The environmental challenges of due diligence and preparing for ESG

Not long ago, a client would ring asking for a proposal for an environmental due diligence assessment. Over time, that request evolved into environmental, health and safety due diligence. Today, a small but reasonable proportion of inquiries relate to environmental, social and governance (ESG) assessment. What the client means by ESG varies widely, often not far from earlier due diligence models, but collectively accounts for the growth of challenges facing businesses in this area.

Historically, environmental due diligence reflected the material business concerns of legacy issues such as land contamination, asbestos and ‘end-of-pipe’ compliance at a target’s main production or operational facilities. More recently, the health and safety management assessment has become increasingly relevant, as the prospect of fines, litigation and reputational damage increases.

At the same time, there has been a shift in legislation, with greater focus on the composition (and safety) of raw materials used in products and their end-of-life disposal arrangements or recyclability. The corporate rather than facility level legislative compliance has also changed the landscape, particularly in regard to energy and carbon in light of the UK’s carbon reduction commitment.

While, in practical terms, it remains difficult to effectively assess issues down a target’s supply chain, there has been a growing understanding of the risks associated with a supplier’s operational practice following a number of high profile cases in this area.

Finally, while informed acquirers have habitually concerned themselves with the level of governance demonstrated by a target firm, together with the nature of its industrial and community relations, formal assessments under the ESG umbrella are becoming increasingly standard.

Environmental due diligence has always been a key topic in investment decision-making for two main reasons: acquirers want to know the scale of potential liabilities and future cost requirements; while lending banks want to know what they might inherit in the event of a default.

Nevertheless the drivers have also increased as private equity has begun to take a more serious approach to ESG, with all the main standards and guidance stating that robust pre-acquisition due diligence is necessary. This guidance has encouraged general partners (GPs) to ensure that diligence is undertaken earlier in the process, with an initial screening assessment, to determine likely factors and work out what will require more detailed diligence as the transaction progresses. This guidance has also encouraged GPs to consider the wider scope of social governance, rather than environmental issues alone, identify opportunities and not just contingent liabilities.

That being said, common pitfalls in due diligence remain the same. The diligence is often too narrow and focused on liabilities and compliance issues at facility level, rather than looking at the business and its products holistically. The process is also often handled hastily, neglecting the evaluation of many issues at a sufficient level. As such, these reports are potentially unhelpful, detailing too many uncertainties, data gaps or broad cost range estimates.

ESG is also a driver in terms of value creation through the promotion of improvement in portfolio companies during the ownership period. Informed limited partners (LPs) no longer expect GPs to just have an ESG policy in place and demonstrate an appropriate level of attentiveness to target investments. They now want to see tangible evidence that improvements are being made during ownership and measured against a set of predetermined key performance indicators (KPIs). This results in an increased push to maintain and demonstrate compliance and the implementation of formal EHS policies and systems. During the search for operational efficiencies, clients are more mindful of a necessary reduction in the use of non-renewable resources, and the elimination or substitution of conflict minerals. This enables portfolio companies to anticipate upcoming issues in legislation and consumer trends driven by ESG factors.

ESG carries a cost that would have historically not been prioritised by GPs wanting their portfolio firms to invest. But it is positive, in terms of keeping the portfolio company operating smoothly and realising operational efficiency, to prepare for an eventual exit. It also encourages more robust vendor due diligence reports, and demonstrates a track record in improvements, rather than liabilities. Although many of the efficiency improvements do not yield the same returns to investment that GPs often achieve in other areas, effective ESG management will help to develop more resilient business and ensure smoother exits.

By Tomas Sys, Principal Consultant, Ramboll Environ