Environmental due diligence

Over the last five years environmental due diligence (EDD) has become an important tool to identify, quantify, and then mitigate the environmental risks which may be associated with providing finance for a proposed project.

A number of factors have contributed to put EDD under the spotlight. Environmental legislation has grown and environmental issues are increasingly on the social and political agenda as well as that of the regulators’, and the definition of environment has broadened to include occupational safety, processed safety, social issues and product liability.

“In the mid 1990s EDD was associated with heavy manufacturing industry and land contamination,” says David Hockin, director at RPS Group Limited. “Over the last 12 months we have been involved in deals related to food hygiene, swimming pool management, and healthcare.”

John Simonson, a director at Environmental Resources Management (ERM), adds: “Every sector now has the potential to apply this broad definition. Four out of ten deals regard occupational safety, while a growing number of deals involve looking into reputation issues.”

Ten years ago private equity firms in Europe, like corporate investors, looked at environmental issues and commissioned EDD reports just occasionally. By the mid 1990s social pressure and a changing regulatory environment meant the failure to address and manage environmental matters could have disastrous consequences, and so routine commissioning of EDD reports became the order of the day. “If a company creates pollution it will end up paying for the cleaning, and will also be involved in lawsuits, prosecutions and find itself with a badly tarnished public image. When you add all those factors together, then environmental due diligence becomes a front matter to be addressed in a transaction,” says Ron Sheldon, a director at Advent International, the private equity firm.

“ERM has been doing environmental due diligence over the last 15 years, but it is only in the last five years that environmental due diligence has been growing steadily.

In particular, over the last couple of years, the importance of financial buyers, especially private equity firms, has grownfrom zero to 40 per cent of our business”, says John Simonson. As a result the relationship between the EDD consultants and PE firms has positively developed and EDD is no longer considered as a burden or another box that needs to be ticked. “Now as soon as private equity firms hear of a deal they lock in a specific environmental due diligence team. If there is an auction, there is then a rush to hire the best advisors on an exclusive basis. Then they start on day one to talk of environmental strategy on a transaction,” says John Simonson.

What’s expectedPrivate equity firms expect EDD consultants to highlight all possible environmental issues, examine their potential impact on the business and provide appropriate solutions in order to minimise hidden risks. In particular they want to avoid the possibility of future liabilities that could affect the exit route. Says Sheldon, “When a PE firm approaches a deal it normally asks two questions: which conditions will prevail when we exit the investment? And, will we be able to provide satisfactory environmental warranties to potential buyers?”

Private equity firms are increasingly asking environmental consultants to assist in the early stages of a transaction and to provide a bespoke’ approach to each deal. The level of due diligence depends on a number of factors, such as the type of industry, the deal timetable and so on. “At the end of the day, though, the scope of our work reflects the interest and the investment period of the company involved in the transaction. This changes the strategy of the whole due diligence,” stresses Jim Finnamore, an associate director at WSP Environmental.

Assessing the risks and the consequent costs is difficult. “If you are out of compliance with employment or tax legislation, it is easy for the lawyer to advice you and reasonably estimate how much you have to pay. With environmental compliance this can be very difficult. Nowadays you can be fairly, albeit not entirely, compliant and still face severe financial penalties.

A lawyer may find it very difficult to estimate how much the fine would be,” says David Hockin. Equally difficult is to provide advice that identifies the way to solve the problem, set up the priorities and quantify the costs. “It is easy to be a scaremonger in environmental issues, but is difficult to put them into context,” concludes Justin Dye, a director at ERM.

Over the last couple of years environmental consultants’ duties have no longer been confined to figuring out the issues related to the company and specific obligations – and the cost of those obligations – that may arise in the future. Consultants are increasingly expected to be involved in the transaction and help the private equity house approach controversial issues with the vendor. “They should lead the way towards concluding the negotiations with the vendor. Generally speaking the vendor would like to achieve his target price, close the deal, take the cash and walk away,” says Ron Sheldon of Advent.

If there is no indemnity to act as a safety net and limit future damages, buyers tend to discount heavily to compensate for environmental liabilities. As the range of risks has widened – for instance, the acquisition of past liabilities in case of contaminated land or the possibility, nowadays quite frequent, of running a plant under the wrong licence – a buyer cannot afford to leave these issues uncovered in the deal.

