Focus – Environmental Due Diligence: The greening of due diligence

Environmental due diligence is playing an increasingly important role in many European management buyouts but there remain concerns among some private equity firms about the varying quality of environmental consultants.

For their part, consultants argue that if they are brought into the process earlier and are an integral part of the advisory team they can often add more value than when they are only given a short period before completion to identify environmental liabilities.

While industrial smokestack industries are still the mainstay of environmental audits, a growing number of acquisitions in other areas, such as hotel chains, are raising environmental liability issues.

It has become harder to categorise certain sectors as high risk or low risk, says Alistair Dalziel, a director at consultants Waterman International. “Traditionally investors have been fixated on the risk of contaminated land but the majority of issues requiring an indemnity or warranty relate to water and air.

“For example, a food processing company may be on a greenfield site but may not comply with air emissions standards and need to install air scrubbing apparatus, which could mean a liability that has not been budgeted for.”

Property is an increasing focus for environmental due diligence. One consultant, who asked not to be named, says: “We did due diligence for the acquisition of a private hospital in France. It was very plush but the building itself was over a hundred years old and we found that there were significant problems around radiation escape and asbestos. Furthermore, there were no effective fire or health and safety procedures in place.”

The broadening of environmental due diligence is largely due to the expanding scope of environmental legislation in Europe. For instance, some 7,000 companies are caught in the net of the UK’s Pollution Prevention Act compared with 2,000 under previous legislation. “Most companies now have to comply with environmental permitting in some area,” says Dalziel.

It is a similar story across Europe but, while legislation may be increasingly harmonised enforcement can vary. Enforcement in northern Europe is commonly tighter than southern or eastern Europe.

This does not necessarily mean, however, that environmental standards can be treated more casually in certain regions, says Mike Atkinson, head of the environmental team at consultants WSP.

“If we’re acting for a UK company acquiring a business in a country where the legislation is similar but regulation is more lax often we apply the same standards because it’s the UK shareholders and investors who will be accountable if there are problems further down the line and there can be considerable negative PR for the company at home.”

But are environmental consultants up to the job of carrying out effective due diligence for private equity investors?

Some investors are concerned that there is still a lack of commercially aware consultants who really understand the needs of equity and debt providers. Jens Tonn, a director at private equity firm Candover Partners, says most consultants are good technically. “But what we really want is someone who can see things from our point of view, is financially oriented and can link the audit to the business plan we are trying to achieve.”

He adds that too frequently, instead of highlighting a handful of significant environmental liabilities affecting an acquisition consultants will detail a hundred issues in a long unwieldy report. “We tend to return to the same consultants and they are the ones who have shown they are business minded and understand what we want to know.”

David Hockin, a director at RPS Consultants, agrees that some environmental auditors miss the point. “You can do a technically competent environmental report that does not really address the concerns of the lawyers in a transaction,” he says.

More sophisticated consultants can tackle issues such as identifying liabilities and apportioning them between vendor and purchaser, he notes, as well as understanding the varying impact on different participants in a management buyout.

“Debt and equity providers may have different outlooks,” he says: “For example, the debt provider may be particularly concerned about land contamination because they will hold the security over land and will want to ensure they are not left with a liability.”

This mix of needs among transaction participants means it is essential to discuss environmental liabilities as soon as possible within the management buyout team, he argues. “Once material liabilities have been identified by the due diligence they need to be discussed internally among the equity and debt providers before there is negotiation with the vendor.

“I’ve known transactions collapse because some bad environmental news has arrived late in the process when if it had been known earlier and discussed internally a way through may have been found.”

Chris Wynne, managing director (Europe) at US-owned IT Group (formerly Fluor Daniel GTI), says it is up to the consultant to interpret the environmental data in the context of the deal size. “If it’s a $100 million transaction there’s no point highlighting remedial work that will cost, say, $5,000. The report should be meaningful in terms of identifying the potential liabilities and putting issues in a commercial context, such as how will the liabilities affect the deal and whether they can have an impact on the pricing.”

Today more information is coming through earlier, as an increasing number of vendors realise the importance of environmental issues and provide their own audits to potential purchasers.

“These days often we find a lot of work has already been done and we’re not starting from scratch,” says WSP’s Atkinson. He adds that a few years ago vendors often did not even consider environmental risks as part of the business. But despite this increasing flow of early information, the consultants will still need to carry out an analysis in the context of the private equity deal. “We try to take the information a step further in terms of predicting what the situation will be over the following five years or whenever the exit strategy is planned for.”

