EDD in practice: risky business for consultants
UK environmental advisors are experiencing a boom in due diligence work driven by stricter regulation, increased awareness of environmental risks and a trend towards taking corporate social responsibility more seriously. Rob Bell takes a closer look at the way EDD services are evolving
Consultants and lawyers offering expertise in environmental due diligence (EDD) to corporate clientele in support of mergers and acquisitions, property transfers and other transactions are finding their services in greater demand than ever before.
Environmental consultancy SLR reports a 90% increase in this sector from last year and Environmental Resources Management (ERM) has seen growth of 22% in its mergers and acquisitions (M&A) advisory services across Europe, the Middle East and Africa for the financial year 2006/07.
The volume of M&A around the globe reached a record high in 2006, with transactions amounting to US$13 trillion.1 With such sizeable investments at stake, organisations are becoming increasingly diligent in evaluating potential deals. Key to this process is the assessment of a range of environmental issues that have the potential to impact not only the initial value of the transaction but also the future success of the deal.
As ERM states in its latest annual report, "by taking a diligent approach for buyers we’re not only able to identify potential hidden costs but also protect their brands – a vital consideration given the increasingly close scrutiny of a number of transactions by the public and investors alike."
Under accusation by the media and increasingly targeted by government and regulators, companies are under mounting pressure to become more transparent and accountable. Also contributing to growing demand for EDD is increased awareness of environmental liabilities and reputational risk.
Adam Black, associate director of risk and sustainability services at KPMG, says: "Clients are becoming much more sophisticated in terms of protecting their reputation. And not just corporates and the industrial sector; but banks and private equity companies are also looking at the environmental and other issues associated with their portfolios."
Waterman Group’s environmental consultancy has advised on corporate deals totalling £13 billion in the past 12 months, representing growth of 30% year on year. Neil Humphrey, who leads Waterman’s EDD team, says the majority of its work is now in the private equity sector: "The prudent private equity firm realises the environment is a big part of the business – and will become more so in the next few years."
Steve McNab, who heads up the environmental and planning team at law firm Travers Smith, has also seen work for finance companies increasing as a percentage of projects. He explains: "Private equity firms always have their eye on their exit in three to five years, and are very accepting of thorough EDD projects on the way in as they’re looking to flush out as many issues as they can. They then want a post-transaction plan to fix any problems so that on exit the same issues can’t be raised again."
Polarisation
The demand for EDD services that encompass the full range of environmental risk is leading to a split into two tiers of EDD work. First, there are the traditional property-focused investigations into contaminated land liabilities, which are becoming increasingly commoditised. And second, there are wider, more far-reaching investigations that have brought management consultancies into the fray, driving a more commercial, financially focused approach from the top environmental firms.
Waterman’s Neil Humphrey says: "The information systems available now mean you can get accurate information faster than ever. And while the traditional Phase I investigation approach hasn’t been replaced, the 24-hour availability of screening reports means that more often than not you can assess to a reasonable level of risk without having to carry out onsite investigations."
These cheap, accurate and fast reports from companies such as Landmark Information Group and GroundSure have fundamentally changed the EDD market (see box 1), acting as a leveller and forcing environmental consultancies to look beyond technical contamination investigations to add value.
Environmental risk report revolution
The rise of the electronically generated environmental report has revolutionised site investigation and due diligence work in recent years, offering cheap, easy, accurate data on historical land use, flood risk and environmental impacts.
The products of companies such as Daily Mail-owned Landmark Information Group, and GroundSure – recently acquired by Emap for £44 million – have partly driven the increasing polarisation of the EDD market. However, Richard Pawlyn, Landmark’s property and environment managing director, is determined the company will not be left behind.
Landmark’s services are squarely aimed at property EDD, a market Mr Pawlyn says is mature due to the rise of corporate social responsibility alongside requirements by the Law Society and many banks.
"The Law Society requires environmental reports in all transactions, so it’s cast in stone really," he says. "The due diligence process for commercial properties takes in an environmental report at the legal stage, and we’ve created other reports – for initial valuations and screening, and Envirocheck for the professional market."
He continues: "EDD is accelerating towards broader spectrum issues. For example, a lot of our current office stock is going to become functionally obsolete because it won’t meet emissions guidelines and green building regulations.
"We’re going to move rapidly towards a position where EDD covers energy consumption, the recyclability of the building structures, the extent to which the building fits the potential occupier’s needs and its environmental strategy."
Richard Pawlyn describes the changes as a huge challenge for the property sector, and says the wider environmental consultancy industry is superbly positioned to expand its range of services to serve a new market in ‘sustainability’ due diligence.
