Deal breakers

James Stacey, head of the environment team at the KPMG Transaction Service, explains the importance of environmental due diligence in mergers and acquisitions

Asurvey undertaken by KPMG Global Sustainability Services, Impact – A Survey of Environmental Due Diligence, confirms that environmental due diligence has become an important feature of merger and acquisitions.

In Europe EDD is considered sufficiently important for 84% of companies in high risk and 42% in medium risk sectors to carry it out during their transaction evaluation. Interestingly however, it is not automatically included in the approach many companies take to their due diligence, even in sectors at the greatest risk from HSSE issues.

Those undertaking EDD often find the transaction is influenced by HSSE findings, with valuation and/or contract adjustments and even deal-breaker outcomes being cited by 70%. However, companies are not always identifying all the issues. One third of interviewees indicated that they have been impacted by HSSE issues post transaction.

Legal and financial (capital and operating expenditure and liabilities) consequences of these issues remain fundamental to most EDD investigations, so integration of HSSE findings into legal and financial due diligence assessments is crucial. But HSSE issues now also impact other business performance variables such as sales, operations, customer relations and reputation – each of which can impact the key transaction “check points” of sale and purchase agreement, valuation model (and assumptions), deal breaker evaluation, acquisition accounting, post-acquisition action planning and exit strategy. As with legal and financial, these issues are often investigated by other work streams such as market, commercial and operational due diligence teams, which therefore also need to be kept in the loop on HSSE findings

Key learning points from the survey

While identifying many examples where companies have suffered problems from HSSE issues arising post-deal, the survey has also identified trends in best practice.
EDD sometimes misses material issues. Not only do some companies not undertake EDD, but many which routinely do are nevertheless caught out (60% of companies being impacted by material issues post-deal had undertaken EDD). It is clear that some assessments fail to identify material issues, as these HSSE managers indicated: “We probably didn’t specify the EDD well enough and didn’t go deep enough,” according to one. Another said: “The whole study was not managed very well. There was not enough focus.”

Some causes are not specific to EDD such as vendor-enforced time and access constraints. However, if the EDD aspect of an M&A transaction is controlled and managed more effectively by an acquirer, risk can be reduced.

For example, a UK company purchased the US-based manufacturer of an emissions testing kit. The kit was supplied to US garages for use during roadworthiness checks. EDD was undertaken by a reputable consultant which focused on whether the production facility was contaminated and the quality of the health, safety and environment management systems. Given the activities at the site, these were all sensible areas of investigation, but not where the key focus should have been.
The EDD did not consider how environmental regulations could influence future demand for the kit itself, despite environmental legislation being the product’s single largest market driver. Six months after the transaction was completed, US environmental regulations changed to ban the pollutant detected by the tester, removing the need for testing. This immediately led to the market for the kit collapsing. The company went into bankruptcy and the acquirer was forced to right down the full value of the investment. The EDD had failed – largely because it had not been sufficiently focused or commercial in its scope.

Good management procedures and guidance

There is an opportunity for companies to tighten up internal management controls and guidance for those managing EDD. Part of the management and guidance issue lies in assessing the findings of the EDD more effectively. Another aspect is ensuring that the objectives and scope of the EDD focus the acquirer’s investigation towards the right things in the first place. But these areas of weakness are not helped by the fact that many in-house EDD managers/teams work without clear internal guidance and procedures:

  • a quarter of companies interviewed do not have a standard procedure or guidelines for undertaking EDD;
  • for those that do, many do not have a prepared generic list of important issues to cover – especially in Risk Category 2 (see box); and
  • a third of those with a generic list have not updated it within the last year, even in Risk Category 1 sectors.

Improving management controls and guidance appears to be a clear area of opportunity, and may come under increasing internal scrutiny as broader corporate governance reforms come into play, and in the case of the forthcoming Operating and Financial Review regulations.

Clarity of objective

There appears to be two quite different schools of thought regarding the objective of EDD, resulting in two approaches to the evaluation of HSSE risk during due diligence. The survey indicates that approximately half focus on how the target company impacts the environment, through a focused technical assessment. The other half uses the findings of a technical assessment to determine how the environmental issues identified will affect future performance.

Those taking the latter approach were found to suffer far fewer material issues arising post-deal than those adopting the former. In essence this second approach follows the principles being legislated under the forthcoming OFR obligation, albeit in a transaction situation rather than part of an annual reporting cycle. That is, the focus should be on how HSSE issues could affect the future prospects of the company (and therefore its value) – whatever form the impact on future prospects might take.

