Source: http://www.businessinsurance.com, August 23, 2015
By: Bill Nellen

Proper assessment and coverage of environmental liabilities can make the difference between a successful or failed real estate investment. Bill Nellen, executive vice president of the Environmental Group at Alliant Insurance Services Inc., discusses the routes to a positive outcome.

Private equity has been demonstrating a voracious appetite for real estate deals, with the pace and velocity of transactions increasing exponentially. As more cash floods the market, a number of deals have fallen victim to a quiet but devastating foe: pollution liability.

Environmental contamination has derailed closings, hampered returns and cost shareholders a considerable portion of their original investment.

During the go-go mid-2000s, many deals were completed with only limited attention to pollution impacts, as the marketplace was overinflated and investors could secure returns despite suffering an environmental loss. After the financial crisis late in that decade, investors — equity and debt partners — found themselves saddled with assets that had significant pollution issues with no recourse.

As smarter capital re-enters the market with far more sophisticated and risk-averse lenders, understanding the overall pollution “hair” on a deal has changed from a “nice-to-have” to a “must-have.”

In response, sophisticated attorneys, investment bankers and in-house acquisition/divestiture teams are using more effective tools to protect against pollution liability exposures. A tool that has proved effective for mitigating risk is insurance — pollution legal liability, or PLL, and environmental impairment liability, or EIL, insurance. Others include additional upfront due diligence expense, reserves for known issues, contractual indemnities and purchase price offsets.

Environmental insurance

Environmental insurance was developed out of the absolute pollution exclusion in the early 1980s and was initially used as an adverse-selected product to cover inherent environmental liabilities associated with bulk chemical transporters, hazardous waste transfer stations and landfills. After considerable innovation and evolution, PLL and EIL insurance now provide greater coverage and more contract certainty, increasing demand for these products. This fact, coupled with the maturing of insurance carrier market capital, has led to an explosion in capacity, with more than 25 insurers offering these products.

Pollution insurance covers liabilities resulting from cleanup, bodily injury and property damage, in addition to related legal defense expenses. Policies are tied specifically to the insured’s insurable interest in a real estate asset or property. Coverage will respond if a pollution condition is found on a covered property, without regard to its source.

Pollution liability insurance can be used to place boundaries around any legacy exposure. This provides excellent financial protections for the deal and attracts preferable lending terms. So if an adjacent property has caused a release of contaminants financially harming the insured, the policy covers it. Additionally, insurers have recently begun to offer this coverage on a blanket basis, effectively making it perform like a general liability policy for pollution losses.

Key enhancements to the off-the-shelf policy include:

• Business interruption/loss of rents

• Legal defense expense outside the limits of liability

• Government re-opener coverage for resolved prior issues with no further action, or NFA

• First- and third-party transportation

• Historical blanket disposal site liability

• Indoor air quality — mold, legionella, methicillin-resistant Staphylococcus aureus, bacteria, fungi — and related disinfection

• Natural resource damages, or NRD

The environmental insurance space continues to expand into coverage enhancements that benefit the private-equity business. Though 10-year terms are still available, fewer insurers offer them. However, five- and seven-year terms are widely available and will support lender requirements for tail coverage.

Due diligence

Private-equity investors will typically “kick the tires” of an acquisition target property from many angles. Environmental risk represents an important aspect of transactional due diligence, serving two key purposes:

• It enables a prospective purchaser to receive limited liability relief under the Superfund Act.

• It provides a baseline for investors, lenders and deal teams to make a “go/no go” determination for pursuing the deal.

In many instances, legacy environmental conditions disclosed during due diligence can be dealt with through reserves held in escrow post-closing. However, challenges abound. Many private-equity holding periods last only three to five years, as limited partners want to see a return on investment within a short time frame. The need to withhold proceeds to cover environmental damages, often for a protracted period of time, can lead to disgruntled limited partners at best or lawsuits at worst.

Indemnities and purchase price offsets

If an initial review indicates the potential for pollution liabilities, smart money would look for someone else to cover the cost. This is the primary objective of an environmental indemnity or purchase price offset. Though subject to extensive negotiations, insurance can be used in lieu of corporate indemnification, contractual liability transfer or escrows. In fact, some insurers will write pollution liability coverage for “known conditions” in excess of a contractual indemnity assumed or assigned in a transaction. The triggers for unique coverage include claims outside the scope of the indemnification or insolvency or exhaustion of the indemnity.

It is important not to overlook historical indemnities, which may not have sunset provisions and may be transferable to new buyers provided the counterparty remains viable. Indemnities can also be drafted using new language in the purchase/sales agreement. While indemnities are only as good as the counterparty credit risk of the indemnitor, they remain a popular means for addressing environmental legacy risk, provided both parties can quantify the likelihood of an issue and its potential for a lawsuit.

Likewise, buyers can negotiate purchase price discounts or offsets for pollution impacts, real or perceived. For example, if a property has a long history of industrial activities but due diligence reveals no pollution effects, an offset will fund the contingent liability assumed by the new buyer. This is a fixed-cost way to exit an asset or investment without leaving a legacy tail.

Environmental liability is a multiheaded beast involving legal, financial, strategic, technical, governmental, compliance and risk management disciplines. Getting buy-in from these disparate constituencies can be fraught with negotiation and concession. However, the ability to bring solutions to the table that mitigate risk and address vicarious and legacy pollution exposures can certainly facilitate deals. Ultimately the ability to fully understand a property’s associated risks and to take the proper preventive measures can mean the difference between a savvy investment and a devastating loss.

Bill Nellen is executive vice president of the environmental group at Alliant Insurance Services Inc. In addition to his brokerage expertise in the sector, he has extensive technical knowledge about environmental issues, having received a master’s degree in environmental science. He can be reached at 404-271-0541 or bnellen@alliant.com.