Managing environmental risk in private equity transactions

Private equity buyers need to re-evaluate their approach in dealing with environmental risk, say Daniel Lawrence and Paul Watchman of Freshfields Bruckhaus Deringer.

Corporate sellers and their advisers are now well aware of the approach that private equity buyers take to environmental risk.  As trade buyers re-emerge, and show a (relatively) greater willingness to manage environmental risk over a long-term ownership, private equity buyers need to re-evaluate their approach in dealing with environmental risk.  At the same time however, effective management of environmental risk is now even more important to private equity buyers than it used to be given the huge potential impact both in depressing equity returns and interfering with a clean and successful exit.

Identification and management of risk has always been of paramount importance in private equity-financed transactions.  Increased awareness on the part of corporate sellers and their advisers of the significance of environmental risk has gradually resulted in private equity firms treating the risks of incurring environmental losses as a critical component of risk management in acquisitions and disposals, not just a price reduction issue.  The result is a fundamental shift in their approach to evaluating and providing for such risks in merger and acquisition transactions.

This briefing explores the reasons why environmental risk is a crucial consideration in merger and acquisition transactions, and suggests from a private equity perspective how environmental risks can be managed from acquisition to ultimate disposal of a target business. 

Structuring and managing environmental risk is likely to become an increasingly important issue as the expected resurgence of trade buyers puts pressure on private equity buyers who need to be competitive in auctions.

Why focus on environmental risk?

As a broad generalisation, trade buyers typically wish to acquire businesses with familiar risk profiles giving them comfort to continue or expand established operations in the same or similar sector.  A trade buyer may, therefore, be more inclined to take a long-term view over the target business and management of its environmental risk legacy.

On the other hand, the overriding aim of a private equity firm is to realise the best returns for its investors in as short a period as is sensible.  While time horizons vary, this invariably involves acquiring the business not to hold it long-term but to dispose of in the short-to-medium-term to a subsequent purchaser.

Key objective 1 – investing in an appropriate business

As part of the process of assessing the suitability of a target business, it is vital for the private equity buyer to be aware of the nature of the target business’ environmental obligations and the likely costs involved in meeting them.

Environmental liabilities are no longer confined to historic soil and groundwater contamination.  Industry (particularly in Europe and the US) is faced with an ever-increasing volume and scope of environmental regulation.  In the past decade, there has been a proliferation of instruments at international, regional and domestic level imposing environmental obligations on owners and operators.  This increase in the volume and scope of environmental regulation has been coupled with a marked increase in regulatory enforcement.

In addition, it is now more widely appreciated that environmental risk is not limited to dirty manufacturing businesses.  For example, a transaction involving real estate assets may give rise to environment-related issues, such as:  land contamination caused by activities historically carried out on the land; health and safety concerns (including asbestos, fire and life safety, toxic mould and sick building syndrome); deficiencies in waste storage and disposal arrangements; and the need for land use and development permissions.

Multinational businesses conduct their operations through subsidiaries located across a number of different jurisdictions.  Regional differences in legislation, policy or approach in each country need to be considered as well.  Failure to meet environmental obligations can prove costly.  Remediation of soil and groundwater contamination may be very expensive; take years to investigate and resolve; and require longer-term monitoring.  Addressing environmental performance and compliance issues can result in significant capital expenditure.
Environmental expenditure has a direct impact on equity returns.  Recurring expenditure on environmental matters may reduce the debt that can be put into a deal by 5 to 6 times because banks increasingly lend by reference to an EBITDA-CAPEX to senior debt ratio.  Equally, lenders or regulators may require financial provision to be made to address future decommissioning or restoration risks that could materially affect a company’s balance sheet or borrowing capability.  Furthermore, unanticipated expenditure on such matters during the private equity firm’s ownership will reduce cash available to pay down debt and therefore the equity gains available on a sale of the business.

There are also risks of incurring personal liability where breaches of environmental law result from the acts or omissions of an individual director or manager or where environmental offences committed by a company are proved to have been attributable to the consent, connivance or negligence of a person acting in such a capacity.

