A changing environment

Since it first came into being around 15 years ago, environmental due diligence (EDD) has become an important consideration when buying a business in the UK. A recent survey from consultants KPMG found that two-thirds of UK FTSE 350 companies now carry out EDD as part of the transaction process. But the same survey also found that, of the 25 per cent of respondents confronted with environment-related problems posttransaction, 80 per cent of them had conducted EDD. So why is the process apparently failing so often?

An integrated approach
In half the cases monitored by KPMG, the subsequent problems were outside the scope of the EDD assignment that had been carried out. Traditionally, environmental consultants would focus on what is commonly termed a ?technical assessment?. This explores three main areas: whether the company in question is having problems with contamination; whether it is complying with relevant existing environmental regulations; and whether it has efficient environmental management controls in place to ensure, for example, the health and safety of employees and that buildings are asbestos-free.

The limitations of this approach were harshly exposed by one recent deal, the name of which is closely guarded by the adviser who relates the story. It involved a company buying a firm that tested emissions from car engines. The buyer paid for a technical assessment of how the business was impacting the environment. What the assignment did not take into account was the reverse scenario of how environmental legislation might impact the business. Hence, it failed to identify the impending arrival of a new ruling that banned the pollutants the firm's products tested for. Overnight, those products became obsolete. The buyer was forced to write off its entire investment.

Although KPMG's survey canvassed only corporates, one could argue that private equity firms are even more exposed to any weaknesses in the EDD process. Advisers observe that because of their relative lack of in-depth knowledge of a particular sector, financial buyers are more likely to use EDD than corporates. But can they feel confident that the important issues are being addressed?

Some advisers say they are meeting concerns by making their assessments more wide-ranging, to include forecasting potential ?market-related? issues, a process that may have foreseen the catastrophe awaiting the emissions tester in the example above. ?There remains a great opportunity for acquirers to gain a clearer understanding of business value by encouraging more communication between their environmental, financial and commercial due diligence advisers,? says James Stacey, senior manager of the global sustainability services team at KPMG in London. He believes EDD is important enough to be a fully-fledged part of the financial due diligence process rather than, as is normally the case, being treated separately. This means exploring such areas as:

  • ? How will environmental liabilities and any subsequent capital expenditure requirement impact the balance sheet?
  • ? How do environmental issues affect good corporate governance?
  • ? Will environmental factors affect the reputation of the company and its brand?
  • ? Will environmental liabilities affect the company's ability to access bank finance because the lender is worried about its security over the assets?
  • ? What are the potential market drivers and how could environmental issues impact them?
  • Reputations
    Stacey says some or all of these issues could have a material impact either on the price being paid for a business, or at least on the terms of the sale and purchase (S&P) agreement. But from his experience, buyers including private equity firms are often unaware that their EDD advisers have not taken such aspects into account. ?To obtain full value from the EDD exercise, they [private equity practitioners] also need to ensure that their EDD adviser is approaching the exercise with a commercial focus, and a clear understanding of the specific transaction drivers and needs,? he says.

    Tellingly, KPMG's survey found that buyers want a wide range of issues to be considered, with just 24 per cent pinpointing environmental liabilities as the major issue of concern, with 19 per cent highlighting reputational risk. In principle, there is almost no limit to the extent of meaningful EDD when an area such as a business's reputation is considered part of the equation. Stacey says it is conceivable for example that his investigations would look at a retailer's supply chain to see whether a company is ? perhaps unknowingly ? sourcing goods from child labourers in third world sweatshops. He concedes that an audit of every single supplier factory would be unrealistic, but it is possible to ensure that sufficient management controls are in place to monitor effectively the supply chain.

    One could of course view Stacey's argument as selfserving. KPMG and other large financial services groups have set out to exploit what they see as an undeveloped niche in the EDD space, and they obviously have an interest in talking it up. Katrina Harris, a technical director at specialist environmental consultancy firm RPS Group, maintains that the ?creative? aspect of EDD is overstated at this stage ? ?the main focus is still primarily on potential liabilities [from contamination]?.

    ?Don't worry about it?
    Harris's view is in contrast with the findings of KPMG's survey, according to which clients say certain issues are not being investigated to their satisfaction during the EDD process. Is this because advisers are simply not aware of their clients' requirements? Or do buyers fail to ensure that the scope of an investigation is wide-ranging enough?

    Commenting in the context of private equity, one environmental consultant has a controversial theory when it comes to MBOs. ?It's not unusual for a management team to see the opportunity to do a deal and sweep potential problems under the carpet. They will say to the financiers, ?don't worry about it, this is a cash cow and we can get in and out before people realise what's going on?.?

    This has a ring of credibility, not least because advisers say management teams are primarily focused on cost and could be persuaded by a cheaper and more limited investigation. But as well as alleging a fundamental lack of integrity on the part of private equity firms, this view also ignores the influence of legal advisers and debt financiers involved in the transaction process. David Hockin, a director of EDD at consultancy firm Enviros, says banks are very cautious in their approach because they are fearful of the long-term damage that could be done to their brand by taking security over an asset in danger of breaching environmental regulations.

    Nicola Eury, a principal at consultants Environ, agrees there is a danger of venture capitalists overlooking environmental issues because of a short-term outlook that stems from their desire to sell businesses within three to five years of the original investment. But she adds that the imminence of seminal environmental legislation in certain sectors means it simply cannot be ignored. For example, European industries such as power supply, pulp and paper and non-ferrous metals will all be profoundly impacted by EU legislation demanding significant decreases in greenhouse gas emission from 2005 onwards.

    Any attempt to cut corners by private equity firms owning such businesses would be extremely unwise as it would elicit fines from regulators as well as damaging their reputation in the sector and having a detrimental effect on exit prospects. VCs may respond that they are well aware of the problems they could encounter with industrial businesses. But it is pertinent to enquire whether they are equally aware of the burgeoning swathes of environmental legislation in a related sector such as packaging – never mind seemingly unrelated ones such as food & drink or retail.

    Simon Wildig, a director at UK mid-market investor Close Brothers Private Equity, says his firm will certainly look beyond mere technical issues. He says the firm normally uses EDD when buying manufacturing businesses, but also chose to use it when buying V-Ships, a third-party manager of vessels in the cargo and leisure sectors, in March this year. Not surprisingly the remit focused on potential liability for contamination in the event of an accident involving a vessel. But it also looked at what the likely effect would be on the company's reputation and brand.

    ?Venture capitalists are much more aware of EDD than they were historically, when they always left it to the eleventh hour on a deal and there was a last-minute panic,? says Environ's Eury.

    What some venture capitalists may yet require some convincing of is that the quality of the advice they can buy is such that it merits greater priority. Asked to comment on why the EDD process had failed to identify post-transaction problems, one of the respondents to the KPMG survey pinpointed ?insufficient attention to detail by environmental advisers?. That may be true in some cases. But purchasers would undoubtedly do themselves a favour by making sure that their own and their advisers' expectations of the extent of the EDD remit match up.