Despite the recent decision by the Federal Reserve to increase interest rates, many continue to anticipate steady competition for mergers & acquisitions (M&A). With sustained demand for deals, there are no guarantees that prospective buyers will secure deals even when they offer bids with high cash flow multiples. Prospective buyers likely will face a number of the same challenges in 2016 that existed in 2014 and 2015 – very short due diligence periods, competitive auctions, and “take-it-or-leave-it” seller-friendly contract terms. To respond to these challenges, buyers are well advised to structure the environmental due diligence framework to focus on obtaining material information at key junctures in the transaction process in lieu of the traditional model that called for Phase I environmental site assessments up front, irrespective of the bidding structure and deal timeline.
Environmental issues can significantly affect the valuation of a deal for a prospective buyer. Ensuring that the diligence process reflects an appropriate business sensibility can be critical. For example, being able to distinguish material environmental issues from nonmaterial environmental issues, focusing on what is most important to the business client, and finding value drivers in transactions and opportunities for cost savings are all key markers for a well-engineered environmental due diligence plan. In addition, a good environmental due diligence plan should be adaptable and seek opportunities to develop information that can be used post closing. For example, the due diligence period can be used to identify potential risk mitigation tools that may be implemented after the deal closes. The EPA’s self-audit policy for new owners, “Interim Approach to Applying the Audit Policy to New Owners,” can help new owners of companies avoid large statutory penalties for violations discovered in the course of environmental due diligence if they are disclosed in accordance with the policy. 73 Fed. Reg. 44,991 (Aug. 1, 2008) (EPA’s new owner policy). To qualify for the benefits of EPA’s new owner policy, however, self-disclosures must be made soon after the environmental compliance is discovered.
A thoughtful environmental due diligence plan can also help buyers ensure that diligence is conducted in an efficient manner and is tailored to the particular deal, target company, and client’s goals. Rather than relying exclusively on one lengthy diligence memorandum that is produced near the end of the diligence period, buyers can request that environmental counsel and consultants provide more frequent oral briefings and shorter periodic written summaries.
More frequent communications can also help avoid common misunderstandings in the diligence process. By discussing the following issues at the outset of the diligence period, buyers can help avoid misunderstandings:
- The materiality threshold for environmental issues
- The type of site assessment or other environmental review to be conducted at various stages of the diligence process
- Who will review documents in the seller’s electronic data room
- Client’s preferred manner for presenting diligence information (written reports, Excel spreadsheets, verbally)
Materiality can vary based on the transaction size, the risk appetite of the prospective buyer and the finances of the deal. The environmental review should be calibrated to take all of these factors into account. Understanding the types of liabilities or magnitudes of costs that the prospective buyer may consider to be showstoppers will help inform the approach to diligence. In some cases, environmental costs below $100,000 may be material to the deal. In other cases, materiality may be set substantially higher. Regardless of the threshold that is determined, experienced environmental transaction counsel will know to flag environmental concerns that individually may fall below the threshold, but in the aggregate may present a material issue.
In addition to a customary Phase I Environmental Site Assessments (Phase I ESA or Phase I), which provides an overview of recognized environmental conditions at a site through evaluation of publicly available records, a site inspection with a focus on operations at the site and the condition of the property, and interviews with owners/occupants – a Phase II Environmental Site Assessment (Phase II) – may be useful to the prospective buyer depending on the environmental risk profile of the target company’s business and the stage in the bidding process.
Phase II ESA activities are undertaken to confirm the presence or absence of contamination, set baseline conditions before acquiring a site, or reduce the uncertainty associated with previously developed cost estimates. Planning for and performing Phase II activities, however, may add several weeks to the due diligence timeframe and significant costs as they can range from $15,000 to $50,000 per site. Phase II activities may also expose the parties to possible reporting requirements if contamination is discovered.
Working together, environmental counsel and environmental consultants can separately prepare cost estimate reports, often in the form of ranges (or point estimates representing varying probabilities of occurrence), to address environmental issues that have been identified in the course of diligence. These estimates also may be developed based on the desktop review, but can be more useful when they are prepared after a Phase I ESA and/or compliance review is performed. The components of these costs estimate reports typically include
- remediation costs associated with known and potential contamination issues;
- capital expenditures required to achieve regulatory compliance or bring equipment in line with the buyer’s best practices;
- financial assurance obligations for the target company’s environmental obligations that the prospective buyer will need to assume post-closing;
- EH&S litigation (toxic tort, worker exposure claims), both pending and potential litigation;
- EH&S personnel expenditures required post-closing if it is not possible or desired for the target company’s EH&S management team to remain in place after the closing; and
- regulatory penalties associated with known and potential enforcement for noncompliance with environmental laws.
As early as possible, the buyer should discuss a strategy to review documents in the electronic data room, with a goal of ensuring that all of the information is carefully reviewed and analyzed while avoiding unnecessary duplication of efforts. A logical initial allocation of responsibilities could entail the environmental consultants focusing on technical and remediation documents and the legal team evaluating documents related to regulatory compliance, environmental enforcement, litigation, and contractual allocations of environmental liabilities (e.g., in customer contracts, real estate leases, and corporate acquisition documents). As a matter of process, environmental consultants should flag for further legal review any documents that may have broader implications to the valuation of the company, specific environmental liabilities, and other general concerns. Discussing this division of labor and client expectations regarding the review should occur early in the process to avoid misunderstandings and cost overruns.
In addition to conducting a desktop review, environmental counsel and consultants can mine other public sources to identify potential environmental risks associated with the target company and the industry in which it operates. For example, if the target company is a chemical manufacturer, the due diligence plan should include a regulatory review of the chemicals sold and rulemaking activity at the federal, state, and local level that could impact the ability to sell or distribute the chemicals. A consideration of regulatory risks should encompass not only environmental, health, and safety regulatory compliance, but also product safety and product compliance, such as Proposition 65 in California and the Registration, Evaluation, Authorisation and Restriction of Chemicals (REACH) in Europe. Additionally, consideration of industry-specific regulatory enforcement initiatives will aid in highlighting potential environmental liabilities that may loom on the horizon.
With increased competition for M&A deals likely to continue through 2016 and potentially accelerate further, a focused, well-organized and adaptable plan for environmental due diligence including the elements discussed above is value added in supporting a prospective buyer’s bid and protecting the buyer’s interests in the transaction.