To be complete, EDD needs to consider a full range of business performance implications (financial and commercial considerations in particular), as well as the ‘softer’ but potentially key issues of brand and reputation.
Half of companies which use EDD focus on technical environmental issues; the other half focuses on the implications of these issues to business performance.
All EDD exercises need to be undertaken with a clear aim – to be able to inform decision-makers of all performance impacts that could affect revenue, costs and liabilities, and any other issues which could impact the acquiring business itself, such as reputation and brand. These can then be factored into the valuation model, contract negotiations and where relevant the exit strategy appropriately.

Deal rationale

The majority of companies appear to recognise that HSSE issues can affect the basic rationale of a transaction. But many do not formally review whether the HSSE findings have a significant impact on the drivers of the transaction.
The balance appears to be shifting, with a greater proportion of companies integrating EDD into the core transaction evaluation process. But for some, EDD still seems to be undertaken as a discrete, technical exercise.

Integrating findings into other assessments

Many companies have made the transition from a technically oriented to commercially oriented and integrated approach. But on the other hand some have not, and could benefit from adopting the approaches taken by those companies leading best practice.

The survey indicates those adopting a technically orientated approach are much less likely to integrate their due diligence assessments into other work stream due diligence. All those taking a business performance approach do. One danger of working in isolation is that some HSSE findings – which may not be material to the transaction when assessed in isolation – are significant when considered alongside financial, commercial or legal findings.

It is important for legal advisers, for example, to understand HSSE findings so they can provide effective advice about them, and to help draft a sale and purchase agreement which takes the issues into account. A commercial due diligence adviser will also need access to the findings where market demand, customer, competitive position and operational issues are impacted by HSSE issues. And financial advisers will need to integrate the financial consequences of what EDD has identified into their evaluation of projected costs and revenues, forecast cash flow, and the robustness of balance sheet liabilities and acquisition accounts.

Even in high-risk sectors, approximately half the companies do not share EDD findings with the legal team; even more work in isolation from the commercial and financial teams; and approximately a fifth of HSSE managers indicated that their company did not automatically share the EDD findings with any other work streams.
Significantly, companies which share results with other work streams experience far fewer post-transaction surprises. For example, 16% of companies which integrated EDD with commercial due diligence experienced post deal problems, compared to 37% that do not integrate.

The survey found that all companies taking a business issue approach to scoping integrate their EDD findings with commercial and financial assessments. None of those taking a technical approach did so. Adopting a business approach is more likely to identify issues that are relevant to other work streams.

Are we considering enough impacts?

In regards to commercial and reputation or brand issues, the survey raises two key questions: do companies scope EDD to specifically investigate HSSE issues; and do companies assess the implications of their findings on performance?

The evidence suggests that companies are more likely to assess impacts that are identified in a ‘normal off-the-shelf’ scope than tailor it to specifically look for issues. For some companies, scoping remains narrow and technical even when the assessment has been broadened to take into account a wider range of performance issues. However, the end result can be that key issues still evade detection.

There are now many regulations which have wide-ranging impacts on business, far beyond regulatory compliance and liabilities. For example, EU requirements for electrical waste and restricting the use of hazardous substances (known as RoHS) are essentially environmental laws, but will have wide-ranging impacts on business. The knock-on effects of these measures will be substantial and varied, for example:

  • a waste management company may be taking advantage of market driver opportunities for the collection of end-of-life equipment and/or for recycling facilities;
  • component manufacturers of WEEE may be competing with competitors who have developed more cost-effectively recyclable components – and therefore be at risk of a declining market share; or
  • a manufacturer of substitutes for materials containing RoHS may be forecasting exceptional growth.

The EDD needs to be flexible to take account of these implications, which will often be company-specific. The end result may be that the EDD team should not only be interviewing the HSE manager, but also working with the commercial due diligence team, and interviewing the R&D, marketing, sales and finance teams – depending upon the nature of the impacts being tested.


While a majority of Europe’s top companies now undertake EDD as part of normal transaction evaluation processes, one in three faces post-acquisition financial impacts associated with environmental issues having evaded detection. Meanwhile 70% have identified material issues during due diligence and taken appropriate action thereafter during the execution of the deal. Two key themes have emerged which appear to contribute to these outcomes.

The first is that two approaches are being taken. The scope of some EDD appears to be based on an off-the-shelf HSE audit checklist, while others takes a more tailored and performance orientated approach. The survey points to the latter being much more effective, and in essence following the principles being legislated under the OFR, although in a transaction rather than part of a annual reporting cycle.
The scope needs to be tailored to the circumstances of the acquirer and target company and be commercially oriented. A reliance on an off-the-shelf assessment of liabilities and compliance could mean that a full understanding of the implications to a company’s value is not achieved.

The second is that the EDD team all too often operates in isolation, despite the EDD findings having direct implications to the assessment being completed by others. Given that those following an integrated approach do suffer post-deal issues on a much less frequent basis, many companies could significantly reduce the risk of surprises if they improved the integration of the EDD into the legal, financial and commercial assessments.

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