For many years now, environmental consultants have been the Cinderellas on private equity and VC deals. Their disquiet over the transaction process and their rules of engagement are well-known: they are appointed too late, and so cannot add any value; they are regarded as an expensive luxury by investment committees focused on cash-flow and not contaminated land; and they are simply not taken seriously enough. This has changed over the last five years, but it is still difficult to find an environmental due diligence provider that is entirely satisfied with its place in the transaction food chain.
Nevertheless, the voices of dissent are quieter, mainly because the industry itself has made a concerted move away from providing a general environmental report with no particular relevance to the world of buyouts. William Butterworth, a principal consultant with RPS Consultants, says: “Environmental consultants are becoming more pragmatic in the advice they offer and plugged into the needs of the transaction. More and more, whatever the scope of due diligence we do, the environmental advice is very much aligned with the business strategy.”
Providers of environmental due diligence (EDD) differ in sophistication with regards to M&A and private equity transactions. On the one hand, there are environmental consultants, which offer a vanilla service in the form of a phase one report and follow the instructions of the lawyer, which is typically the source of their retainer. On the other is the growing breed of consultants with a dedicated due diligence practice, staffed by people with both a depth of environmental knowledge and an understanding of the transaction process.
Like any other intermediary EDD providers must add value by identifying issues which could have a material impact on the valuation process and the investment strategy of the client. James Stacey, an environmental specialist and assistant director, Transaction Services at KPMG, explains: “It is important that EDD reports look at the impact of environment on the business issues which drive value and performance, rather than simply flagging up environmental pitfalls, which may or may not be relevant to the deal.”
Butterworth says: “People have tended to think that the environment is a woolly issue that people in sandals deal with. It is not anymore. It’s an integral part of the management of the business and historically legislation has forced that upon business. Environmental management can offer as many opportunities as it can identify liabilities. So you need to make sure the environment is managed to your best advantage.”
Put simply, EDD analysis should be mindful of the range of needs clients have. The interest groups include the MBO team, the private equity firm, the debt provider and vendor and EDD providers ignore their differing priorities at their peril. David Hockin, group director of Enviros, comments: “The MBO team does not really care about environmental concerns. They see it as a waste of money because their view is that they want the business at any price because it is a cash cow.”
By contrast, the VC house requires a more thorough report because they will typically be joining the board of directors with directorial responsibilities. So they will be hawkish because any environmental offence constitutes a mismanagement of the company and any environmental offence will be aggravated under EU law. Meanwhile, the potential debt financier is concerned about how it can secure its lending. Bankruptcy filings are increasing in the current economic climate, so the best way for a bank to manage the transaction risk is to take security of the land. The principal output they require from the EDD provider is a contaminated land study.
The onus is on the EDD provider to understand the issues that underpin a transaction and this often means that they redefine the brief they receive from the client. They must have a process that looks beyond a traditional box-ticking approach. Stacey, formerly of RPS, notes that at KPMG the environmental audit forms an integrated part of the overall financial and commercial due diligence process. In the past, environmental due diligence was confined to contaminated land studies for industrial companies, but increasing EU legislation covering recycling and health and safety issues has led firms operating in sectors as diverse as consumer products and leisure to rely on EDD reports.
Stacey comments: “The key is to understand the strategy of the investing company, then focus on how environmental risks and/or benefits can impact upon or enhance that strategy.” Stacey says the process is divided into a consideration of market influences; capital/revenue spend; consumer relations; operational concerns; contingent liabilities; access to capital; corporate governance and reputation. The individual importance of any of these factors depends upon the transaction and the sector in which the company operates.
For example, in January 2002, a new End of Life’ EU directive was ratified which requires manufacturers of vehicles and electronics to recycle up to and in some cases more than 75 per cent of goods sold at the end of their working life – a whole new criterion to be considered in EDD. Stacey estimates this could add as much as between one per cent and three per cent to existing production costs in those sectors, while also opening up an opportunity for businesses in the supply chain to expand market share by manufacturing more cost effectively recyclable components.
The importance of pending legislation grows when it impacts on the VC’s investment cycle. Charles Burns, senior consultant at Enviros, says: “Typically a VC will want an exit in four to five years so any environmental due diligence should take that into account. If a piece of legislation or a potential liability falls outside that timeframe, then it is of less importance.”
