What lies beneath




As anyone involved in a private equity transaction knows, the process of buying or selling an asset involves detailed, complex and often lengthy due diligence. Whether it’s analysing the cash flows underpinning an asset, ensuring that key contracts are thoroughly examined, or reviewing the target’s track record to highlight potential reputational risk, there is an abundance of paper processes designed to address every aspect of the acquisition mechanism.

In recent years, driven by the increasingly vigorous enforcement of anticorruption legislation, including the US Foreign Corrupt Practices Act and the UK Bribery Act, these processes have extended ever further into the realm of compliance. The main private equity houses, especially those investing in potentially high-risk sectors or jurisdictions, or where the transaction involves exposure to some form of government involvement or interaction, are now alive to the risk of bribery, whether in revenue stream acquisition, or operational risk such as obtaining licences. The US Department of Justice publishes regular updates of FCPA-related enforcement actions, which are enough to concentrate the mind of any director or shareholder.

A comparatively less well known area of potential danger, especially for UK investors, relates to money laundering, where profits generated from so-called tainted assets – assets associated with a legacy of bribery and corruption in, for example, their chain of ownership or in the way they have been operated – may entail violation of the Proceeds of Crime Act 2002. Personal liability may accrue through placement on a board, leading to potentially very serious implications for investor representatives within transgressor portfolio companies. And not only does this increase the risk to the individual investor, but an asset that is tainted by corruption may become unsaleable, with the commensurate impact on income streams and hence, for governments, on tax revenues and employment.

All these factors have raised awareness of corruption and other crime related risks in the context of a transaction. M&A lawyers are now fully engaged in a way they were not only five or 10 years ago. But beyond the obvious forensic due diligence of going through the data and documentation attached to any transaction, what other steps can an investor take to address and mitigate these risks?

One of the easiest ways of lowering potential exposure to corruption risk is simply to avoid doing business in ‘high risk’ environments. This may include transactions where rights have been acquired from governments, or contracts are from governments, where there is a high degree of intersection between the business and the government, or – rather crudely – where the jurisdiction involved falls below an acceptable threshold on Transparency International’s Corruption Perceptions Index. But for some PE houses, their mandate is to invest in ‘high risk’ or emerging markets, or they are required to do so because, for example, their business is strongly reliant on oil and gas. The challenge then is to manage the risk.

Having accepted that generating returns may require exposure to higher-risk countries and sectors, understanding the people behind the target becomes an important route to negotiating corruption risk. Who are the key principals? Where have they come from? What are their values? These questions resonate not only in terms of cultural and commercial ‘fit’ – whether these managers are the right people to take this business forward – but also in the critical area of attitudes toward ethics, responsible business and compliance.

Many companies these days have worked hard to introduce robust policies and procedures aimed at preventing bribery; the ‘tone from the top’ may be just so. But actual corruption is typically not recorded, which means that learning as much as possible about the character and approach to commerce of the people you are proposing to do business with is a vital component of any due diligence programme.

The challenge in understanding your target is knowing which information-gathering methods to apply. Most PE managers naturally take great pains to find out as much as possible about an asset before committing to an investment. Their knowledge of a sector or a jurisdiction may be based on years of experience, with extensive personal networks and in-depth understanding both of the market and of the type of business they are proposing to invest in. On compliance-related matters, some managers may commission a report on an organisation or its senior management with the aim of highlighting any corruption related risks.

But this type of investigation is necessarily backward-looking: even if issues do emerge from such a review, getting under the skin of an organisation to really understand whether its people and managers are culturally attuned to its ethical code of conduct and compliance with the law involves more than internet and database research, however skilfully executed or thoughtfully presented. Proper investigative research will examine forensically not only all aspects of a manager’s track record and career history, but also his or her relationships – with their employees, their suppliers and their customers – to probe how they operate and how they are perceived, and the extent to which their business reflects their personal values and integrity.

Alongside this, an independent investigative programme aimed at examining the extent and strength of a business’s existing compliance-focused policies and procedures may highlight at an early stage any practical vulnerabilities or misalignment between an organisation’s vaunted approach to compliance and the reality. Interviews with key staff or a review of how an organisation deals with its whistleblowing programme may reveal weaknesses that, if not addressed promptly, could undermine the business once it’s too late.

Most private equity investors have taken great strides in recent years in acknowledging the importance of robust compliance procedures. Many have put in place practical tools to spot risks before they can damage an investment. Some of these steps can add to the complexity of the due diligence process. But the consequences of not doing so may be considerably worse.


Tom Russell is director of business intelligence, EMEA & Asia at the Risk Advisory Group. He can be contacted on +44 (0)20 7578 0000 or by email: tom.russell@riskadvisory.net.

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Tom Russell

Risk Advisory Group

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