Avoiding environmental liability

Assessment of environmental liabilities, which covers everything from land, water and air pollution to the seemingly mundane health and safety at work regulations, has for many transactions in the last five years joined financial due diligence, commercial due diligence and the exit review as a must-have component of the overall due diligence package.

While private equity investors tend to resist the pressure to spend ever increasing amounts of money on the overall due diligence package the cost of environmental due diligence is negligible compared to potentially limitless downsides if an environmental issue is discovered post acquisition. Lisa Bushrod asks how the private equity buyers of environmental due diligence consultancy services rate the offering available to them.

Three to five years ago one of the strongest and, perhaps more serious, complaints from private equity investors centred on the quality of the environmental due diligence reports being served up by the environmental consultancy profession.

It wasn’t that the work undertaken was in any way judged to be flawed rather that the reports appeared to be an expensive exercise in standing still.

Today things are rather different. The message of dissatisfaction appears to have reached those environmental consultants who see private equity investors as part of their target market and, on the whole, private equity investors now seem to be appreciative of the usefulness of work resulting from their commission. Usefulness in private equity investor terms can be boiled down to quantifying the risk and the costs associated with a potential environmental liability in layman’s terms.

“Environmental issues are fairly technical and generally the finance director is not interested, for example, in how much contamination is present but wants to know how much it is going to cost and when it’s going to hit the books,” says Charles Gooderham, manager of environmental risk management at Deloitte & Touche.

How much?

This move to more user-friendly environmental consultancy reports does not mean the issues of cost and liability are cut and dried. Typically the environmental consultants outsource site visits to qualified technical consultants who, when forced to put a figure to something – contaminated land clean up, for example – can come up with figures as disparate as between £1m and £10m. Getting a more precise costing is going to involve more additional technical consultancy fees to enable them to undertake the investigatory work they deem necessary to reduce their margin for error.

Timing is often a sensitive issue here. One private equity investor reported an environmental due diligence report that had identified a minor leak in an underground storage tank. If fixed immediately the cost was estimated at £50,000 but if untreated and at full scale the cost of land contamination could have run to £1m. Given that predicting

when such events will occur is a bit of a star gazing exercise it makes sense that technical consultants reports give a here and now one point in time view of the circumstances.

Be good to look good

This is also true of what can seem the mundane issue of health and safety. This is an area that has increased in importance for private equity investors as a group since the remit of health and safety encompasses far many more businesses than perhaps, for example, pollution issues might. Directors, in the UK at least, have a clear interest in ensuring health and safety working practices are adhered to on an ongoing basis. The UK Health & Safety Executive recently reported that more than 70% of cases they bring against companies for failing their health and safety obligations are successful prosecuted.

Given that it is not always clear what, if anything, will happen if health and safety regulations are not followed the potential liabilities here are not something technical consultants should even consider quantifying. Where loss of one or more lives is involved the damages are potentially punitive. Likewise with a seemingly endless number of human and wildlife special interest groups ready to lobby trade associations, local and national governments, environmental liabilities can result in real problems, beyond the immediacy of those created on the balance sheet.

Money is clearly the key driver in achieving a clean environmental bill of health, whether it’s being able to quantify current spending requirements or those that may arise in the future. For the banks or specialist finance houses supporting an investment through

debt funding the issue is clearly to ensure the business will be able to perform to plan so that their funds are repaid with interest and the private equity investor is looking beyond that stage to the eventual exit.

What and who is needed?

Patrick Reeve of Close Venture Management, which has made investments in property-related businesses, goes straight to the technical consultant rather than employing an environmental due diligence consultant, which would effectively act as a third party. “You can make a meal out of it, but it’s pretty basic stuff. We do it from a common sense point of view because if there is an issue we cannot sell [an investment] on,” he says.

He refers to the acquisition of a disused office block in Bristol city centre, which was subsequently turned into the Express by Holiday Inn, in which Close Venture Management recently sold its investment. For that investment Reeve employed a structural engineer, who identified the scale of the asbestos problem which ultimately resulted in the building being sealed so clean up work could take place.

Being able to cut out the need for an environmental due diligence consultant is dependent on being sure of what is required in a specific case and knowing which specialists to use. Arguably the appropriateness of this approach will be determined by the type of business or assets being bought and the level of regulatory supervision they are subject to and how

fast moving that particular regulatory environment is. Environmental due diligence consultants will argue too that their ability to add value by making potential purchasers aware of possible tax rebates on clean up bills, for example, should not be overlooked.