The EDD study should also be prepared in the context of the type of exit a VC is aiming for. An eventual trade sale demands a different process to an IPO. The importance of IPO due diligence has grown with the proliferation of socially responsible investment funds (SRIs) and the advent of indices such as FTSE4Good, where ethical concerns must be taken into account for the VC to tap the broadest pool of capital. While the ethical and environmental qualification criteria for FTSE4Good are by no means as stringent as environmental pressure groups would like them to be, they cannot be ignored. Stacey says: “The trend for fund managers to require environmental reporting will continue to grow and while it can be regarded as a soft’ issue, there is no doubt that negative press coverage or lobbying from organisations such as Friends of the Earth cannot do a potential equity offering any good at all.”
As evidence, he cites the withdrawal of bank funding from Huntingdon Life Sciences following sustained attacks by environmental groups. Irrespective of the exit strategy, the audit must incorporate a review of reputational risk at the outset, because unethical or potentially criminal practices will have an impact on the VC’s valuation of, and strategy for, the business it is buying.
In an ideal world, the environmental due diligence provider will be hired in advance of the VC making a bid, but in reality it will become involved either when the information memorandum is circulated, or in a less favourable scenario, only when an environmental obstacle is identified. The traditional EDD process is a square peg to the round hole of the transaction process. For example, the traditional approach involves the preparation of a phase one report generated from the findings of the data room – which will often throw up more questions than answers, and will necessitate a phase two investigation, at which point the EDD team will collect soil samples from the site. Once those findings have been analysed, the team may need to do further research, and the process passes into its third phase. Each phase must be signed off by the investment committee, which may or may not provide a budget. In most cases, the client will want this work completed in a three-week timeframe, which means that rigour could be sacrificed at the altar of pragmatism. “We are all technical experts by trade, ” says Stacey. “So we have to check our instincts sometimes and decide whether a piece of research while valid – is actually relevant to the needs of the transaction.”
Any environmental consultancy without a grasp of this tenet is likely to fail its client, or at least fail to add value. Hockin comments: “There is nothing worse than an audit which is too high level, only for the bank to demand more work. This creates time pressure and can lead to tensions. Traditional environmental consultancies may adopt a rigid phased approach and keep returning to the client and only find things out as time goes on.”
The ability of the consulting firm to go beyond its brief can be augmented by establishing a long-term relationship with a client, or by getting onto the deal as early as possible without hampering the client. The answer to this lies in an initial scoping or phase zero audit’, in advance of any bid being made, which will direct the subsequent phase one investigation. Hockin explains: “This can flag up the possible areas of concern and should be broad enough to incorporate whatever is necessary.”
The problem with this approach is that the investment committee will have no budget assigned to early stage environmental due diligence. Again, sophisticated EDD firms will get round this by sharing some of the risk with the client. Hockin comments: “This means if the VC pulls out, the early work will not be paid for, but equally, if the bid is successful the EDD firm will share in that success. Basically, we have procedures in place whereby if the client wants us to jump, we will jump.” When the VC house is considering appointing an environmental consultant, it must be convinced that the firm it uses can demonstrate commercial awareness and has a flexible approach so it will not overstretch itself.
By eschewing the box-ticking approach, the EDD provider can interpret the client’s brief. Hockin cites a deal in the leisure sector, where the target company had multiple sites across Europe. “The lawyers told us that no operational aspects were implied and instructed us to do phase one studies of the various properties. This would have been good work for us because there were a large number of properties to look at. But when we started our research, we advised the client that there was no way the environment agency would shut down the facility because of historical contamination. We recognised that the main area of their concern should have been food hygiene and food safety, rather than land contamination. We told them that the value of the deal was not related to the land, it was related to the property.”
Where the audit covers a company operating in multiple jurisdictions, the logistical challenge of providing a meaningful report in a limited timeframe increases. Although EU-wide legislation should reduce discrepancies at a local level, in reality, the interpretation of the law differs from country to country. In short, laws are easier to pass than they are to enforce.