Landmark too has plans for the future: "We’re moving forward into new territories – environmental impact assessment, transport impact assessments, building energy efficiency certificates – all services that will be pertinent to EDD."
The company has recently launched a new version of its flagship Envirocheck product with a detailed geological mapping layer, and plans further products for the coming year.
Mr Pawlyn says: "A European product is on its way. Mapping the UK has cost us an investment of £20 million and it’s a relatively small place – Europe is vast, so we’re pursuing a step by step approach.
"We’ve now opened a business in Holland offering residential reports, and we intend to expand into other environmental products, and will most likely open another European company during 2008."
Simon Pringle, marketing director at WSP Environment & Energy, explains: "A few years ago, EDD was carried out purely in terms of guarding against exposure to some form of liability – end-of-pipe risks, core compliance with legislation, or contaminated land – which could end up meaning a substantial bill if you got it wrong.
"That’s still the core of reporting now, but the remit has broadened to encompass energy-related risk, carbon, supply chain issues and reputational stuff like how the company’s performance stacks up against its CSR reporting."
URS Corporation, a US-based consultancy with a major presence in Europe and worldwide, has seen a similar shift. Karen Aitchison, environmental lawyer and service leader for URS’s UK M&A practice, comments: "What we’re seeing now is a greater focus on softer issues – ethical, social and reputational, climate change and carbon footprinting. All of these areas are becoming much more high profile, with public and investor pressure mounting."
These changes are driving the polarisation of services within the market. Smaller, more technically focused consultancies continue to serve the need for property-related, mainly contaminated land investigations, while larger operators may offer a more thorough audit of risks and operations, which is being expanded to cover a much wider range of impacts and seeking to inform post-deal actions.
Simon Pringle says: "There’s a maturity in the UK offering when you’re talking about delivering EDD reports and the market is now aware of what a good report looks like and what should be in it. But there’s also a limited number of firms providing high-quality information that goes beyond a traditional EDD report – such as ERM, ourselves, Environ and others."
In 2007, ERM scooped two national awards for its environmental due diligence work (see box).
ERM wins praise for EDD
ERM was recently named ‘environmental due diligence firm of the year’ for 2007 at the Private Equity News awards for excellence in advisory service.
The awards were made based on the decision of an independent panel comprising 40 leading players in the European M&A market.
On receiving the award, John Simonson, global director of ERM’s M&A practice, said: "This award recognises the exceptionally hard work and high standards of ERM’s M&A teams based in Europe and throughout Eurasia, Asia Pacific, Africa and the Americas.
In addition, we believe that the award reflects the confidence which the private equity industry has in ERM for deals based in Europe and elsewhere globally."
ERM undertakes thousands of due diligence audits each year for a wide range of clients, working with all transaction partners including corporate environment, health & safety management, process specialists, lawyers, financial advisors and investors.
The consultancy also received an accolade for its due diligence work at the edie awards for environmental excellence in October 2007, as voted for by clients and industry professionals.
Commercial focus
This distinction between a straightforward desktop study – inevitably informed by reports from providers of GIS and historical mapping and accompanied if necessary by site investigations – and a full due diligence audit of wider environmental impacts, is forcing the top environmental consultancies into a race to increase their skill base to provide a more financially focused service.
Chris Jones, who has just taken up a position as head of WSP’s US environmental due diligence operations, says: "Commerciality is still an issue in our industry, because of our technical background. A lot of environmental consultants are in the industry because it’s a vocation – if a member of staff is an ecologist, it’s because they’ve got a passion for ecology. But those people don’t necessarily make the best commercial advisers."
Guy Mercer, head of corporate sustainability at Atkins, agrees: "People doing EDD now tend to have a more commercial focus. In response to the demands of the market, practitioners often possess an additional commercial qualification (for example, in corporate finance or an MBA) so they are able to demonstrate a mixture of skills. An essential part of any EDD engagement is a robust understanding of the wider commercial aspects associated with the project."
This more sophisticated approach to environmental due diligence has brought consultancies with a management focus into the arena, with KPMG, PricewaterhouseCoopers and others offering EDD services. However, KPMG’s Adam Black describes the role of management consultancies as "more of a strategic, trusted advisor relationship" with clients, advising on how to use technical providers rather than competing with purely environmental consultancies.
Rather than a threat, most environmental consultancies see the presence of the likes of KPMG in the EDD market as a boon, as Simon Pringle explains: "A lot of people think that the ‘big four’ coming into the environmental market represents a bad thing, but I’m not convinced it does.
"The services they provide are more transformational, as befits management consultancy, and if that draws environmental consultancy more into the corporate mainstream that can’t be a bad thing – it brings the whole industry up in terms of credibility and our market position."
