Virtual realism: Realizing investments remotely

If there was one piece of conventional wisdom left untested by COVID-19, it may well have been the idea that private equity deals involve too many variables – both subjective and objective – to be realized remotely. Now it appears that domino has fallen as well.

Capricorn Capital, a UK investor currently rolling up corporate services businesses in Hong Kong, brought this into focus last week with its acquisition of administration and accounting provider Ethos. The deal is said to have been negotiated remotely under the territory’s quasi-lockdown conditions, with Robin Harris, Capricorn’s Hong Kong managing director, noting that all regulatory approvals were finalized within about a week of signing.

It is unlikely the deal was a 100% video-communicated affair, especially given Capricorn’s faith in the value of personal connections. “When I look at businesses, 99.9% of the due diligence is around the individual that I’m partnering with and investing with,” Harris told AVCJ last year. “When you buy a services business, you’re really buying people, in the form of staff, customers, clients and intermediaries. All the value is in the individuals.”

AVCJ followed up, asking Harris for more details on the Ethos transaction. He admitted that agreeing terms and finalizing documentation via Zoom was challenging, despite a high degree of trust and respect on both sides. In particular, the Capricorn team struggled to read body language and gauge tone when engaging with counterparties who were not in the same room.

"I think the old saying that '90% of communication is non-verbal, truly does apply, which made for a few misunderstandings," Harris said, adding that he has known Ethos' Bangkok-based founder Richard Watson for two years but has not seen him for more than six months. "It was also hard to build a personal relationship and connect on a personal level outside the framework of the deal, which so often can clear the path for better or easier negotiations."

Still, the Ethos deal does suggest a shift at the margins regarding the necessity of handshakes and tire-kicking companies at point-blank range. China Creation Ventures says it is pursuing initial encounters online – five to six companies a day – before finalizing deals with face-to-face meetings. Australia’s Square Peg Capital has started down this path as well but has yet to find a substitute for on-the-ground due diligence.

“The process has to modulate,” says Tushar Roy, a partner at Square Peg, noting that his firm is currently in negotiations with several founders who have not been met in person. “We haven’t got to the point where we’ve made an investment in a team we’ve just met on video. But what we are trying to be cognizant of is, we don’t know how long this will go on for, so maybe we will have to come with a process for doing it. But the bar is extremely high.”

This kind of process experimentation would be a challenge even if it didn’t need to be done in a cratered macro landscape with wildly fast-changing political overlays. Now, any temptation to play loose with due diligence in the name of evolving best-practice methodology will be quickly and rightly checked by the mounting casualties of the downturn.

China’s dubious track record for back-office bookkeeping is fueling some of the most dramatic examples here. Luckin Coffee, a PE-backed coffee shop chain pursuing breakneck growth with a tech-heavy model, admitted last month that more than half its sales in 2019 were fabricated. Shares duly tanked, wiping out about $5 billion of value. Since then, other US-listed Chinese companies – TAL Education and iQiyi – have been embroiled in similar scandals, although the latter has challenged accusations of fraud.

The connection between these cases and coronavirus-driven economic pressure is indirect but clear. A tougher operating environment has made it harder to hide irregularities, whether they’re premeditated or not. The industry’s underbelly of insufficiently vetted companies may not be any worse than before the pandemic, but it has become more exposed. For now, that could keep most remote diligence process innovations on the blackboard.

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• Topics
• Buyouts
• Technology
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• Asia
• Due diligence