Anthony O’Connor reports on the ever widening legal and regulatory issues facing environmental due diligence practitioners and their private equity clients.
European Union member states have never been faced with implementing so many environmental directives before. This does not mean that Europe has become an impossible market to buy and sell businesses, rather that managing environmental risk is increasingly shifting in importance up the due diligence ladder.
Environmental professionals are armed with anecdotes about how PE and VC firms basically ignored the environmental angle in a deal, only to stamp their feet later and demand a solution. Sometimes this lack of foresight can break a deal.
“Pensions and environment have become the two major issues in the PE field particularly because there are more US players in the market,” says Paul Watchman at Freshfields’ environment, planning and regulatory practice in London.
“Generally, not enough bidders are doing enough environmental due diligence. The problem is that many of them put in the bids before they do enough work. Then suddenly they become preferred bidders and start asking for indemnities,” says Watchman. “It’s often difficult to get corporate and PE people to focus on environmental issues until it has become a price reduction issue,” he says.
Some clients come in at the same time as they start commercial and financial due diligence but there is a real trend of others starting later, placing environment, insurance and property together; perhaps taking the cost-control approach too far.
“It was almost as if the deal had to progress to a certain point before anyone would spend any money on environmental due diligence. It should be one of those issues that should be triggered from the outset,” says Mark Thompson, a senior manager in the environmental practice at PricewaterhouseCoopers in London. “We’re now seeing a lot more vendor due diligence than we did before.”
Quantifying just how many deals feature environmental due diligence (EDD) at sufficient levels and at a sufficiently early stage is virtually impossible. However, a recent survey of FTSE-350 health, safety and environment managers in the UK, conducted by KPMG’s Sustainability Advisory Services, gives a good indication of the trends.
The survey is based on 44 replies. It found around two-thirds of UK companies undertake environmental due diligence as part of their transaction process. Just 40% of respondents said they combined environment with financial and commercial issues.
However, what might set alarm bells ringing is that about 25% of respondents said environmental issues had come to light post-transaction despite the fact that 80% of them had carried out the due diligence. In about half of the cases the issues raised were outside of the scope of the original assignment.
James Stacey, head of the environment team at KPMG Transaction Services in London says: “Historically the focus of EDD was on environmental liabilities and regulatory compliance. These remain important issues, but others have now entered the frame.”
The way environmental regulation has changed over the last 10 years across Europe has indeed been dramatic and quick paced. Environmental due diligence is no longer just
about contaminated land and water pollution, which are very real and important issues, but also about a complex blend of commercial and environmental considerations. “You need to focus on how the environment impacts on the business and not how the business impacts on the environment,” Stacey says.
The KPMG research raises concern about the number of corporates taking environmental due diligence seriously enough and raises the question of whether EDD consultants are being thorough enough.
The FTSE-350 companies and the PE community tend to use the same environmental advisers, which leads to the assumption that the findings among FTSE-350 companies could be applied to PE deals. Although the fact that a PE house buys with a future exit, within a given three to five year period in time, suggests the focus and scope of the EDD reports they commission might differ significantly from that of a buy and hold corporate investor. However, big corporates tend to have expert environmental officers on their payroll, which PE houses do not.
Much of the first phase environmental research involves scoping a project. Here a general report on a target company, say if the consultant is working on the buy side, is produced focusing on technical and regulatory issues and more increasingly on how the changing climate of environmental issues will impact on the business.
This is increasingly known as an enhanced desktop project. However, PE professionals are advised to stay away from off-the-shelf packages. Information is collated from regulatory authorities and other database resources. And more often, consultants
are relying on media resources like news clipping databases and trade publications.
The pressures here appear to be cost-related. Investors want a picture of a company but are not prepared to spend too much on the initial research. That said, a good basic picture of a target can be established.
European markets have become more EDD-friendly in recent years, making the consultant’s job easier and securing a successful conclusion to more deals. “Around five years ago or so, if you were doing a due diligence assessment in France, for example, it would have been very difficult to obtain regulatory information about a site. You just wouldn’t get any feedback from the regulator,” said Pascal Meyer, a senior consultant at Golder Associates. France now has an easily accessible database listing contaminated sites and industrial sites and the regulators are happier to talk to researchers.
When due diligence becomes more detailed, it focuses on specialised and local knowledge. “The key to doing due diligence is having local people doing the groundwork. We use a lot of local consultants because they know what’s going on,” says William Butterworth, a senior consultant at RPS in London.
“With fewer deals being done, some people are holding back on increasing the level of their fees until they’re sure the deal will get done,” he adds. “Overall, coming in at the end of the process is never ideal.”
