Reputational due diligence: No stone unturned

From the outside it looked like a great opportunity for a private equity investor: an Indian company preparing for an IPO, with an experienced management team and a capable founder.

But when due diligence and fraud investigation service provider Alea International Consulting took a closer look at the company on behalf of a potential investor, it discovered a troubling bit of history. The founder had started a similar business in the US, but had been sanctioned following a regulatory investigation. After returning to India, he started a new company, neglecting to tell his backers about the previous regulatory action or to mention it in the IPO prospectus.

The legal issues were bad; the fact that the company hadn't disclosed them was worse. The investor felt it could not go ahead in partnership with a founder it could not trust. "The sad part is that there were two other private equity firms that had previously invested. They did not hire us," says Deepak Bhawnani, founder of Alea. Of the evidence, he notes, "My team found it just from open source research."

Situations like this are far from uncommon in private equity, and they highlight the need for reputational checks as part of a due diligence process, particularly in a developing market like India. While these checks may not necessarily result in the outright scuttling of a deal, industry participants say they can often turn up issues that will affect the functioning of a partnership even years down the line. Those who are conscientious about background checks will be glad they made the extra effort.

Informed decisions

The value of pre-transaction due diligence in general is obvious; investors need to know that they are exposing themselves to excessive risk and potential financial loss. Situations in which GPs either neglected their financial and legal due diligence, or entrusted the task to partners who arguably turned out not to be up to the job, form cautionary tales.

Bain Capital and TPG Capital, for instance, have spent years dealing with the fallout from their investment in Lilliput Kidswear, after irregularities surfaced in the clothing retailer's financial statements. In 2014 Bain sued EY, claiming that the firm certified financial records on behalf of Lilliput prior to Bain's investment that it knew were fraudulent.

Reputational due diligence is harder to quantify than the financial and legal variety. Financial statements, though often complicated, nevertheless deal with verifiable facts, and legal diligence is much the same. Judging a founder's personality calls for more nebulous skills, and it can be difficult to justify one's decision on such a subjective matter. However, a hasty decision can lead to an unhappy and contentious partnership.

"The business will always throw up challenges as you go along, and you want to be with people you can work with and where you don't have to deal with issues around reputation or behavior," says Dhiraj Poddar, a director at TA Associates.

Though the importance of finding strong partners is widely understood, not all industry participants apply the same level of rigor to their checks. In some cases, reputational due diligence is approached as an afterthought, with firms that carry out legal or financial diligence offering background checks as well.

Such services are not the convenience they seem to be, industry players warn. When a reputational diligence check is conducted as an add-on to another service, there is a risk that the firm responsible is not suited to the task, which requires very different skills to financial or legal analysis. In addition, such checks are often carried out with limited resources and therefore lack thoroughness.

For Alea, reputational diligence is a multi-stage process. Stage one involves checking publicly available information relating to the investee company, its promoters, and important associates. Often this step turns up issues that the company had never even considered. In one case, a company was found to be using a logo that was not actually registered to it. The problem was not that the company had never registered the logo, but that the copyright office had awarded the wrong trademark due to a transcription problem.

"Who would tell you that? Your legal due diligence would not tell you that, your financial would certainly not even be looking in that direction," says Bhawnani. "The company itself, their own team, would not be looking at something so mundane."

In this case the investee was able to fix the problem simply by reregistering the proper logo, which was still unclaimed. But without the background check the company might never have known about the issue, until it caused legal issues down the line.

The next step in the diligence process is to reach out to people close to the company and its management team. This can turn up previous suspicious incidents that have been kept out of the public domain, as in a case where a founder was accused of taking kickbacks in his operations overseas.

Essential insight

Even when no illicit activity is identified, these checks play a valuable role in exposing the true character of an entrepreneur. Padmanabh Sinha, managing director of private equity at Tata Capital, says that though the firm does not need a reputational check when investing within the Tata Group, for investments outside the parent group it relies on reputational assessments.

"If it's not meeting our first threshold of people who we know well and have great confidence in, then at the very least we need to research that better and feel comfortable about it, because if there are any concerns around that, then I think we would rather not risk capital and do the deal," he adds.

These checks do not necessarily have to be done by outside parties. Some firms, including TA, routinely perform reputational risk assessments themselves, though TA does hire other firms as a second set of eyes.

In addition, the purpose of reputational diligence is not just to find deal-breakers. While it is always possible that something will emerge that is serious enough to derail a transaction, finding addressable issues is good for the investee, which can fix the issues at an early stage, and the investor, which does not have to spend its own money to address the problems.

"You are telling potential investors about things that are of concern, or potentially of concern, and they're able to assess the gravity of these flags, prior to investment. Because at this stage one has a lot more flexibility to advocate changes," says Bhawnani.

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• Topics
• South Asia
• Advisory
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• Growth capital
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• professional services
• Alea Consulting
• Tata Capital
• TA Associates