Therefore, it should be clear that identifying and quantifying environmental obligations and risks is an extremely important consideration for private equity buyers. Potential environmental liabilities need to be considered from the very outset when considering a proposed acquisition, because the private equity investor needs to assess the likely costs involved and take a view as to whether the business is a suitable investment.  All too often, the mention of environmental problems induces apprehension but it should be appreciated that a very real competitive advantage can be obtained in auctions if the environmental due diligence and reporting process is managed in a way that addresses environment risk in an adult fashion.  Equally important is the fact that a seller is likely to lose patience with financial buyers who quote debt free/cash free prices and then treat a conservative environmental remediation cost estimate as debt.
 
Key objective 2 – minimising expenses and maximising return

A second key objective of the private equity purchaser is to reduce or eliminate unnecessary expenditure on acquiring and operating the target business, to improve investment return over its 3 to 7-year holding period.  Meeting this objective requires the private equity investor to address environmental risk prior to acquisition, to monitor environmental risk during the operation of the business and take steps where necessary to ensure that it is properly managed. 

Environmental risks that are not identified at the acquisition stage of the transaction may emerge during ownership of the business, requiring unanticipated expenditure.  Similarly, environmental law (whether national, local or EU) may need to be monitored or anticipated due to its constantly evolving nature.  Failure to anticipate changes in environmental law or regulatory practices and to keep track of legislative and regulatory changes may ultimately result in otherwise avoidable compliance and remediation costs.

Key objective 3 – exiting the business without residual liability

A further key aim of a private equity firm is, as seller in a subsequent transaction, to sell the business at target price and to do so as efficiently as possible with minimal exposure, leaving as many environmental liabilities as possible with the original vendor or transferring all environmental liabilities to the purchaser.

Most exits involve the sale of the original acquisition vehicle, which will have (to the extent it remains) any contractual protection given by the original seller against environmental liabilities.  The private equity firm may, however, envisage a partial sale of the business after acquisition or assets of the business to pay down debt or, for example, as part of a strategy to sell off parts of the business and acquire others in order to achieve a critical mass in core areas.

Whether a private equity seller can sell assets of the acquired business or parts of the acquired business with the benefit of the original contractual protections depends to a great extent on the scope and duration of the original contractual protections and the willingness of the original seller to allow part-assignment or back-to-back cover to be provided to subsequent purchasers.  Focusing on the environmental risks associated with the target business at the acquisition stage and during the operation of the business can facilitate a more advantageous exit for the private equity firm as seller on subsequent disposal of the business or parts of it.

Managing environmental risk from acquisition of a target business

Focus on environmental risk early

Leaving environmental risk matters until the preferred bidder stage is at best a potentially costly mistake or at worst a mistake that could result in an environmental issue becoming a potential dealbreaker.  It may be difficult at that stage to address the issue in a way that meets the expectations of the vendor and the objectives of the purchasers.  By focusing on environmental risk early in the transaction, an informed decision can be made as to whether the deal is worth pursuing and a better understanding gained of the investment value of the target, taking account of actual or potential environmental liabilities.  Another important advantage in focusing early on environmental obligations and risks is that should a decision be taken to pursue the deal, knowledge of such matters can assist the private equity buyer in structuring the contractual protections appropriately.

Private equity firms usually do not have the same level of detailed knowledge of a target business as a trade buyer and are not normally equipped with the specialist skills within their own organisations to identify, assess and quantify environmental risk.  This is particularly so in those transactions where the private equity buyer does not have good access to or co-operation from management early in the process.  Accordingly, it will be necessary in most cases for the private equity buyer to appoint specialist environmental consultants to assist in the due diligence by identifying and quantifying potential environmental liabilities.  This is a sensible approach in general but especially where the seller has also appointed consultants to provide vendor due diligence reports, given the scope for different views to be taken by experts acting for vendors or purchasers.

Environmental due diligence

The aim of a pre-disposal or pre-acquisition environmental due diligence is to identify material environmental risks and liabilities of the target company, evaluate the need for any remedial action and estimate the costs of compliance or remediation.  The results of environmental due diligence should effectively drive the negotiation of the environmental protections later in the transaction, except where the purchaser or vendor adopt entrenched positions on environmental risk transfer – in which case the progress of the transaction itself may falter.