But the fact that the vendor has provided an environmental report up front can be a mixed blessing and any information should be treated with caution, says Waterman’s Dalziel. “If the vendor has prepared the report he may have played down some liabilities and it will not be as exhaustive as we would require.

“This means a vendor’s report can be of dubious value and may even slow down the process and make it more costly because we may have to spend a couple of weeks going through it and finding out it hasn’t covered certain issues properly so we have to re-investigate.”

Vendor’s information can be cursory, he adds. “We may get a so-called due diligence report on 20 to 30 sites, in which information on liabilities have simply been gained from some phone interviews.”

It is also important for consultants and the purchasing team to maintain a healthy scepticism, no matter how trustworthy they may feel the vendor is. Jens Tonn of Candover says: “We had a situation where we were dealing with people we knew and yet there turned out to be a highly relevant two-year-old environmental report that they did not make available early in the process and that kind of behaviour makes you very suspicious.”

But the growing recognition among vendors of the importance of environmental issues does make it easier to negotiate changes to the pricing structure when liabilities are identified. “You can develop a sliding scale mechanism for the pricing, governed by the scope of potential contamination,” says Tonn.

Nevertheless, predicting the cost of environmental liabilities is by no means an exact science. “A good consultant should be able to give a fairly realistic forecast of the cost of remedial action,” says Alistair Dalziel: “There can be wildly varying opinions on the costs of cleaning just two acres. There have been a couple of cases where the costs of remediation have been out by up to 50 per cent and in one case a consultant was sued.”

The risk of being held responsible for poor advice has led in the past to some consultants providing overly cautious reports, in an attempt to cover themselves if things go wrong, says IT Group’s Chris Wynne. “Two or three years ago the initial environmental report became a commodity market, with firms competing over who could provide the 20-page report for the least money,” he says. “But such reports were of little use to the private equity investors because they were so conservative and more recently investors have been looking for consultants with more expertise, who can do more than just gather data.”

Dalziel argues that consultants cannot afford to be too cautious in an attempt to protect themselves from future professional liability claims. “At the end of the day the consultants that are invited back are those that help get the deal through, unless there is a material reason why not. We always aim to produce a readable short report that hones in on the main issues rather than 20 pages of housekeeping.”

He says there is far greater awareness of consultants’ own liabilities if advice turns out to be poor. “Companies like ours are quoted on the stock market and have a fairly robust standing and professional indemnity cover.”

Increasingly the large environmental consultancies are marketing themselves as able to offer more than simply advise on “holes in the ground”. They argue that they can often have a role in non-smokestack industries and that when they are fully involved in the advisory team, rather than called in at the last minute, they can add value to many deals.

WSP’s Mike Atkinson gives the example of a management buyout last year of a company that manufactured the plastic seals found on jam jars. The investors were concerned that because the company was still using cellulose to manufacture the seals, rather than PVC which most its rivals had adopted, there would be major costs in updating production equipment.

“Cellulose is biodegradable and much more environmentally friendly than PVC,” he says. “Our study showed that, far from being a liability, this put the company at an advantage to its competitors in terms of marketing the product to supermarkets, which are increasingly demanding environmentally friendly products from their suppliers.”

He cites the case as an illustration of how environmental consultants,

by approaching an investment from a different perspective, can add to the bottom line.

Involving environmental consultants at an earlier stage can bring significant benefit for the investors, says RPS’s Hockin, although he accepts that time pressures are not necessarily the fault of clients. “They’re often involved in auctions and many consultants, although not us, are unwilling to offer contingent services, in which they are only paid if the client is successful,” he says.

Dalziel comments: “Those clients that understand the process well bring us in early, with the other advisers, and we are involved in the debriefing at the end.” Those investors know the consultants can often shed light on the quality of management in the company being purchased, he says: “The way that environmental issues have been handled at various sites within a group can tell you a lot about the quality of management at those sites.”

A similar point is made by Chris Wynne: “Just presenting a report through the lawyers can become an academic process that the investors feel they must go through.

“But if we are involved in the negotiating team from an early stage we can influence the transaction more by, for example, benchmarking the environmental management standards in different parts of the company.”

Attitudes by both management buyout purchasers and vendors to environmental due diligence have changed significantly in recent years, says David Hockin. “To some extent I think people have over-reacted and some are obsessed with environmental risks but the basic approach must be to identify sensible consultants who can give sensible advice.”