Buyer Beware: Environmental Liabilities
In today's regulatory structure, target companies may have dozens or hundreds of environmental liabilities. Buyers should quantify these liabilities during M&A due diligence because they can add significantly to the ultimate cost of an acquisition. A painful example of these costs is a $4 billion Superfund bill that one company faces because of a chemical firm acquisition it made in New Jersey. Although using environmental liabilities as part of a walk-away threat may be rare, environmental liabilities can deflate acquisition profitability and distract from future merged operations. However, factoring environmental liabilities into the acquisition price can be difficult because generally accepted accounting principles (GAAP) allow balance sheets to carry only portions of the cost to closure; oftentimes, environmental risk expertise is not necessarily in a buyer's sweet spot; and other business issues usually take precedence in the due diligence process.
Environmental liabilities come in two forms: operating and legacy. Operating liabilities are generally well defined and include air or wastewater treatment for permit compliance. Legacy liabilities can be less well defined, particularly for complex acquisition target companies. There are many uncertainties in existing projects, and new projects can arise unpredictably. Uncertainties for an M&A buyer to consider include:
* Future, new involvement at sites from long-forgotten historical waste practices
* Poorly defined environmental conditions from site studies
* Undefined future remedies
* Unanticipated events
GAAP rules require balance sheets to carry only environmental reserves that are reasonably anticipated. Many companies interpret this standard to mean only what has been ordered or required to date by an agency. This could be just the tip of the iceberg, however, and a buyer must consider if a target company has:
* Possible new, future sites
* Sufficient studies at known sites to define remedy needs
* Defined remedies at known sites
* Sufficient remedy cost estimates
These considerations involve uncertainty and unknown risks, and a buyer needs a seasoned environmental adviser with the expertise to define and quantify these uncertainties to estimate the cost of a target's environmental liabilities during the M&A due diligence process. However, no matter how seasoned, no environmental expert can nail the future exactly with a single predicted outcome. A statistical analysis that more accurately accounts for a range of reasonable study and remedy alternatives should be considered. One process for this analysis, environmental portfolio valuation (EPV), uses a decision tree to lay out each step and its alternatives, along with a statistical technique called Monte Carlo simulation to analyze the combinations of alternatives, to arrive at a total cost estimate of a target company's environmental portfolio. The process is based on the American Society of Testing Materials (ASTM) International, Guidance E2137 for estimating environmental cost.
The strength of a statistical approach for estimating future environmental costs is that the answer (estimate) can be tuned to the risk tolerance of a buyer in light of the nature of the cost variability. EPV provides a distribution of possible costs, from the 0 percentile (no chance) to the 100th percentile (largest cost possible), along with a mean and variability statistics, so that a buyer can select a cost estimate based on risk tolerance and the nature of the predicted cost distribution.
The first important detail is to define each future environmental project properly. Both practice and regulations (e.g., the U.S. Environmental Protection Agency's [USEPA] National Contingency Plan and hundreds of guidance documents) determine the prescribed course of action. For example, a site must be studied, but study costs can easily balloon. Some of today's Superfund studies cost more than $100 million. Each project step has alternative possibilities, and each alternative has a likelihood. Project steps include studies, remedies, agency oversight, monitoring, insurance reimbursement and cost allocation.
Within the EPV framework, environmental professionals know the steps and can define a limited number of alternatives, spanning potential costs, to each step. In addition, existing project documentation can often shed light on each alternative's likelihood.
Each step and its alternatives, start times, durations and quantities or rates are laid out on a decision tree in EPV. Once each project has been defined, the next detail is to assign costs for each alternative. This determination can be accomplished using either project-specific information or industry-based estimates. Project-specific information is preferred because it can expedite the due diligence process, and it generally uses site-specific information and is cost estimated. Often, however, reliable cost information is not available for all remedial alternatives, so it must be developed as part of the due diligence process. This is done using a response cost database (RCD).
The RCD includes capital and operations and maintenance-cost estimates for about 220 activities common to addressing legacy contamination. The RCD has the capability to provide costs for studies and remedies with options for size scaling, activity nuances (e.g., hazardous versus non-hazardous disposal) and appurtenances (e.g., design, agency oversight, permitting, treatment plant buildings). In addition to chemical contamination, the RCD handles special types of contamination, such as explosives, radiation and asbestos. Legacy contamination activities often have many pieces, which are all included in the RCD. For example, soil-removal remedies in the RCD include equipment mobilization, excavation, stockpiling, loading, transportation, final disposition and backfilling.
After assigning costs to each step's alternatives, EPV's final stage involves a Monte Carlo simulation of 100,000 combinations of those alternatives to arrive at an estimated cost distribution for the entire project. The advantage to a buyer is:
* It considers alternative outcomes.
* The decision frameworks are already developed, so there is no learning curve.
* It supplements missing cost information with the proprietary RCD.
* It enables a buyer to adjust its acquisition model based on its risk tolerance.
The alternative to EPV for M&A due diligence is what the ASTM guidance calls a "most-likely estimate," which is usually performed by a trusted advisor but offers little insight into the uncertainties of environmental projects and provides no insight into the magnitude of high-end cost probabilities.
For more coverage on how dealmakers can leverage sustainability initiatives to increase value, read "Private Equity Perspective: Environmental Due Diligence Creates Opportunities" or watch the video.
Neil Shifrin, Ph.D., has been an environmental engineering consultant for almost 45 years and is a director at New York-based advisory firm Berkeley Research Group. Terence Rodgers, Ph.D., has more than 30 years of experience using quantitative modeling in construction and valuation, and is also a director at Berkeley.