India due diligence: Smoke and mirrors

As soon as General Atlantic (GA) and India Equity Partners (IEP) set eyes on the report they commissioned into finances of Fourcee Infrastructure last year their worst fears were confirmed. The numbers simply did not add up. It appeared the promoters had been less than forthcoming about the performance of a company that was struggling, despite EA and IEP pumping in $131 million between them just two years earlier.

Within days the alleged transgressions were public knowledge. The two private equity firms filed a petition with the Company Law Board (CLB) in Mumbai, declaring themselves the victims of an "extensive forgery and willful deceit" perpetrated by the promoters and several other top management.

On its own, the incident may have garnered less media attention had it not been the latest in a string of public spats between GPs and portfolio companies.

Less than six months earlier, SAIF Partners India, following forensic audit carried by KPMG, accused kidswear retailer Catmoss Retail - to which it committed INR1 billion (16 million) in 2010 - of siphoning off funds. TPG Capital and Bain Capital had previously taken another kids wear retailer, Lilliput, to the High Court after accusing the promoters of accounting fraud. They owned 45% of the company, having invested $86 million.

While issues of accounting fraud and financial mismanagement are by no means unique to India, the emergence of several cases in succession prompts talk of an endemic problem. It may indeed only be the tip of the iceberg, given that private equity investors usually see legal action as a last resort.

A recent Global Fraud Report published by Kroll Advisory Solutions goes some way to shed light on the prevalence of fraud India and the risks investors are facing. Of the Indian companies surveyed, 69% reported some kind of fraud. Alarmingly, in nearly nine out of 10 cases, an insider - junior, middle management or a senior employee or an agent - had played a leading role.

Body blow

This is yet another blow to an Indian private equity market reeling from a slowing economy, a volatile rupee, pre-election political uncertainty and a tough fundraising environment. Many of those GPs that still have the mandate and appetite for exposure to India are being forced - by their LPs if not their internal oversight mechanisms - to reexamine how pre-deal due diligence is carried out and how portfolio companies are monitored.

The irony is that a number of the struggling investments can be traced back to the crowded market of 4-5 years ago, when it might be argued that GPs acted with undue haste.

"The private environment has been very competitive and a large amount of capital has been deployed," says Reshmi Khurana, India head at Kroll Advisory solutions. "A number of these funds only take minority positions, so you have a lot of funds chasing similar opportunities, which means there is pressure to deploy."

Fundraising for India-focused vehicles came to $24.2 billion between 2006 and 2008, six times the amount raised over the preceding three years and more than twice the sum raised over the succeeding three years. Until the tremors from this explosion began to ease off from around 2011, India did not want for dry powder - and this is before regional and global funds are factored in.

Growth capital investments peaked in 2007 and 2008 with 213 and 233 deals, respectively, totaling $8 billion and $7.5billion. There was an inevitable dip following the global financial crisis before a return to form in 2010 as $5.9 billion was transacted across 196 deals. In 2008, growth investments accounted for just under half of total PE deal flow in India, rising to around 60% in 2009. The growth share rose again in 2010, reaching 63%.

With promoters spoilt for choice and financial advisors flocking around them in search of fees, many of these transactions were executed via auction. Indeed, a number of the investments that later turned sour -such as Lilliput - came by way of a competitive process. The onus was on GPs to get deals done and get them done fast, resulting in rapid and potentially ill-considered due diligence.

Kroll's Khurana identifies several key problem issues: the quality of the due diligence being done; conflicts between information offered by existing diligence providers; and how that information was then interpreted by GPs. In short, procedures were being followed but execution was sometimes flawed.

However, even with perfect execution and a forensic review of internal financial data, the fraud might be so astutely conceived that it still goes overlooked.
"A decade ago, a promoter might take the investment and buy himself a luxury car," says Deepak Bhawnani, CEO of Alea Consulting Asia. "But now malfeasance is far more sophisticated with promoters having the ability to defraud millions of dollars through dummy companies set up offshore."

For this reason, many service providers are preaching a more comprehensive approach to due diligence that brings together financial, legal and operational functions. Indeed, some advisory firms are bolstering their local capabilities to meet demand for more holistic diligence efforts.

Kroll, for example, recently entered into a strategic alliance with BMR Advisors, incorporating the latter's experience with analyzing financial records into Kroll's own process. Meanwhile, Alvarez & Marsal (A&M) has recently expanded its India presence, adding a new transaction advisory group that offers financial accounting, tax and operational due diligence services in addition to setting up a dedicated commercial due diligence practice.

Vikram Utamsingh, who was recently appointed A&M's joint country head, notes that it is often the operational element of due diligence work, in particular, that is missing; this includes assessing if there are operational issues in a business that could cause problems when a private equity firm comes in to help it scale up.

"It is important to ask if the operational issue a one-time problem or is it a fundamental problem that can hurt the future profitability of the business," says Utamsingh. "This is the piece that has been missing and I think that if PE firms would add that piece, they would have a much more informed and holistic view of the business they are investing in."

A number of GPs claim they already recognize the importance of making due diligence more than just a box-ticking exercise. Varun Batra, a partner at Baring Private Equity Partners India, says while his firm will carry out the usual mix of internal and external diligence in addition to business, forensic, legal, accounting and tax diligence, the most important part comes in bringing together separate elements in an attempt to find a common thread.

This "joining the dots" process not only protects GPs from investing in the wrong companies, but also can prevent them from missing opportunities.

