“This will be essential not just for sustainable development, but also ensuring the sustainability of a company’s future operations.”
ESG tools and analytics have always had a component of legal risk embedded in them. Poor ESG performance in the face of increasing regulatory scrutiny on environmental or social issues implies increasing risk. Conversely, strong ESG performance can connote investor and growth opportunity, as well as reputational and competitive upside. In this first of several pieces on lawyers using ESG tools, we hear from Paul Davies, Partner at Latham & Watkins LLP, on a series of practice themes. Tim Nixon, Managing Editor, Thomson Reuters Sustainability.
Tim: Please describe how you are using ESG or sustainability data to evaluate merger and acquisition opportunity?
Paul: Studies have shown that “ESG compatible deals outperformed ESG incompatible deals by an average of 21% on a five-year cumulative return basis.” As such, assessing ESG matters is important in helping our clients to mitigate such risks in the M&A process.
It is in this context, we were looking at how we could develop our due diligence to ensure that ESG matters are appropriately addressed. Transactional environmental due diligence (EDD) has changed little since its emergence into the mainstream in the 1990’s. Therefore, a major overhaul of EDD is required to address both conventional compliance and legacy liabilities, as well as sustainability performance and future-proofing. This should include incorporating ESG into investment analysis and decision-making processes, through early phase ESG screening of investments. Technology and innovation are therefore the primary means of changing how we undertake EDD.
There are a number of databases and indices that provide useful ESG information, but none that specifically assist in the context of transactions. This led to our involvement in RiskHorizon™, developed by Anthesis in conjunction with Latham & Watkins. It is a purpose made tool for use in the EDD process. Its development will continue through the use of advanced risk analysis and the incorporation of AI. Output is displayed in a dashboard, facilitating:
- Screening the commercial and financial implications of sustainability factors
- Reducing transaction costs / time through early identification of potential ESG issues
- Using RiskHorizon™ throughout the lifecycle of the investment – including identifying outperformance opportunities
Tim: How does the ESG tool set apply to private equity transactions?
Paul: Pension funds are significant investors in private equity and they have been increasingly willing and able to take positive steps via their direct investments, attaching conditions on ESG to their investments or latterly influencing behaviour via their voting rights.
The requirements of pension funds, often referred to as Limited Partners (or “LPs”) in the private equity sector, are routinely cited as the principal driver behind private equity houses (the “GPs”) responding to ESG.
Alongside this, the Principles for Responsible Investment has nearly 1,200 signatures with assets under management of over US$70 trillion. However, as discussed above, EDD has not yet changed to reflect these fundamental market shifts.
Transaction timeframes are frequently condensed and increasingly limited information is made available through carefully managed transaction sale processes. ESG databases and search tools means that the power of big data can be harnessed to facilitate early screening across a range of legacy and future ESG risk scenarios (which the Principles of Responsible Investment require should be undertaken).
Tim: Does this type of data provide a new kind of overall opportunity for client-attorney collaboration?
Paul: There has been growing pressure for investors to include the evaluation of non-financial risk when assessing the value of a potential acquisition. This is driven by both: (i) legal developments (such as corporate reporting requirements – for example, the Non-Financial Reporting Directive, Anti-Bribery and Corruption and Modern Slavery risks); and (ii) asset managers signing up to voluntary ESG standards – such as the Principles for Responsible Investment (noted above). With no law firm or consultancy willing to break the hegemony for the way EDD has been undertaken since the 1990’s, we think these issues do require greater collaboration between attorney, client and all other advisers with an interest in ESG issues (such as consultant, accountant and operators and supply chain teams).
It is only through such collaboration that businesses develop an integrated approach, blending ESG risk with commercial risk in a way that mainstreams sustainability at a senior leadership level. Our work can support companies looking to report on their exposure to ESG risks and opportunities, with enhanced financial reporting leading to greater transparency and ultimately longer-term insight into the viability of a company. Used at all stages of the investment life cycle, it can demonstrate the risks and opportunities and the subsequent realization of value.
Tim: How do you obtain the tools and data you need?
Paul: The power of big data! Limited information is required to enable investors to model the ESG risk and opportunity landscape in the transaction, so that they can be subsequently evaluated during more detailed due diligence. For example, RiskHorizon™ provides the user with:
- The ability to identify potential ESG risk exposure via two pathways: by industrial sector and/or geographical region
- A geographical display of the executive summary to highlight and prioritize findings, make recommendations (including recommendations regarding a more detailed and focused scope of EDD), and to identify next steps
- Built-in and customizable questions and risk standards, to further evaluate materiality of each risk within the context of the client’s needs and the acquisition context
- Cost-effective, web-based tool spanning millions of data points from more than 175 countries, covering 30+ global risks (Economic, Environmental, Technical, Social, Geo-Political).
Tim: Are there limitations to the current data and tools available?
Paul: Put simply, yes. Assessment of big data provides a helpful and relatively low cost means of considering ESG issues. However, the use of data and new technology – such as RiskHorizon™ – is currently best deployed as an early stage risk screening tool. It is not a substitute for more detailed site specific and organisation specific EDD. For example, certain organisations may have a long corporate history that includes operations considerably different to their current business model. Using data and search tools may not reveal these issues, whereas targeted questioning and research may reveal some of these hidden liabilities.
Tim: How does reputational risk factor into the lawyer-client engagement with ESG?
Paul: Reputational risk plays a significant role in ESG. In many ways, the reputational risks and the damage that we have seen inflicted on corporate reputations due to revelations about remote parts of a business’ supply chain, are one of the key driving factors behind the growth in ESG.
Tim: How would you assess the rate of uptake in the legal community using ESG? Is it accelerating?
Paul: The legal community is cautious – and often rightly so – but we do see increased interest and greater use of ESG terminology and tools and a willingness to engage with ESG issues. Lawyers are fully aware of the need to do more with less (whether that be with less time or less money). Tools that enable lawyers to do so are to be welcomed.
Tim: What is the potential for lawyers using ESG data to help influence the overall direction of sustainable development?
Paul: As noted above, ESG is a truly cross-disciplinary and cross-sector issue and we see all stakeholders (advisers, shareholders, employees, consumers and others) playing a key role in shaping the future of organisations. Of course, lawyers will be involved and this will be as part of a collaboration with the client and other stakeholders. This will be essential not just for sustainable development, but also ensuring the sustainability of a company’s future operations.