June 20, 2017
So you’re thinking about acquiring a company in order to generate inorganic growth. Of course you’ll be doing your due diligence to understand exactly what you’re getting and what it’s worth. And if the target company is in one of the eight environmental “hot sectors”, you’ll need to dig even deeper to understand potential risks, as well as value creation opportunities, related to environmental matters.
For these industries, it’s necessary to understand potentially material environmental exposures in either the past, present or future of that company. When you acquire a company, you’re getting both the assets and the liabilities. Before you buy, you should conduct a thorough assessment to evaluate the total asset retirement and environmental obligations (including accounting differences) associated with the company and identify potential environmental costs that may be incurred or recognized post-transaction. Such costs can include remediation liabilities and capital expenditures, as well as impacts to operating expenses.
Companies should factor these liabilities and costs into their investment model. You might discover a reason to rethink your acquisition or gain evidence to adjust the purchase price based on future environmental costs and potential accounting differences. Such exposures could include:
- Balance sheet impacts – adjustments that may be required to recognize additional asset retirement and remediation liabilities may be material.
- Fines and penalties – a target’s compliance record may have resulted in pending fines and penalties.
- Capital expenditures – depending on deferred maintenance, permit renewals, compliance performance, etc., capital spending projections may reveal exposures that can impact deal value.
- Operating expenses – permit renewals, new regulations, proposed expansions, etc., may result in increased operating expenses that can lower projected earnings.
- Accounting differences – including timing of cost recognition, remediation time periods or durations, different inflation and/or discount rates, and costs to be included in these valuations.
Opportunities for cost reduction may represent value creation in your next deal. Due diligence can also include assessment of potential opportunities through decreased waste generation, air emissions, water use and wastewater discharges.
So how do you conduct an environmental assessment?
Honestly, it’s not easy. Environmental due diligence requires a wide and deep understanding of how a target’s environmental aspects potentially intersect with financial considerations. Such considerations include the types of remediation and compliance issues, the cost and timing of the solutions, the nature of various asset retirement obligations, regulatory requirements and mandates, and the various regulatory agencies involved. In addition, you need to perform this due diligence by involving the appropriate engineering, legal, accounting and regulatory perspectives to perform effective diligence.
Once an exposure has been identified, it is necessary to determine the best way to manage it. Depending on the regulators for that jurisdiction and the nature of the issue, you may be required to do various forms of investigation and remediation to reverse or stop the environmental impacts. Clean-up costs can be difficult to assess as they are highly dependent on the remedial technology and typically span several years to several decades. Based on where the clean-up is in its lifecycle will reveal the real exposure and the accounting that should be done to get an accurate picture of the book-end costs. If you’re faced with asset retirement, you’ll want to consider the timing of future cash outflows and the appropriate accounting and financial reporting requirements.
Experienced environmental accounting professionals can help you identify and assess these risks and opportunities, including the financial reporting implications.
What risks are there?
What costs are related to these risks?
Is there cash flow going out the door?
How could this affect your earnings and future periods?
What opportunity or up-side is there?
These are the questions that need to be answered in order to understand whether you feel comfortable proceeding with the acquisition and how to properly value the target. Check out our recent report for a deeper dive on evaluating environmental liabilities and their impacts on future earnings.