Prior to acquisition, the more comprehensive the environmental due diligence available to the private equity firm the better positioned it will be to decide whether the target business is likely to have significant environmental issues and if it does, what contractual protections should be sought during the pre-acquisition negotiation phase.  Equally, this may weaken the position of the vendor in trying to pass off the business as a low-risk business environmentally.  Environmental due diligence results are also likely to influence the private equity buyer’s approach to structuring the transaction. For example, the private equity buyer may engage in an asset rather than a share purchase with a view to limiting the acquired liabilities to those associated with the assets purchased (rather than all liabilities associated with any acts or omissions of the company owning the assets) or may exclude or ring-fence assets with higher environmental risk profiles.

Typically a private equity purchaser will wish the seller to disclose any environmental audits or investigations of the target business and (along with its finance providers or equity participants) will want to be entitled to rely on any resultant reports.  Any agreement on reliance may also contemplate immediate post-acquisition or future refinancing and, potentially, the ability to assign in whole or in part the benefit of the environmental reports to a future purchaser.
If the seller has not commissioned environmental audits or investigations, the private equity buyer may decide to commission them.  The scope of the environmental audit or investigation will be important.  For example, an audit can range from ‘risk-sifting’ the portfolio (with the aim of eliminating properties with small or negligible risk), through to a Phase I review (a desktop audit) or even to intrusive Phase II investigations (eg where potentially significant problems are identified in the Phase I review).  In some cases, particularly where the purchaser or its lenders are US-based institutions it will be expected that auditing will comply with American Society for Testing and Materials (ASTM) standards.  Increasingly, environmental due diligence reviews cover not only soil and groundwater contamination issues but also regulatory compliance, health and safety, planning considerations and building management matters (including asbestos and fire safety). The consultants may be asked to evaluate the risks as ‘low’, ‘medium’ or ‘high’, and as quantifying environmental risk and costs can be tricky, to provide estimates of remedial works within parameters as to the likely costs which may be incurred, or the worst-case scenario expenditure that is unlikely.

Of course, an environmental audit or investigation may not necessarily identify all environmental issues of a target business.  The private equity purchaser will also need to review documents and reports disclosed by the seller which may identify past or continuing environmental problems.  Typically, a seller will disclose various documents to the prospective purchaser in the course of the pre-signing due diligence to assist in enabling the purchaser to evaluate various aspects of the business, including environmental matters.  Specialist advice can be useful in identifying and reviewing the most relevant and important documents in the data room to arrive at a realistic assessment of the environmental risks associated with the target business.

Normally the seller must provide ‘fair’ disclosure of all matters covered by the environmental warranties that are negotiated for the transaction.  In civil code countries such as Germany and France, if the provisions of the civil code are not or cannot be discharged by separate agreement between the parties, the seller may be liable if he fails to notify a prospective purchaser of a defect of which he is aware.  A private equity buyer who has carried out only limited environmental due diligence before signing may seek to resist blanket disclosure of all documents in the data room and insist on specific disclosure of all material environmental issues.

There are four basic levels of contractual protection, namely:

duty of care of the environmental consultant;
the contractual duty of care owned by environmental consultants under the terms and conditions of their appointment, which calls into question how adequate the level of the consultants’ PI cover is with regard to the value of the transaction, its risk profile or the appetite of the vendor or purchaser for risk;
environmental warranties;
environmental indemnities; and
environmental insurance.

 
Duty of care of the environmental consultants

Typically the scope of the work and liability of environmental consultants is limited.  This reflects the fact that often only Phase I (non-intrusive) environmental audits or reviews will have been carried out.  Environmental consultants are also careful to attempt to qualify their work with reference to the amount of time they have been allowed to conduct site visits and interview relevant site personnel.  In spite of any agreed limitations and qualifications, consultants may still be liable where they have failed to exercise the standards of skill and care that would normally be expected of them, in which case the level of cover provided by the consultant’s PI insurance may be important.

Environmental warranties

The first level of contractual protection for a private equity purchaser is the provision by the seller of environmental warranties and the disclosure of known environmental problems against those warranties.  Typically, sellers will attempt to restrict the scope of and otherwise limit environmental warranties by qualifying the environmental warranties by the seller’s knowledge or whether the matter is material.  The general approach of the purchaser on the other hand is to seek to widen the scope of the warranties as much as possible and resist awareness and materiality qualification of the warranties. 
In negotiating environmental warranties, it is important to bear in mind that for the purchaser they may perform two functions.  First, to obtain disclosure of information: this assists not only in evaluating the environmental liabilities of the business but also structuring the transaction, in terms of how best to transfer the assets of the business to the purchaser.  Second (having regard to the fact the purchaser will not be entitled to claim for breach of the warranties to the extent the seller has fairly disclosed against them), to identify particular issues/liabilities for which it may be appropriate to seek indemnity protection.  In some cases the purchaser may even seek to obtain an indemnity or report of breach of warranty.

