While it is difficult to generalise, in some parts of this new frontier region environmental standards lag behind the EU and/or enforcement is much less rigorous. At the same time, because of the complacency of state-owned industry under Communist rule, many industrial companies are likely to have significant environmental issues to tackle. So how do PE investors handle this situation?
There are different responses to this, depending on which country the investment is in; the specific exit strategy of the PE house; and whether they are acting in partnership with multilateral organisations, such as the European Bank for Reconstruction & Development (EBR&D).
According to some advisers, it is possible for PE investors to keep their costs down in some countries by investing minimally in environmental measures and taking advantage of a more benign legal framework or enforcement culture. But Michael Rusiecki, a partner at Poland-based PE house Enterprise Investors, says the situation in countries newly acceded to the EU, like Poland, is that similar standards to the EU are in place.
Enterprise Investors uses the same team of international consultants, who over the years have moved between different firms, to identify environmental liabilities and, if necessary, supervise clean-ups. “We’ve done clean-ups on several of our 99 investments here, usually costing a maximum of US$1m, and we’ve passed on a number of opportunities because we weren’t sure about the environmental liabilities,” says Rusiecki.
He adds that because the firm is generally selling on to international trade buyers it makes sense to ensure environmental standards are high and the environmental due diligence (EDD) process will reflect that. “We want an asset that we can sell and so high levels of EDD are necessary and that was true even before Poland joined the EU,” he says.
Sebastian Foot, a consultant at ICF Consulting, agrees that in the newly acceded countries the law is generally consistent with the rest of the EU. “It’s created a level playing field and in any case a lot of external investors were already applying Western European standards of EDD.”
Nick Biagetti, senior consultant at DNV, says PE firms are finding it hard to come to terms with the fact that regulation in the newly acceded countries is coming into line with the rest of the EU: “We’ve been approached by two PE firms who have recently made investments in Eastern Europe and are now burdened with the requirements to comply with existing and forthcoming EU environmental directives.”
This is also often true in non-EU states, says Sebastian Foot, pointing to a project in Georgia last year. The potential investment was in a downstream oil company and involved the creation of 50 petrol stations, to be sold in a few years to a multinational oil company. The George Soros fund, Bedminster Capital, was interested in investing and insisted on international standards of auditing, both financial and environmental, which was uncommon for Georgia.
Subhead] Selling on
“They wanted to get all the ducks in line so that in a few years it could be sold on,” says Foot, adding that for various reasons the deal did not go ahead. He says domestic owners and investors in these countries are increasingly recognising that if they want to attract external investors they must offer good standards. In the Georgian case, the company was seeking to put in place ISO standards in environmental management, even though there was little expertise in Georgia itself to implement such standards.
But external investors sometimes take a pragmatic view when it comes to operating in countries where the laws or regulation are more benign than Western Europe. Simon Taylor, a senior consultant at consultants ERM, says the further east one travels, beginning with the EU candidate counties like Romania and Bulgaria, the less developed the environmental law or enforcement of that law tends to be. The fact that a country appears to have an EU-style framework does not necessarily mean this will be applied, he says.
“You need to look beneath the surface at what really goes on. For example, in some countries you can have Western investors come in and who are seen as an income generator by local regulators,” he says. In such cases the regulator may specify an emissions limit knowing that it is impossible for the plant to comply and therefore fines will be levied.
“There’s not usually a prosecution but just fines,” says Taylor: “Some clients from the West don’t like the idea of that but others just see it as the price of doing business in some of these places. It used to happen in countries like Poland but is rare there now and happens more in the former Soviet Union.”
Ben Sawford, director of M&A at consultants Amec, has been working on a number of oil and gas deals in former Soviet Union (FSU) countries like Kazakhstan, Turkmenistan and Azerbaijan. Despite the prevalence of rules and regulations there has been a blatant lack of investment by companies in environmental management. “A lot of these companies didn’t come under scrutiny from the regulator when they were state owned but when there’s a new owner and restructuring it’s a different story.”