"It is important to have a seamless approach where you take the information from a background check and test it against the information from financial due diligence and vice and versa," says Kroll's Khurana. "So you can really get to the bottom of the issue rather than saying ‘I have heard rumors and I am not going to touch this deal or this sector.'"

Conflicts of interest can also be eliminated when working with third-party advisors by ensuring no one has previously worked with the diligence target. "If it is a private company then we definitely insist on some outside of the comfort zone of the company and employ a firm we are comfortable with," says Baring's Batra. "Using an existing auditor unless part of the Big Four is not something we can live with."

This sentiment is echoed by A&M's Utamsingh who reports of a misconception among some Indian GPs that if an accounting firm is working for a target business in some other capacity already, then it knows the business better than anybody else, thereby presenting an advantage. More often than not a PE firm needs a fresh pair of eyes to look at a business and assess whether there are any fundamental issues - somebody not colored by previous experience and relationships.

A minority partner

Still, the issue for many GPs is how to bring this influence to bear when in most cases they have little control at board level. India is still very much a market dominated by minority investments. Growth capital deals accounted for 212 of the 452 private equity transactions that took place in 2013; there were just 21 buyouts, although of course the ticket sizes tend to be larger.

Trust between GP and promoter is therefore of paramount importance. Not only does the PE investor want to ensure the promoter will not do anything illegal but it needs them to be able to take on board advice and execute a business plan. Respective interests regarding financing, governance, transparency and environmental practices must be completely aligned.

"This involves agreeing on a governance model and discussing a path to exit prior to an investment, and understanding the promoters' outside business interests and investments," says Heramb Hajarnavis, a director at KKR in Mumbai. "The one thing that we look for in our global portfolio partners is a strong management team that is open to partnering with us, rather than just seeking a capital injection."

Yet, in many cases the promoter is seeking just that, viewing a private equity investor as check writer, not active investor. Indian promoters have traditionally been reluctant to allow a minority shareholder to have too much of a say in the running of their businesses, although numerous industry participants attest that the relationship is now changing, with GPs demanding greater input and transparency regardless of their stake in the business.

It helps that sponsors are no longer spoilt for choice. Fundraising in India has declined every year since 2011 when $3.7 billion was raised across 27 funds. Last year, a total of $1.8 billion was committed to country-focused managers, less than one fifth the 2008 peak.

"We are seeing GPs in India being more active in managing the portfolio, they are speaking more frequently with management they are looking at financial reports and taking a more active and also putting into international best practice with regards to corruption and compliance," says Sidharth Bhasin, a partner at Shearman & Sterling.

Accordingly, background checks on the promoters have become a central feature of any due diligence process. In the past, this might have involved light-touch measures such as looking into whether the promoter has a criminal record, been accused of stealing money, or treated joint venture partners badly. Now, the process extends more deeply into business issues: the promoter's level of professionalism, how much freedom and he gives to his second line of management, and how strong the management is.

Some maintain that is this kind of due diligence is often ultimately reliant on the quality of the GP's own network and connections. "People do not give much credence to the informal channels of diligence you build though your networks and that only come through a period of time and obviously as you build relationships across sector," says Gulpreet Kohli, managing director with ChrysCapital Partners.

It is also important to look at the promoter's networks. One of the central issues in this respect is whether or not the business is dependent on favors and personal connections for growth - which comes back to the issue of how portfolio companies can be effectively scaled.

"The ability to grow is a key question when we try to assess background checks because most funds come to use and say, ‘He is running a great INR2 billion ($32 million) business but we want to make it five times the present size - is he capable of doing that?" explains Kroll ‘s Khurana.

Belt and braces

But due diligence process is not limited to the pre-investment stage. Post-deal diligence has also become a necessity for GPs looking to be more proactive in monitoring portfolio investments. They are also increasingly willing to get outside help if any irregularities occur.

This is precisely what has happened in the corporate governance disputes that have emerged in country.

Alea's Bhawani - who reports a 65% surge in post-transaction due diligence in the last full calendar year - says more GPs should look to exercise their shareholder rights: asking for monthly or quarterly financial statements and interacting with management - other than the promoters - more frequently.

Anecdotal evidence suggests that a GP is often two years into a minority investment before it is clear whether an investee is really on target and able to meet growth projections. This is typically because private equity firms must wait one year after their capital commitment for audited financial reports along with projections to arrive for formal analysis. Indeed, these reports might not be completed or not completed properly prior to the investment, so processes also require time to become entrenched.

With this lag period, spotting potential issues early is vital. "Problems arise when one starts to see beyond the smoke and mirrors - financial statements not being submitted to the local departments on time, tax filings being delayed, frequent changes in CFO and auditors. That is when the alarms bell start ringing," says Bhawani.

A&M's Utamsingh notes that the evolution of industry in India will be dependent on promoters opening up to GPs as partners and appreciating what they bring to the table. "The PE firms are forcing the change," he says. "They realize that success in investing in the country by relying on management to execute the business plan and just playing the role of investor is not enough."

At the same time, the long-term impact of a greater emphasis on proper due diligence and risk aversion is fewer private equity firms chasing the same deals. A more mature market is a less volatile market, however - the frauds and private equity write-offs will thin out, but then so will the intermittent cases of outsize returns.

"It is a situation where term sheets are signed for 60 days rather than 30 days or less," says Bhawani, "and this allows investors to evaluate comprehensively as the diligence process is not rushed."

 

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• Topics
• South Asia
• Advisory
• professional services
• Alvarez & Marsal
• Baring Private Equity Asia
• KKR
• ChrysCapital Management
• India