Evaluating environmental risks in complex financial transactions

I gave a talk at the Environmental Bankers Association meeting this week about environmental risks associated with non-real estate secured loans, and one aspect of my talk related to mitigating environmental risks in complex financial transactions. So I thought I'd summarize a few of those points here.

The first challenge is in scoping and conducting due diligence for the transaction, but that's a topic for another blog post. However, once the due diligence research has been completed and I have a list of findings in front of me, the real work begins. I put together a risk-mitigant table that usually has four columns for:

The area of risk - is it an environmental permit issue, a community risk issue, a labor or social issue?

Details about the risks identified for the transaction - a brief description and a link or citation to the document or report where the risk is discussed in detail. I always try to label risks according to their possible impacts:

  • Impacts to cash flow or asset value assumptions used to underwrite the investment
  • Compliance with our internal financial institution policies.
  • Compliance with legal requirements that apply to the target entity. It's really important to match the appropriate jurisdiction to the finding of non-compliance, so that you are not mistakenly applying a U.S. requirement to a facility in Malaysia, for example.
  • Reputation risks, either to the target entity or to my institution

Relevant policy, statutory, or regulatory requirements. It's critical that due diligence reports clearly identify the citation and source for any non-compliance findings and that these be distinguished from issues such as housekeeping or industry best practices.

Mitigants that can be applied to the risk - this is really a menu of possible mitigants. Mitigants can include:

  • Loan or investment structuring - for example, determining whether real estate will be part of the assets to secure a loan, ring fencing certain assets that present a particular risk
  • Loan or investment tenor - if a risk is not likely to crystalize within the timeframe of the investment, this could be an effective mitigant
  • Pre-closing conditions - establishing a list of actions or documents to be completed by the target entity before the transaction is signed or to be completed between signing and closing.
  • Post-closing conditions - establishing a list of actions or documents to be completed after the transaction has closed. These conditions are most effective when accompanied by a loan holdback, escrow amount, or other financial incentive for the target entity. I am always careful to include specific timeframes and documentation needed to show completion of both pre-closing and post-closing conditions.
  • Loan exit requirements - this may involve conducting additional due diligence in the event of a default or workout, or actions like transferring permits or outsourcing certain services in the event we must take control of an asset or operation to preserve the value of the investment.
  • Contractual protections - contractual protections can include reporting and information requirements, representations and warranties that a target entity is in compliance, audit and inspection rights for the investor, and affirmative covenants for compliance. Contracts may also include indemnities and guarantees that cover financial impacts from environmental and social risks.
  • Insurance - in addition to pollution liability insurance, I learned recently about representation and warranty insurance that may be helpful in mitigating environmental and social risks. Other kinds of insurance may also be helpful in mitigating environmental risks, such as business continuity coverage.

Once the risk-mitigant analysis has been completed, I have a handy tool for working with the banking or deal team in discussing how to complete the underwriting of the investment to successfully address environmental risks. I will often work with the banking team and the target entity to ensure everyone understands how we are looking at the risks and make updates or correct errors that occurred during due diligence. I also use the risk-mitigant table to discuss any significant issues with the risk officer who will be signing off on the transaction. Once all the decisions are made about how we are approaching a particular investment, I follow up on each mitigant we have identified to ensure we are incorporating the requirement into the legal documentation and our own portfolio management program.