EDD at this level remains at the very high end of the consultancy sector, leading companies such as WSP, ERM and others to look to bridge the gap between management and environmental advice and offering an opportunity to raise fees.
Mr Pringle comments: "Our industry is relatively young compared with lawyers and accountants. But if management consultancies and accountancy practices start operating in the environmental sector it helps to raise our profile and revalue our services."
As well as driving up fees, the offerings of KPMG, PricewaterhouseCoopers and the like are also forcing environmental consultancies to be much more commercially minded in their reports, as Waterman’s Neil Humphrey explains: "Clients don’t need the whole report, they need a financial extraction. So our reports are more financially quantified than ever before and can be dropped into a financial due diligence report.
"This need is not something that’s really being recognised by many other technical consultancies and is part of the movement towards a two-tier market."
WSP technical director Tim Clare says clients should be looking for broad technical ability, with great people in contaminated land, energy and wider legislative compliance issues. "But ultimately, sitting at the top, you need out-and-out due diligence experts."
Global business
International presence is also key to providing effective EDD services to the corporate M&A sector, and is clearly a bone of contention among some consultancies, with accusations flying of ‘shopfront’ offices and false claims of expertise on the ground in far-flung places.
Guy Mercer of Atkins says: "There is only so much you can do from your desktop, but you can’t really do proper due diligence without viewing the site to get some kind of feel for what’s going on. So you need people on the ground, because it’s not just about the technical aspects, it’s also about the culture on the site."
However, while most of the leading environmental consultancies have networks of international offices – ERM for example has more than 135 offices across 41 countries (see Global Markets article) – controversy rages over whether presence alone is enough.
Tim Clare is adamant that while office number and spread are important – consultancies often win work on those grounds alone – WSP also offers connectivity between its operations, allowing the skills of the company’s wider workforce to come into play. SLR, in contrast, has taken a different approach, one that managing director Neil Penhall believes brings greater local knowledge to the company’s EDD offering.
"Sometimes we have clients initially looking for a consultant because they have people based in many countries, but we believe there is a better option," he says.
"Where a company says it has 40 offices across Europe, the client should be asking what benefit that brings as they’re often purely shopfronts. We find that by using a specialist linked affiliate you gain the language and an understanding of local law, an approach that is often more effective than having an office staffed with people without the right level of expertise."
"SLR EDD consultants work closely with the affiliate organisation to provide the best of local knowledge of legislation and specialist EDD technical expertise. This way we can really add value to a client’s DD exercise," adds Mr Penhall.
New opportunities are being created within emerging markets, such as Central and Eastern Europe, reflecting the changing face of global business. WSP has seen its business in Romania doubling for two years running, while Poland is viewed as another potential success story, particularly as it is the focus of a great deal of German investment.
Tim Clare says: "It is the activity in Europe – be it real estate where cash is being spent in Central Europe or industry moving manufacturing into Eastern Europe – that is driving the business forward."
According to Neil Penhall, the real growth of EDD in Eastern Europe is driven by potential multinational acquirers that are "very, very focused on their brands and the need to do the right thing from an environmental point of view".
These firms are seeking to minimise risk by undertaking environmental due diligence to internal, EU or US standards, going well beyond what is required to comply with existing domestic laws.
New generation risks
Alongside a European and wider international presence, the ability to offer expertise in the ever-expanding range of issues becoming commonplace factors in environmental due diligence has become key to remaining on top.
WSP’s Simon Pringle comments: "A few years back we were providing technically robust solutions to fairly well-understood problems, but we’re now moving into a space where the problem is not particularly well understood – let alone the solution. If you’re looking at an acquisition you now need to investigate energy supply, carbon footprints and how to take effective action after integration."
Climate change and carbon issues head the list of non-traditional environmental impacts coming under scrutiny, due to the media frenzy about CO2 emissions, and driven by regulation such as the EU emissions trading scheme and proposals such as the UK’s Climate Reduction Commitment Scheme. The latter will impact on thousands of businesses including large offices, retailers, hotel chains, transport operators and hospitals.
At Atkins, Guy Mercer observes that "we’re seeing an increase in carbon due diligence and are wrapping it up in our service offering. Companies want to know if, by making an acquisition, they’re buying a carbon liability that is likely to become more onerous as legislation tightens further."
ERM notes in its 2007 annual report that "forward-thinking companies in the energy-intensive industries are starting to make decisions about investments and divestitures based on how much associated carbon and greenhouse gas ‘credits’ may be worth". The consultancy reports to have carried out a "large number" of carbon assessments in an M&A context in 2006.