Unfortunately, it is still the case that some deals are pushed through in a hurry for commercial reasons with no regard for environmental issues. However, it has become more common to identify ways to solve the problem before closing a transaction. “The solution can be technical or contractual.

The contractual approach means to find a legal way to cover the situation,” says Hockin.

Market downturnThere is some concern that the current economic downturn and uncertainty in financial markets will affect the environmental industry. It is certainly the case that the industry may suffer a bit in the short term, resulting in a deceleration in its growth rate. The environmental consultants, however, are sure that in the long run their business will continue to grow steadily. “There is absolutely no question that the market will continue growing,” says John Simonson. “We expect the deal flow to pick up again in the next quarter as there may be some opportunistic situations with companies needing to sell their business.”

“The current slowdown has not changed the dynamics of the relationship between environmental consultants and private equity houses. If anything carrying out environmental due diligence has become even more important for securing financing as investors are now more cautious,” says Chris Miller Jones, a senior consultant at WSP Environmental. As a consequence, debt providers are expected to become more involved in EDD rather than staying in the background.

So far debt providers have rarely instructed EDD consultants directly, preferring to leave the private equity investors to manage the relationship. “But, as they are an important part of the deal and have to be happy, they indirectly influence how we shape the due diligence,” says John Simonson.

Different parties involved in the deal normally have different requirement from the due diligence process.

“One of the concerns of PE houses is the directors’ liabilities for environmental issues because they normally put a director or two on the company’s board. The debt providers, on the other hand, are more concerned with issues such as land contamination that can have an impact on the security they hold,” says Hockin. “PE houses want to know how to address the business case, not only the financial case,” adds Jens Tonn, a director at Candover Partners. “It is easy to talk about numbers but, unlike the debt providers, we need to assess the impact of environmental issues on the business, for instance how many people we need to recruit, as the scope expands.”

EU Directives

What keeps EDD on the transaction agenda is the constant need to fully understand and be aware of EU directives and, most of all, the need to look ahead and assess the impact of their future implementation on a company’s performance. In recent years the EU has been particularly active and issued a series of directives in the fields of environment, health and safety.

Although a White Paper has been produced recently to harmonise the approach across Europe, it is still up to individual member states to set timetables and implement directives. As a result there is wide variation in member states’ legislation and enforcement practices with the result that regulations and agreements have emerged piecemeal and at the national rather than global level. For instance, Germany and Scandinavia have put in place good environmental legislation, in some respects anticipating Brussels’ requirements, while countries such as Spain and generally the whole of Southern Europe, have kept legislation down to a minimum.

This is confusing for business, especially for multinationals, as there are several scenarios that a company has to take into account for managing environmental issues. Moreover, the time lag between the approval of a EU directive and its implementation by a member state can be tricky.

“We always have to look forward. For instance, there may be a piece of legislation that has not been properly implemented, but that can have a strong future impact on the business,” says Jim Finnamore. This is particularly true for Central Europe, which, according to Ron Sheldon, is the biggest issue at the moment. Investors will need to assess how much companies based in central European countries would need to spend to comply with EU directives once those countries have become EU members.

The key environmental, health and safety issues being addressed at the European level are the discharges of industrial waste (IPPC Directive), the ratification of the Kyoto protocol on climate change and the reduction of solvent emissions (VOC Directive). “At the moment companies are concerned that the IPPC directive may hit them in a couple of years,” says Justin Dye of ERM. “We anticipate that the new permitting procedure will take approximately two years to settle down.

But it is already clear that companies must be prepared to enter into a great deal of detail regarding their installation.” According to the EPPCdirective existing facilities have to be phased in by industrial sector over the next seven years.

There are many other general regulations in the pipeline, including the Water Framework Directive and Landfill Directive. In addition there is a range of Directives aimed at specific sectors (i.e. electronics, automotive etc.), which will come to force over the next five to seven years. In the longer term, there is some discussion regarding liability for soil and groundwater contamination. “This is typically one of the most significant environmental cost/liability issues for transactions,” adds Dye.

Few doubt that, as environmental issues move further up the agenda of European societies, environmental risk management of all sort will continue to grow at a healthy pace. There is, therefore, plenty of opportunity for environmental consultants, and these opportunities are due to grow in scale and scope. But to stay up to the task: “Environmental consultants have to continue to understand PE needs and add value,” concludes Jens Tonn.