Key environmental warranties sought in M&A transactions
The target business is in compliance with environmental laws Environmental laws often impose strict liability (with no need to show fault or negligence)

Adding awareness qualification reduces risk to the seller if it has reliable internal reporting procedures (and so can be confident about what it ‘knows’)

Qualifying by materiality is important for the seller
The target business has all requisite environmental permits and has complied fully with any conditions attached to them Many approvals and consents may come within the definition of a permit Again, adding an awareness qualification is less risky for the seller but may not be acceptable for the purchaser

Adding materiality qualification is important to seller
There are no facts, circumstances or conditions that may give rise to any environmental liability
Seller likely to resist as too wide, even if qualified by awareness

Buyer may aim for such a warranty to keep risk with seller
There are no environmental reports or audits other than those disclosed in the data room Seller may view this as posing unreasonable disclosure obligation, particularly for large multijurisdictional businesses

Buyer will want to ensure that all relevant reports and audits have been made available, as these will facilitate identification of issues on which contractual protection by way of indemnity may be sought


Negotiating environmental indemnities

The next and arguably by far the most important level of protection for a private equity purchaser is obtaining an environmental indemnity.  Indeed, negotiating an environmental indemnity may be the only way (other than price reduction) that the buyer will have recourse against the seller for environmental liabilities that arise in respect of precompletion conditions.  Typically this is because the purchaser cannot sue for breach of warranty to the extent that the seller has disclosed a matter that would otherwise form the subject of the breach.  It is vital that the following elements of the indemnity be considered, as these factors will determine the level of protection the indemnity will afford the private equity purchaser and the level of protection offered by the private equity seller.

Environmental indemnities
ISSUE
Who gives/who gets indemnity? Possibilities include:
Gives indemnity:
Seller
Parent company?
Members of the seller group?
Gets indemnity:
Purchaser
Purchaser as trustee for members of the purchaser group?
All members of the purchaser group?
EXPLANATION
Environmental indemnities are normally given by the seller, but may also be given by the ultimate parent company of the seller and/or other members of the seller group.

Environmental indemnities are often given to the purchaser as trustee for each and every member of the purchaser group
The scope of the indemnity may extend to:
Soil and groundwater contamination
Health and safety?
Food safety?
Fire safety?
Legionella?
Asbestos?
Offsite waste disposal?
Contamination at former / closed sites?
Pre-completion contractual obligations?
Pre-completion non-compliance with environmental laws and/or environmental permits?
This is often limited to soil and groundwater contamination, but may also include other matters such as those listed left

Where the proposed acquisition is of a company, the buyer may want cover for pre-completion acts (such as non-compliance with environmental laws)

A PE buyer will want the widest possible scope to reduce the risk during the time it owns the business and at the point of exit
Definition of ‘Environmental Laws’ may include any of the following:
Domestic and supranational (such as EU) statute law and subordinate legislation
Domestic judicial interpretation of environmental law (case law)
Statutory guidance notes, codes of practice etc
Laws relating to health and safety
Laws relating to town and country planning / zoning
International treaties and conventions
International ‘soft law’
Change in laws after completion
PE buyer may want indemnity to survive for the benefit of a subsequent purchaser, by including all such laws ‘in force from time to time’

Seller likely to resist expansion of the definition in this way, particularly wanting to limit to laws in force and binding prior to completion
Circumstances that might trigger indemnity claims:
Commencement / determination / settlement of environmental proceedings?
Formal orders or notices from a regulator?
Formal threat / imminent risk of environmental proceedings / orders / notices?
Remedial works required to avoid environmental proceedings / orders / notices?
Remedial works required to avoid migration of contamination?
A reasonable and prudent operator would undertake remedial works in the circumstances?
Remedial works in an emergency?
PE buyer may seek soft triggers (as those further down the list at left) to enable recovery for taking pre-emptive remedial action, e.g. to avoid environmental proceedings