Meanwhile, in response to "growing demand for socially responsible assessments", ERM has also extended its traditional due diligence activities to capture issues such as impact on local communities, culture and brand risk. For instance, when the paper and packaging firm Mondi announced plans to demerge from parent group Anglo American, ERM helped assess the new company’s social obligations and commitments, as well as forestry stewardship.
Other new generation issues becoming a critical focus for EDD include planning constraints on subsequent growth, flood risk, packaging, the cost implications of green building regulations and the risk that initiatives such as the REACH [registration, evaluation and authorisation of chemicals] legislation will regulate raw materials out of availability.
Waterman’s Neil Humphrey cites the European ozone-depleting substances regulations as a "huge issue" that will impact on the food sector from 2012. He says: "Replacement costs and plant upgrades can cost millions. In a recent deal we managed, the acquirer had no idea that would be an issue – it’s just not something you would ordinarily think about, but it’s relevant anywhere where refrigeration is concerned."
Consultants and lawyers
The higher profile of environmental risk has also changed the relationship between consultancies and their clients and other service providers such as law firms.
In the past, environmental experts were usually the poor cousin in M&A work, appointed late in the process and dictated to rather than consulted, as lawyer Steve McNab recalls: "When I started out we had a very different way of dealing with consultants; it was very hierarchal, with the lawyers close to the client over and above the heads of the consultants. We’d revise the scope of the project and really influence what the consultant would do, leading to a lot of quite unpleasant meetings."
However, this is no longer the case, and Karen Aitchison, a lawyer herself, says URS values consultants with a legal background for EDD work.
WSP’s Tim Clare says: "It’s increasingly common for companies to select a consultancy and law firm separately, where five years ago it would have been routine for the lawyer to procure the consultant."
Consultancies now often have ongoing relationships with both clients and law practices. By joining the team working on a deal earlier in the day, they can work with lawyers to agree the scope of an EDD project, ensuring the client gets exactly the information required and that suitable warranties are put in place.
Tim Clare puts forward the case for clients to heed the trend to appoint expertise early in the process: "While this might sound like the plaintive cry of the overlooked, don’t bring us in too late – we’ll charge more as we’ll have to bring more resources in more quickly and the result won’t be as thorough.
"Also, ensure the consultant has an EDD track record, as there are plenty of firms that will offer the service but don’t necessarily have the skills. We have a certain amount of business that consists of rescue jobs, where we come in halfway when what’s been done isn’t good enough. People knock stuff up and you think ‘oh my Lord’. It happens less, but it still happens."
The future for EDD
Environmental due diligence should no longer be seen as a process geared purely at identifying environmental risks and a tool to bring down price or limit liability, but as an opportunity to improve performance in the future.
Simon Pringle says: "We’d encourage our client base to see EDD as an entry point to transformation of the business, rather than simply a tick-box exercise."
And for the environmental services industry, enormous opportunities are opening up EDD work in Eastern Europe, the Far East and India, alongside China, as manufacturing moves away from the West. The proposed EU soil framework Directive – if it goes through as it stands – will also kick-start further growth closer to home, with its requirements for national contaminated land inventories and assessments as part of every property transfer.
UK consultancies, with their wider offering and new-found understanding of the importance of commercially-focused EDD reports, are also proving attractive to US companies. Neil Penhall explains: "In the US, consultancies have often had a more formulaic box-ticking approach, that was appropriate several years ago when EDD was much lower on the business radar. We look to really add value by undertaking more detailed EDD and our clients are looking for a higher level and broader expertise than they were historically."
Jim Gott, commercial director at Conestoga-Rovers & Associates, a Canadian consultancy that has developed a UK presence due to demand from North American clients for M&A support work, also says: "There’s a real gap in the market for ‘update audits’ for want of a better term, and I’m surprised we’re not asked to carry them out more often.
"US firms do ask for a health check to make sure that what they’ve bought in the first place is implementing necessary improvements and required changes – it’s a sensible way to look after your assets. There has been a certain amount of reticence in paying for updates, but demand is increasing and I expect we’ll get a lot more of that kind of work in the next two or three years."
Overall, the EDD sector is flourishing in the new business climate of environmental awareness and corporate social responsibility, with a further boost from EU expansion, globalisation of operations and increased regulation and scrutiny of business activities.
As Adam Black of KPMG says: "We’re being asked to comment on wider sustainability and supply chain issues, along with how the client might be perceived by wider stakeholders. For example, in the food sector the need for sustainable fisheries is an emerging issue. The traditional environmental issues are still there, but the scope of EDD has broadened and reputational issues are coming to the fore."
FURTHER INFORMATION
- Thompson Financial fourth quarter 2006 M&A review