Nevertheless, even if a consultant is charged with a detailed assignment, there are certain situations where access to information is not so easy. “Particularly in public-to-private transactions information is restricted, so you have to extrapolate information from across the board,” says Butterworth.
“There are significant differences that exist. Often we find a target company does not want to provide enough detailed information, because they are generally not used to being in the spotlight. But other companies can be very helpful. It just depends,”
Some sophisticated environmental due diligence may require close scrutiny of a company’s accounts, which is a form of disclosure some companies are not happy to offer. One example is a privately owned paper manufacturer, which is one of the main employers in its local area. It may not want to release information on provisions in its accounts for future health claims against the business. Or it may be sensitive to water waste or air-bound emissions, for example, but all of these issues are vital to facilitate
an informed purchase.
“There’ve been a few deals recently where we’ve had no access and all we can do is look at information in the public domain. You get a lot of deals like that,” says Mark Browning, senior manager in the environmental practice at PricewaterhouseCoppers in London. His colleague Mark Thompson, also a senior manager, adds: “In some cases you might come across cultural resistance. But you have to acknowledge that it can be very uncertain for everyone involved.”
With indemnities a point of concern for a financial investor buying from a trade vendor, then this concern can only become more complex as the PE secondary market develops. “We’re now seeing PE selling to PE so you want to structure an indemnity with a long enough duration so the ultimate purchaser will still have the benefit in the eventual sale,” says Watchman.
Generally, in cases where the sale features PE counterparties, drafting legal documents not only has to take into account the three-to-five years following the firm’s entry into the private equity investment, but it has to take into account environmental considerations on the firm’s eventual exit.
Added to this dynamic is that a deal may feature a number of sites across Europe and each local issue has a completely different set of legal requirements. “Deals feature national as well as international aspects so you’ll never get a blanket indemnity for all the French, German and Italian aspects, for example,” says Watchman. “Try to ask for a 10-year indemnity in Germany; this is just not possible”Knowing what environmental issues to look out for not only depends on the country but also can differ from region to region within a single country.
In the UK, for example, the application of contaminated land issues, playing catch up from the Environment Act 1995, will be applied in many different ways. “Environmental regulators have a responsibility to investigate contaminated land issues. But different local authorities will apply different resources so second guessing this is difficult,” says Butterworth. “It is difficult to be sure how your site or collection of sites will be viewed by the regulators.”
Germany takes information on site disclosure very seriously and any party with information or data on it is required to disclose the information to the regulator. This can sometimes spark friction between the vendor and the purchaser, making EDD complex and sensitive at the same time. Consequently, one of the last things anyone doing environmental due diligence in Germany wants to do is put a spade in the ground because it will dig up more than just worms.
Conversely, regulators in Switzerland require the owner of a site to prove it complies with environmental targets; otherwise it is listed as contaminated or non-conforming.
Different EU member states have different legislation, which either lags behind new and upcoming directives or pre-empts it. Certain countries like those in Scandinavia, Germany, the Netherlands and Belgium have good track records on environmental regulation and enforcement. The next tier of countries includes the UK, France and Italy. Spain, Portugal and Greece lag the rest. In certain cases, some countries are
given the opportunity to take more time to transpose and enforce EU directives into their national law.
For the EU’s new members, the 10 Accession countries, the challenge will be intense to enforce the laws many of them have transposed into their national laws. However, those pressures are also expected to translate into investment opportunities.
One of the main directives that will have an impact on European business is the climate change issue in relation to greenhouse gas emissions, which will initially focus on CO2 emissions. “It’s going to affect all 25 member states in the expanded EU and it will have an effect on tens of thousands of organisations,” says Simon Taylor, senior consultant at ERM in London.
Companies will be given targets to work within over a two-year period and if they achieve this target they will get rebate on their energy use levies, which could be as much as 80%. Those that fail will lose their rebates and will have to wait.Companies will be able to trade their emission credits. If one company exceeds its target it can buy credits from another company.
This is a prime example of environmental legislation generating PE opportunities. “If they are clever, companies will see opportunities here by storing up credits and trading them,” says John Simonson, partner at ERM in London. “We’re getting a lot of interest from our heavy industry clients,” he says. Although others point to the fact that the US has failed to sign up to the Kyoto Protocol as a reason for this fledgling market remaining just that.
The EU Landfill directive, coming in soon, will make it illegal for liquid waste to be dumped into land sites, sparking a demand for liquid treatment plants. Land sites will have to specify a single waste purpose under the law.
There are also plans for more recycling of food and garden waste. There are expectations that this waste will be made into compost for gardening, at the same time protecting the future of peat-based products that have typically been farmed from fragile locations in Europe.