Private equity, M&A and finance transactions: Sustainability clauses and ESG related KPIs



Investors and lenders seek to include contractual ESG clauses in transactional agreements with the companies that they invest in or provide financing to. This article describes the contractual terms in private equity, M&A and finance transactions that lawyers in Schjødt often negotiate in relation to sustainability.

Companies are met with ambitious demands on sustainability from key stakeholders as well as regulators. A company's ESG performance is often measured by Key Performance Indicators (KPIs) related to CO2 emissions, water and energy consumption, biodiversity, diversity in management, employee composition and employee well-being.

A high standard of ESG policies and reporting strengthens a company's reputation and image, giving it a competitive advantage. In addition, ESG policies and reports of companies are often scrutinised by potential investors, lenders and purchasers as part of their due diligence of a company.

The growing reporting requirements under the EU Taxonomy, SFDR, and CSRD Regulations, mean that companies will continue to provide much more comprehensive data for assessing both transition ambitions and other material risk exposures than previously seen. Also, companies are encouraged to publicly report information relating to their KPIs as this will help establish a target benchmark across industries. On the basis of more comprehensive data being available, investors and lenders are also becoming more precise in defining and monitoring relevant KPIs.

Contractually, ESG incentives are used in different ways across investment agreements, shareholders' agreements, loan agreements and bonus agreements. In general, ESG KPIs should seek to motivate shareholders, management and employees to make a company and its operations more sustainable.

Investment agreements and share purchase agreements

In M&A transactions, lawyers often play a key role in the ESG due diligence connected to “governance” elements, such as anti-corruption, economic sanctions and export controls as well as the liability aspects of the environment and social elements of the company's operations. A targeted ESG due diligence can detect past and present violations of applicable laws and international standards for ethical business conduct. In addition, lawyers are able to offer valuable advice on the company's ESG risk management and compliance program, governing documents and reporting based on previous experience of the market and industry.

A legal assessment of a company's ESG risk management and performance can identify whether there are potential risks or opportunities for value creation. If potential ESG risks are identified in due diligence, a key consideration is if such risks can be priced into the deal and managed in the investment agreement, rather than being matters to be warranted. In some instances, it may also be advantageous for an investor to require the remediation of specific ESG findings before closing.

When regulating ESG risks in transactions, it is not sufficient to simply include traditional legal liability and contractual limitation clauses, as it can be extremely difficult to define loss, price impact or trigger events within ESG.

It is important that, along with general warranties such as compliance with laws, the warranties are expanded to also cover sector specific warranties in light of the company, e. g. certifications to voluntary international standards, and explicit findings of the ESG due diligence. More general ESG warranties can still be useful for disclosure purposes even if they may be difficult to enforce in practice.

Shareholders' agreements

For investors and companies looking for a long-term ESG strategy, this should be regulated in the shareholders' agreement. By including ESG commitments in a shareholders' agreement, the parties will first and foremost have the necessary ESG discussions, which helps to ensure that their values and sustainability goals are aligned. As future shareholders will also be bound by a shareholders' agreement, they will also commit to the ESG targets that existing shareholders have already agreed on.

If the shareholders are companies, specific ESG KPIs can be included in the shareholders' agreement to improve the shareholders' climate and environmental impact for example by reducing their own CO2 emissions or by committing to having equal gender distribution in the shareholders' own management or board of directors. These clauses can be penalised so that non-compliance will result in not being entitled to take part in the next dividend distribution or not being able to take part in a pre-emptive right.

Another way of control is to include a put option that allows the shareholder to sell the shares to the company or a third party in case of breach of ESG undertakings of the company. Often, such triggers will allow for a remediation period for the company and for a consultation with the shareholders or its external advisor to agree on a remediation plan.

As such, a shareholders' agreement can be an efficient way to push shareholders and the company towards better ESG performance.

Loan agreements

Use of proceeds loans and sustainability-linked loans (SLLs) are the two most common types of loan instruments available to companies to finance their sustainability goals.

Use of proceeds loans provide financing for individual ‘green’ and/or ‘social’ projects while SLLs encourage borrowers to foster sustainability. Currently, SLLs tend to be the more favoured instrument as the proceeds of SLLs may be used to finance any kind of business activities that the borrower is pursuing. The principles of sustainability-linked bonds (SLBs) follow the same principles as the SLLs but SLLs are the focal point in the following.

The economic outcome of SLLs is linked to whether certain pre-defined and externally verified ESG objectives are met. These objectives are evaluated using predetermined KPIs and are measured against predetermined Sustainability Performance Targets (SPTs).

When using SLLs, it should be an ambition to create ambitious ESG targets, e.g. KPIs on CO2 emissions and energy efficiency. Fundamentally, the loan is linked to interest rate adjustment, whereby the interest rate on the loan is subject to adjustment, with a higher interest rate applied if the borrower does not meet the specified SPTs in the manner set forth in the agreement. There are numerous variations of this as well as specific adaptations made to the particular industry of the borrower.

To be classified as a SLL the loan should comply with the SLL principles. Firstly, the selection of KPIs must be relevant to the borrower's business now and to its future operations, the KPIs must be measurable and measured on a consistent basis and should be able to be benchmarked against an industry standard or similar.

Furthermore, annual SPTs for each KPI should be established every year of the loan term. The SPTs should most importantly show a material improvement and thus indicate a substantial enhancement in the individual KPIs, surpassing both the expected "business as usual" progression and the regulatory targets. The borrowers should on an ongoing basis provide the lenders with sufficient information to enable the lenders to monitor the results of the borrower's SPTs and should seek independent, external verification.

As the SLL market matures and comprehensive data becomes available, it is now possible to evaluate borrowers' ability to achieve their SPTs in different industries. Some sectors such as the energy and utilities sector have been impacted by changing market conditions and macroeconomic factors, which may increase the difficulty for borrowers within these industries to meet their targets.

Finally, loan agreements often include ESG reporting obligations of the borrowers that are intended to enable banks and financial institutions to comply with the lenders' own ESG reporting obligations. Initiatives have been taken in some industries to develop a set of standard covenants such as the Poseidon Principles that are used in the shipping industry.

Bonus plans and incentive programs

Salary and benefits can be an effective way to create and shape an ESG focused mentality in a company. Not to mention that a strong sustainability focus may help attract and retain employees.

In Scandinavia, it is advisable but generally not mandatory for companies to include benefits related to ESG KPIs in bonus deals, plans or employment contracts. However, many Scandinavian organisations do include ESG indicators when designing remuneration policies and compensation systems. Specific ESG KPIs can be included in a bonus plan, or general KPIs s can be linked to the calculation of bonuses within a relevant business area.

An individual or collective incentive program between a company and its employees is also an important and commonly used mechanism in achieving certain KPIs on ESG. The use of ESG components related to diversity and inclusion as well as climate are often used in this respect.

Please do not hesitate to contact us if you have any questions about the contractual or regulatory use of ESG KPIs in your specific situation. Schjødt have experienced lawyers that advise on transactions and sustainability in Denmark, Norway, Sweden and England.

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