Because many of these companies are in breach of environmental regulations and, under new ownership, are likely to attract the attention of the regulator, Sawford says it is important for the EDD to flag up what the costs of environmental works are likely to be in year one, two, three and so on. To do that, he stresses, it is important to open a dialogue with the regulator and to find out what the relationship of the various parts of the business are with the regulator.
He says: “You need to get an idea of how amenable the regulator is to the new owner’s plans and it’s important to be open and honest about what you’re aiming to do.
Subhead] Paying fines
“For instance, you may say you’re willing to pay fines for the first year but that after that you’ll be putting new environmental management measures in place and would expect the regulator to look on that favourably, given that you’re making the air cleaner, taking on local people to help with the measures and so on.”
Wayne Holden of consultants URS Europe says application of the law by regulators can be inconsistent: “A country may have strict standards but the regulator may not apply them rigorously to national industries but as soon as a foreign investor arrives they throw the book at him.”
Craig Carson, a partner at ERM, says it not the letter of the law that is important but how it’s applied. “In Russia the law is probably as stringent at the EU but it’s not enforced in the same way so you need to take a pragmatic approach by, for example, benchmarking environmental practice against similar companies. It’s a halfway house between strict legislative compliance and disregard for the rules.”
Max Griffin of consultancy Atkins takes a similar view and he argues that PE investors can take a slightly different approach to trade buyers: “In both the EU accession states and further east there’s often a difference between the paper regimes and the practical enforcement of quality standards and remediation of past pollution.”
Often the regulators lack teeth, he says, which means a PE house investing with a relatively short time-frame will take a different view of the environmental liabilities than a longer-term trade buyer. He points to the environmental due diligence done on a steel deal in Bulgaria in 2000, which ended up recommending significant environmental improvements. “To our knowledge little or none of that work has been done,” he says: “Of course, in the long term the work will have to be done but if you’re a PE investor you can judge that the problems won’t begin to bite in the short term.”
EDD in countries like Bulgaria, he says, is often about reading between the lines and about advising the client what the practical consequences of the acquisition will be in terms of environmental costs. “It’s about saying ‘legally, this is what is required but in practice your costs will be x’.”
This knowledge feeds into the EDD required by PE investors, says Jonathan Steeds of Atkins: “They take the view that because their investment is short-term they don’t need to look at EDD in the same detail as a trade buyer and they want more of a tick-box approach. It’s probably not EDD best practice but if you’re trying to be competitive in a commercially tough world it’s pragmatic and the investors obviously feel they can manage the business risks that flow from this.”
But Griffin and Steeds point out that this climate is unlikely to last forever and the gap between the EU and countries further east is gradually narrowing. Griffin says another commercial advantage enjoyed by PE is that international trade buyers may have international environmental standards to meet, which may be higher than those PE buyers are comfortable with. However, if a PE house is investing with the support of a multilateral lender, such as the EBR&D or the International Finance Corporation (IFC), the environmental standards the project will reflect that.
Russia-based PE house Baring Vostock has the EBRD and IFC among its investors. David Bernstein, who is responsible for Baring Vostock’s environmental policy, acknowledges that in Russia it is not so much the regulations that are different to the EU but rather the enforcement culture.
Subhead] Souring relationships
But Bernstein advises against external investors cosying up to local authorities or regulators, in a bid to avoid costly compliance measures. “You can have a good relationship with the local authority but that can change quickly if the individual you’re on good terms with moves or if the company gets into hot water over another issue.”
He also echoes the words of some other PE houses that when planning to exit via a trade sale it is in the PE house’s interests to make sure it carries out necessary environmental works. He says: “If you don’t do the work the final price you get for the asset will be lower, and that even goes for potential Russian buyers because they’re also trying to ‘clean up their act’.”
