it is not as easy as it sounds – condensing a practical concept into words is a trap for ridiculous simplification. Nonetheless, I’ve managed to deconstruct the concept into its prime elements. It is crucial to underscore that ESG due diligence casts its net over all entities involved in a transaction. Also, undertaking conventional financial due diligence while neglecting non-financial facets such as ESG is akin to disregarding factors that may become legal and financial risks in the long run (See FTX, Binance, OpenAI, Terra, Gemini Trust and BlockFi). ESG considerations wield the power to either fortify, erode, or forge value. Investors sidestepping ESG due diligence do so at their own peril.