Close Venture Management was again able to go directly to the technical specialist when it needed soil samples tested on a site that had formally housed a printing works. The results of the tests necessitated the removal of several inches of top soil that had been infected by the high concentration of arsenic present in printers’ ink. Clearly examples such as those Reeve cites would have an impact on overall acquisition costs and perhaps ultimately the price achieved by a vendor.

Too many vendors have had the sale price of their business or assets for sale vastly reduced by the emergence of environmental issues during the due diligence process. Consequently there has been a growth in vendor due diligence – embraced by vendors as much as it is pushed by the consultants – to counteract this problem.

“We often advise vendors to undertake due diligence because it allows them to programme the work, identify risks, put in place a risk management strategy at an early stage, and have the relevant information available for the purchaser, making the due diligence process more efficient and putting the vendor in a stronger position to protect value. But the vendor due diligence process needs careful management to make sure that the acquisition party has bought into the process and the information that it will generate. The terms of reference for the environmental due diligence should not be restrictive but seen to be broadly encompassing all potential issues.” says Gooderham.

Having a broad assessment of the environmental risk and its associated costs can also be helpful in self-selecting potential buyers that are likely to stay the course. It’s at this point when a vendor might consider buying an option on insurance. But, warns Gooderham, making sure the option is transferable to the new owner (typically incurring a financial cost) at the point of sale is essential. Likewise commissioning environmental due diligence reports that can be transferred to a new owner is important. Although a transfer fee will be involved here too it’s likely to be considerably less than the purchaser paying for the report to be done from scratch.

“With environmental liabilities there are two elements of risk, the perceived risk and reality. Different types of investors have different risk profiles… The due diligence process needs to cut through the perceived risks and define the actual risks which are material to the particular investor,” says Gooderham.


At what point in the investment process the environmental due diligence is carried out should be determined on a case-by-case basis. Typically the environmental consultants bemoan the fact that they are often called onto a deal at the eleventh hour when a potential environmental issue needs to be quantified. If introduced at the start of the progress there would, they argue, be enough time to get through the work required without holding up the deal timetable.

Private equity investors for their part are anxious to keep non-contingency, and therefore potentially abort costs, on deals to an absolute minimum. As such they only want an environmental consultant involved on the deal once the financial and commercial due diligence hurdles have been passed.

This is not always the case, however. Andy Tupholme of Gresham notes that on a deal that the investors recently looked at the first piece of work that was undertaken was that of commissioning an environmental due diligence report. Gresham was aware that there were potential environmental issues for the business and as such needed to quantify these early on in order to assess whether to proceed with the investment or not. In this case

the initial review killed the deal.

The way the market for environmental due diligence operates appears to be reasonably transparent and user-friendly. Typically the start is to commission a Phase I report. “Generally speaking, we get a Phase I [report] done and if there are no high risks associated with that we accept that as being good enough,” says Simon Wildig of Close Brothers Private Equity.

Phase I will look at publicly available information and as such is often referred to as a desktop report.

If Phase I raises concerns the option, depending on the risk profile of the investor, is to move to Phase II. Phase II typically involves site visits and employing technical consultants to do things like dig holes and send off soil samples to be tested.

Choice & value for money

“There are not that many people that do [environmental due diligence consultancy]. There are probably half a dozen supplying to the private equity market and I think they provide pretty reasonable product for the money,” says Wildig.

The marketing employed by the firms to get themselves known to the private equity investor community appears to have varying degrees of success. Some choose to retain close links with the private equity investors that they have worked with in the past, although some private equity investors report that they have used particular consultants as

a direct result of the recommendation of another service provider, such as a lawyer or accountant, employed on the transaction.

But other private equity investors note that so little contact is maintained by the consultants post acquisition that they were in fact unaware of significant organisational changes that had taken place at the consultancy firm.

The private equity world is at times almost stiflingly small and as such reputation and word of mouth recommendation carries the sort of weight that might not be experienced in many other industries or financial sectors. As such treating the private investors as a relationship client rather than a one-off deal contact is likely to pay dividends.

“If a consultant moved from a particular firm to [a different environmental consultancy] we would probably move with them,” says Wildig.

Ongoing audits

Identifying and resolving current environmental issues is clearly the focus of any buyer but with the complexity and ever changing landscape of environmental legislation some private equity investors commit to undergoing an environmental audit of their investee companies each year.

Enterprise Investors, the Warsaw-based private equity investor, is one firm that runs such a programme, which is overseen by Michal Rusiecki, a partner at the firm.

Some consultants report that is easier, although not without problems, to get an audience with some of the regulatory authorities to find out which way they are moving on particular issues.

This is often brokered by environmentally trained consultants who can speak to the regulatory authorities in their own language and is clearly of benefit to private equity investors looking to manage future exits in potentially fast changing environmental regulatory environments.