Bernstein does not minimise the seriousness of some environmental clean-ups Baring Vostock has been involved in, particularly as the house invests in sectors such as oil and gas, cement and forestry. “Implementing environmental measures can take years, especially in the regions of Russia where often these matters have never been on the company’s radar,” he says.
That was certainly the case at Terapia, Romania’s second largest generic pharmaceuticals company, acquired by Advent International in a public-to-private last year. Emma Popa-Radu, who heads Advent International’s Bucharest office, says although Terapia is a pharmaceuticals company it originally manufactured chemicals and raw materials on the site, which led to pollution of the ground-water and soil. “When they switched to pharmaceuticals they simply put a padlock on the old buildings and forgot about them but Terapia offers a good example of how private equity can, in such a situation, add value at the environmental and social levels,” she says.
When Advent International was considering buying the company the vendors had commissioned environmental surveys but Advent International wanted more detail and had its own study done. Following this the PE house, whose investors include the EBRD, went to the Romanian regulator to gain agreement on a remediation plan for the 17-hectare site. Using international consultants the PE house has virtually cleaned up the site and demolished the old buildings, at a cost of several million dollars. “Because it was a former state-owned enterprise we weren’t able to get warranties on the environmental liabilities, but we got a lot of support and advice on the clean-up from the EBRD,” says Popa-Radu.
The situation of Terapia is far from unique, she adds. “The problem in a lot of these countries is that a lot of heavy industry was set up by the state and today those companies, which are among the biggest polluters, are often not doing very well and so don’t have the money to carry out remediation.” The policy of the regulators, she says, is often to focus on what they see as the priority of eliminating current and future pollution rather than remediation of past contamination.
Hayden Morgan, senior consultant at DNV, says former state-owned firms in the Soviet bloc have a history of low capital expenditure and when compared to EU standards have been and are still operating in a weaker regulatory regime. “This has often resulted in aging infrastructure and management systems requiring significant investment to bring the business up to EU standards. It is essential therefore that these issues are at least highlighted, and if at all possible, quantified in terms of liabilities, capital expenditure and operational revenue costs before the deal completes.”
He adds that although many private equity firms are now conducting EDD as standard on most deals, many are unaware of the raft of forthcoming EU environmental legislation which can have a material impact in deals done within the EU states, not least the recently joined, and even more so in transactions done in the soon-to-join accession states.
Subhead] Tick-box exercise
Yet even as investment firms have accepted and recognised the application of EDD, many too often view it as a box-ticking exercise and of very little value post-acquisition, says Morgan. “This seems to be more prevalent in US-based firms, where ASTM standards for due diligence are generally de rigueur. While such standards are useful in states where environmental information is readily available, the same cannot be said for CEE. “Typically, national environmental agencies in this region do not have access to the same level or quality of data enjoyed in the US or UK, for example, hence the scope and method of due diligence undertaken needs to take this into consideration.”
In addition, he says, investors now expect their consultants to identify added value in the transaction process and beyond. This could come from operational upgrades to critical facilities, supply-chain assessments, optimisation of assets and synergies through mergers. “The potential for this type of added value EDD is much bigger in the CEE region due to the rapid development and increasing investment in the region over the next few years,” says Morgan.
While it seems clear that in much of CEE and the FSU environmental regulation and enforcement lags behind the EU, it is also essential to realise that there are significant differences between countries. As well as the country situation, it is also true that the approach adopted by a PE investor will depend on the investment time-frame, exit policy and other factors.
Some PE houses, especially those with multilateral lenders among their investors, may choose to adopt international standards even if these are more stringent than local law. Others may choose to align their policies with local practice and thus save costs, even if this runs the risk of fines or negative publicity.
But it seems the current window of opportunity will not be there indefinitely. As more and more countries, particularly candidates for EU accession, bring their environmental regulation into line with the EU the gap between West and East will narrow and investors will be faced with greater standardisation of environmental regulation across Europe.