Companies like KPMG use their global network and are able to execute each audit at a local level using indigenous consultants, while Enviros is part of the Cat Alliance, a network of EDD providers which spans Europe, and Asia. RPS will run an audit from the jurisdiction where the mandate is won and will fly consultants to different countries or, where the in-house expertise does not exist, will appoint a local firm. Any of these approaches can provide the right results, provided the consultants have the necessary cross-border expertise, and the systems in place to co-ordinate the research.
But Hockin fears it is hard for a consultant based in one country to remain attuned to regulatory differences elsewhere: “The advantage we have [in the alliance] we have specialist logistical skills which we can apply on a corporate deal where you do a sample study of a large number of sites which lie all over Europe. The way our IT network is put together means that everything feeds back through the alliance in a co-ordinated and timely fashion. Other consultancies will fly in consultants. This is OK when there are lots of deals around because it means the consultants are up to speed. But when there are fewer deals, expertise may suffer.”
The importance of local knowledge applies when it comes to assessing contingent liabilities or issues relating to land contamination. While regulators in one country will impose a fine for non-compliance, in others the threat will be minimal even though the same law applies. The consultant that recognises this can save time and money for the client because compliance may not be a matter of urgency.
Even then, they may face cultural opposition from the client. Butterworth explains: “US firms play more strictly by the rules. If they are buying a European business and there is a redundant underground tank on the site, the US view is that you should remove it, irrespective of whether there is a risk posed by that tank or not. From the European viewpoint, the attitude is why spend the money? If it has been appropriately decommissioned and there is not a risk of pollution being caused by the presence of that tank, why not leave it there?”
In general, European EDD providers will appoint consultants locally in the US, because there is such variance at State level that they need to buy time and expertise from those who know best. Furthermore, they should also be aware of client’s attitude to environmental risk. Butterworth continues: “That depends on the nature of the business, the nature of the market and the price they are paying for the business. If you are getting a very good deal for the business, the fact that there may be some environmental risks that we have not been able to fully quantify then you can take a view on the extent of the risk as in the grand scheme of things the client may not want to jeopardise the chance of the transaction going ahead. Understanding the background and the view the client is taking on any risks associated with the deal is very important.”
So the principal cultural challenge that consultants must adapt to is that they are not just churning out a phase one environmental audit report. The important bit is ensuring the issues that report identifies are properly factored into the advice they offer the client with respect to the way that they should view and look for protection for the risks associated with that business.
Environmental consultancies are increasingly called upon to prepare vendor due diligence reports, which purchasers can rely on from the data room phase. Vendor due diligence is a significant part of KPMG’s business because it has a broad corporate client base. It is less so for consultants, which tend to win mandates from the private equity community. But consultants should be mindful that as with the work they conduct for MBO teams, banks and private equity houses, vendor due diligence (VDD) should also be tailored.
Butterworth says: “The difference between VDD and purchaser due diligence is that the VDD report must present the information in a way that is straightforward and not open to interpretation. The second that the information is open to interpretation is where the bargaining begins. I see too many VDD reports which stop short of drawing conclusions with respect to contaminated land and operational issues. For example, a VDD report may recommend a phase 2 investigation, but that is useless because as a consultant advising a purchaser you are saying well if they recommend a phase 2 they obviously either think there is a problem or they are not prepared to put their necks on the line to state the potential for liabilities. Either way you can use this uncertainty to your advantage.”
The key to any VDD report is that it must be assignable to the purchaser so that if the work that is being done by the vendor’s adviser is incorrect, and the vendor has made a mistake or been negligent and the purchaser relies on that information for their conclusions, then they could potentially go and sue the advisers to the vendor. This is a moot point. Butterworth attests: “One of the big gripes that I’ve heard from the legal side is of the hassles they have to go through to try and get reports re-assigned so that parties acting on the other side can have the benefit of the work. The RPS view is that if you are preparing a report for the vendor then the purchaser has to be able to rely on that work otherwise there is little point in doing it.”
Inevitably, ongoing EU legislation and the growth of socially responsible investment funds means the environment will move closer to the heart of business and as it does, environmental due diligence will become less a necessary and expensive evil, and more of a cornerstone to the successful completion and exit of private equity transactions. The ability of consultants to combine pragmatism, commercial awareness, technical expertise and geographic coverage will determine their ability to add value and shed their Cinderella status.