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Beyond the Balance Sheet: Understanding Environmental Liabilities in Mergers & Acquisitions

November 20, 2018

Pursuing a merger or acquisition? Make sure your valuation process considers all of the costs – including the cost of environmental compliance, deferred maintenance and legacy environmental issues.

A company’s balance sheet details its assets and its liabilities at a given point in time.  An individual, business or group of investors looking to merge with or acquire the company will rely heavily on the balance sheet to determine its value.  

But does the balance sheet tell the whole story? 

“Not when it comes to environmental considerations,” said Mike Kulka, founder and CEO of PM Environmental. “In most merger and acquisition (M&A) deals, you assume both the company’s assets and its liabilities,” he explained. “But the balance sheet doesn’t usually reflect liabilities associated with managing environmental issues that might be present at the company’s location or locations.”

Kulka speaks from experience. PM Environmental has consulted on hundreds of M&As, helping investors identify and evaluate the costs of environmental compliance, deferred maintenance and legacy environmental issues before deals are finalized. And for more than a decade he has served on the board of the Detroit chapter of the Association for Corporate Growth (ACG), a community of M&A specialists, private equity (PE) managers and business leaders focused on driving middle-market growth.

Discovering the ‘hidden’ costs  

Any one of a range of property issues can impact a deal. If the business involves a manufacturing process that discharges harmful substances into the air or water, or if hazardous materials like asbestos or lead paint are identified, cleanup or treatment must be factored into the cost of doing business. There may also be outstanding citations for the improper storage of hazardous materials on company premises.

For businesses with multiple locations, the status of each property must be considered, and a typical appraisal won’t flag environmental issues. “Some appraisals have disclaimers noting that they are not responsible for environmental liabilities,” noted Kulka, “and some make no mention of them at all.”   

Even when valuations reflect the ongoing costs of environmental compliance, they may still not paint the whole picture. “It’s when you consider factors like the remaining useful life of existing equipment and technologies in use, and potential violations the current owners aren’t aware of, that the real dollars add up,” he cautioned. “We’ve seen deals valued at $10 million that don’t take into account $1 million in environmental cleanup.” 

Be proactive and don’t go it alone.

Of course, the key to avoiding costly oversights is to factor environmental compliance, deferred maintenance and legacy environmental issues into the deal up front. That’s where PM Environmental can help. They have a team dedicated to PE/M&A. They have consulted on deals across the country, and have worked with the majority of PE firms in the great lakes region.  

Three PM Environmental service lines address the major risks not typically reflected in valuations:

A Phase I Environmental Site Assessment (ESA) gathers historical and current information to render a professional opinion about a site’s environmental condition and potential contamination risks prior to ownership changing hands. Kulka cited one recent example of a service business operating in a facility constructed on vacant land. “We determined that the property was once a farm hub, which meant we had to investigate past uses like fueling operations, underground storage tanks and chemical mixing areas, none of which were initially suspected.”  

A Property Condition Assessment reviews the records of a wide range of past capital expenditures and repairs, from construction materials to electrical and plumbing systems to landscaping and parking.  Environmental issues aren’t the only concerns to consider,” cautioned Kulka. “Any deferred maintenance, including replacing roofs or HVAC systems, should be factored into the value of a property.” 

A Property Condition Assessment reveals far more than a property appraisal. Appraisals rely on comparisons with similar properties, and don’t fully consider the condition of a property. “A building appraised at $1 million isn’t really worth that if it needs a $300,000 roof,” Kulka explained.

An Environmental Compliance Audit is a comprehensive, site-specific review of overall compliance with state and federal environmental regulations. Particularly important for businesses operating in chemical- or waste-stream intensive industries, these audits help identify current compliance costs and minimize the risk of regulatory enforcement.

On a case-by-case basis, other PM Environmental service lines, such as industrial hygiene surveys to look for lead paint, asbestos or radon, might also play a role in completing the environmental picture prior to finalizing a deal.   

“The bottom line is, the more you know, and the sooner you know, the smarter deal you’ll make,” said Kulka.