Seller likely to want hard trigger, such as court order requiring remediation
De minimus, threshold and cap If too high, de minimus and aggregate threshold limitations may bar justifiable claims, whereas if too low may unreasonably limit buyer’s ability to claim

The overall cap on the amount that may be claimed may not actually represent money that can be claimed under the indemnity (e.g. if the amounts that would otherwise be claimed do not achieve the aggregate threshold)
Cost sharing PE buyer likely to resist cost-sharing provisions, whereas the seller may argue that the principle of cost sharing is reasonable in terms of transitioning liability risks to the purchaser over time
Post-completion limitations may include limitations on:
Development of the site
Material change of use / intensification of use of the siteInvestigative works
Disclosure of information to regulators / authorities / third parties
Closure / decommissioning / demolition of the site
Increase or acceleration of environmental losses by thePurchaser
Instigation of / encouragement of environmental proceedings
PE buyer will want to resist as far as possible limitations on its post-completion conduct disentitling claims

Seller will want wide range of limitations to avoid claims arising or being increased due to purchaser’s post-completion acts, e.g. disclosure of information to regulatory authorities, intrusive works, development, change of use, and/or closure of the site(s)
Duration of the indemnity and assignment
Known risks?
Unknown risks?
PE buyer may need to offer cover to a subsequent purchaser; in which case contractual protections sought need to be negotiated with a view to obtaining sufficient cover for that purchaser

The seller to the PE buyer may resist covering known liability risks that the business itself could pay as OPEX and CAPEX to meet ongoing environmental obligations

Private equity investors will invariably wish to exit clean by avoiding giving environmental protection to subsequent purchasers.  If the protection enjoyed by the private equity firm is long enough in duration and assignable to provide the next purchaser with sufficient protection, this will facilitate a clean exit significantly.

Environmental insurance

Environmental liability insurance usually excludes all known environmental conditions or cover beyond known remediation costs and so may only provide protection against unknown risks or risks that are beyond expectations.  In practice therefore, particularly when dealing with known environmental issues and conditions, environmental warranties and environmental indemnities normally assume the greater importance in allocating environmental risk in merger and acquisition transactions.

Operational environmental due diligence

It is important for the private equity purchaser to make its advisors on environmental risk strategy aware generally of its strategy for the business as this will enable them to seek to structure the contract to enable the strategy to be achieved.  The investment case for acquisition of a target company often includes adding value by actively managing its business (eg closing premises, expanding product lines, redeveloping sites).  It is critical therefore that this can be done without undue restriction and without adversely affecting the environmental protection afforded by the seller’s indemnity.  Environmental due diligence during the operation of the business is necessary in order to manage the risk of emerging environmental issues (not identified at acquisition) and known environmental issues that have worsened and to keep abreast of changes in environmental obligations to which the business may be subject.  Failure to do so could expose the business to unnecessary expenses or reduce the value of the business at exit.

Disposal environmental due diligence

Environmental due diligence is also useful for sellers in identifying environmental issues that are capable of being remedied prior to completion through seller-initiated environmental audits or investigations and in providing assurance to a buyer that contractual protection is not needed.  Ensuring that a purchaser and its lenders can rely on environmental reports and disclosures of material environmental issues can accelerate the sales process by reducing the need for the purchaser to undertake extensive and time-consuming due diligence of its own, and may avoid more difficult negotiations aimed at price reductions and environmental indemnities on exit.  The results of environmental due diligence will also assist the private equity seller in anticipating the environmental protections which the subsequent purchaser may attempt to negotiate.

Conclusion

Corporate sellers and their advisers are now well aware of the approach which private equity buyers take to environmental risk.  As trade buyers re-emerge, and show a (relatively) greater willingness to manage environmental risk over a long term ownership, private equity buyers need to re-evaluate their approach in dealing with environmental risk.  At the same time, however, given the huge potential impact both in depressing equity returns and interfering with a clean and successful exit, effective management of environmental risk is now even more important to private equity buyers than it used to be.

Daniel Lawrence is Of Counsel in Freshfields Bruckhaus Deringer's environment, planning and regulatory (EPR) practice group. Paul Watchman is a partner who specialises in environmental, planning and regulatory matters.