In the same way that environmental issues used to struggle to receive intention from governments and corporations, environmental due diligence has not always been a top priority for corporate financiers, trade buyers and financial sponsors looking to make acquisition. However, a shift in environmental policy coupled with an increasingly environmentally conscious and issues-savvy public has led to an elevated role for environmental consultancy, both in day-to-day business management and as part of the M&A process.
In terms of their emergence on the business landscape, private equity and environmental due diligence (EDD) share a chronology that is not entirely coincidental. Over the past twenty years, both have made rapid advances in their fields, with the last five years seeing the sharpest growth as they moved from the fringes towards centre stage of their respective industries.
There is also something symbiotic about the way the two professions have developed alongside each other: assisting private equity firms in their dealmaking has been lucrative for EDD practitioners, while at the same time providing their clients with important resources. ?Environmental due diligence has played an important role for private equity firms seeking to establish the environmental risks of a transaction, primarily because financial buyers tend not to have in-house teams that can carry out due diligence work,? says William Butterworth, principal consultant at environmental consultancy RPS Group. ?This has increasingly been the case as governments have established ever more stringent environmental regulation.?
When the environment went mainstream
EDD started to play a more important role in US corporate activity in the 1980s when the US government introduced legislation concerning environmental damage caused by industrial activity. The legislation brought with it the threat of heavy fines, steep clean-up costs and, in the most serious cases, closure of offending sites. ?The introduction of new environmental legislation in the early to mid-1980s saw environmental practitioners transformed from a novelty player to an important, but unfamiliar, part of corporate activity,? recalls Michael Rodburg, managing director and environmental law specialist at US law firm Lowenstein Sandler, one of the foremost practitioners in the field in the United States. ?By the late 1980s, changes to government policy meant that environmental issues had gone mainstream.?
Europe followed, with the majority of EU nations introducing environment acts in the late 1980s and early 1990s. Despite the legislative advances, it was not until the mid-1990s that specialised European practices became established. ?Around this time, the importance of EDD became apparent to the private equity industry because although private equity firms are risk-takers, practitioners like to manage the environmental risk as much as possible,? says David Hockin, group director at Enviros. ?Our role is to deal with the sort of risk that is not quantifiable within a traditional financial framework.?
So what are these risks? The primary aim of the environmental due diligence process is to identify the material liabilities of a company being acquired. ?Traditional material liabilities range from establishing that soil and water resources at a site are not contaminated through to ensuring that activities and control equipment are compliant,? says Emma Farthing, a senior manager at international environmental consultancy Environ who advised KKR and Wendel Investissement during the bidding for Legrand. ?Compliance relates not only to current law, but to legislation that may still be in the pipeline.?
The valuation of a business is likely to deteriorate considerably if it is established that land or water at a plant require costly decontamination treatment, in much the same way as non-compliant machinery will negatively impact on the value of a company's assets. If responsibility is established at the time of the transaction being completed, the acquirer will inherit the liability for any remedial work that is required to make a site or its operational equipment compliant.
The worst-case scenario within the due diligence process relates to the existence of asbestos products liabilities with respect to former businesses. ?Corporations have collapsed following the discovery of asbestos liability with respect to acquired businesses,? explains Rodburg. ?Even cases where the liability has been at the subsidiary of an acquired company have forced asbestos defendants into bankruptcy.? It is instances like this that highlight the need for potential problems to be addressed before proceeding with an acquisition.
Once potential liabilities have been identified, environmental consultants are able to formulate and price remedial action. Such evaluations make it beneficial for EDD to enter the fray as early on in the transaction process as is feasible, although predictably perhaps this does not always happen. ?We tend to come into the equation later than we would like,? says Butterworth. ?The earlier we enter the process, the sooner we can establish whether there are any material issues that may have an impact on the transaction price and need to be factored into negotiations.? This view is shared by Rodburg ?EDD can effect the shaping of a transaction. If essential issues are discovered, there is often insufficient time to factor this in to the purchase price.?
These issues are what might be considered the more standard aspects of the due diligence process. However, environmental consultants believe the remit of EDD could and should extend beyond these factors. Health and safety, waste management, energy efficiency and noise pollution all play a key role in determining whether a company conforms to legal environmental standards. In addition, there are other more intangible areas such as ethical and social responsibility and corporate governance that companies may need to consider as part of the due diligence.
Butterworth thinks that private equity firms are becoming increasingly aware that sectors far removed from the traditional image of heavy industries need to take action to address these risks. ?I think it has become clear to sophisticated investors that some level of environmental due diligence is needed for every transaction. This is true even if it is simply an informed decision that due to the nature of the business, no further action is needed to identify potential risks.?
Such risk needs to be taken in the context of how it will be perceived by the regulatory authorities. According to Hockin, an important part of environmental due diligence process consists of trying to secondguess the likely position of the regulators. ?We try to put ourselves in their shoes in order to determine what assessments they would make given access to the same amount of information.? Consultants also maintain links with regulatory bodies in order to keep abreast of likely policy reform.
SLR Consulting, a UK based environmental auditing consultancy, acted for HSBC Private Equity when it backed the £220m management buyout of UK funeral services and cemetery business Dignity Caring in February 2002. ?In assessing the potential environmental implications of the acquisition, we had to consider all the issues that can impact on such a business,? says David Richards, a director at SLR. One of the major questions arising from the EDD process was linked to UK air pollution legislation. The process was complicated by the fact that at the time the laws governing air pollution were under review by the UK environment. ?By maintaining close relations with, and occasionally working alongside regulators, in this instance the Department for Environment, Food and Rural Affairs (Defra), we are able to stay informed about possible changes to legislation, which we can then pass on to our clients.?
It is not solely the equity sponsors that benefit from an environmental health check. Mezzanine and debt providers also depend on the information unearthed during the due diligence to ascertain the pros and cons of lending against a business. ?Banks need to know that the target company's assets are suitable security for any loan made in relation to an acquisition,? says Hockin. Although equity providers are responsible for costs relating to the upgrade of machinery or remedial work relating to conforming to health and safety, the debt to equity ratio of a transaction can be affected if banks are not given the required assurances about the assets. ?Private equity professionals are often willing to take a view on a company, given the close relationship they expect to have with management,? according to Butterworth. ?Banks are not in a position to do this, and so are often the main drivers behind due diligence.?
Environmental due diligence, like many aspects of the acquisition process, is likely to become all the more complicated in the event of a transaction being carried out across borders. Legislation varies from country to country, making it difficult to adopt a single set of criteria for each transaction. US policy is rigid and offers almost no scope for case-by-case interpretation of the law, whilst European frameworks tend to incorporate context into their assessment of each case. On the face of it, this would suggest that Europe provided the more favourable environment for M&A activity, although practitioners find that this is not necessarily the case. ?US firms are often alarmed by the subjectivity with which European law is interpreted,? says Hockin. ?At best it can avoid unnecessary expense, but it can also add an unwanted layer of uncertainty to the process.?
Varying interpretations of EU legislation within the European Union also complicate the situation. ?Southern European countries tend to enforce regulations in a more flexible way than their North European counterparts,? says Richards. ?The lack of consistency has led many US firms to refer to the more stringent rules applied in the US when evaluating environmental issues overseas.?
Once areas of potential liability are established, it is necessary to apportion responsibility in a manner agreeable to all parties. Where traditional solutions involving indemnities and warranties are not applicable, such as in the case of a publicto-private deal where there is no parent company completing the sale, private equity firms are increasingly turning to new methods of dividing the cost. Over the past 18 months, insurers such as CERTA and AIG have responded to this by offering third party insurance to cover any resulting liabilities. ?If the vendor is willing to assume potential liability of up to £1m and the acquirer believes the liability is closer to £5m, it is possible to insure against the difference between the two amounts,? says Richards. The main setback of such off balance-sheet solutions is that they are a relatively expensive option, although Richards puts this in context: ?On a £50m transaction, an insurance payment of, say, £150,000 is not too expensive if it saves the deal.?
Necessary evil or value add?
The evolution of environmental policy has made it necessary for private equity practitioners to ensure that potential targets have a clean bill of health from an environmental perspective, or failing that to ensure that any potential liabilities are factored into the price. The importance of careful due diligence is two-fold, given that these same acquisitions are, all things being equal, successful exits in the making, which will inevitably lead to the portfolio company's bill of health coming under scrutiny for potential buyers.
Environmental consultants have developed a sophisticated understanding of the transaction process, making them an important cog in the transaction machine. ?Consultants have certainly got a lot more sophisticated since the mid-1980s, when buyers would be sent fleeing with dramatic worst-case scenarios that would halt a deal in its tracks,? explains Rodburg.
As a result, due diligence practitioners today feel EDD deserves a shift away from the ?necessary evil? perception, which is stigmatises many consultancy procedures. They are keen therefore to point out the potential upside of the environmental due diligence process. ?There are also many ways in which the process can add value,? explains Farthing at Environ. ?We are able to advise companies on how they can improve their service, whether this comes through a market leading position on environmental issues, or through providing consumers with good value that does not come at a social or ethical cost.?
As yet, this aspect of the environmental due diligence process is not a priority for most private equity firms. As Hockin says, ?most clients still prioritise minimising the cost of consultation over using the process as a means of adding value.? Persuading private equity clients that environmental consultancy can help them optimise the price they should pay for a business, give them an edge over other bidders or indeed help an investment perform better post acquisition is the next challenge for an industry that has already benefited from private equity's increasingly prominent role in international M&A.