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Due Diligence: Go Your Own Way

Asian Venture Capital Journal

27 September 2017

While GPs in Western markets increasingly rely on outside consultants for portfolio management services, Asian investors are skeptical about its usefulness. Will horror stories eventually elicit change?

When investigators from Alvarez & Marsal were called in by an Indian GP to investigate a cash flow irregularity at one of its portfolio companies, it didn’t take long to find the problem: money from three of the four business units had been used to hide a significant buildup of working capital in the last one. What stunned the team was how long the issue had been allowed to fester.

“When we went to examine it we said, ‘This has been around for 15 months, why didn’t they see it earlier?’” recalls Vikram Utamsingh, a managing director at Alvarez & Marsal. “The firm hadn’t dug deep enough into each of the business units to see the buildup, which resulted in a one-time loss by the time they got the company’s management to fix it.”

To some industry participants, incidents like this illustrate the shortcomings of the dominant approaches to post-transaction monitoring, especially for minority stakeholders. While normal diligence efforts can often catch such issues prior to an investment, GPs are vulnerable if problems arise during their holding period. Even a seat on the board is not a sure defense, since investors need to deal with the information the portfolio company provides them.

The solution proposed by many due diligence specialists is for firms to retain their services after investment for ongoing portfolio monitoring, an approach that is gaining a foothold in markets like Europe and the US. But many private equity players in Asia remain skeptical of the idea, seeing it as an added expense unlikely to yield practical value, particularly since a well-run firm should be able to gather its own portfolio intelligence.

While a few investors in the region have tightened their monitoring, more graphic demonstrations of the pitfalls of current approaches may be needed to bring the market to the tipping point.

Minority matters

For some GPs, post-transaction monitoring is a matter of little difficulty, if any at all. Buyout firms are the obvious example: with a controlling stake, investors potentially have access to all levels of a portfolio company and control over management as well. In these circumstances the available information is limited only by the private equity firm’s willingness to ask.

The situation is more complicated for minority investors, who often lack the leverage to compel investee companies to share information with them and must take a passive role. While these GPs aim to build productive relationships with management, they may also seek outside verification of the information provided – particularly early in the investment process.

“Anything about the management or operation of the company, you have to hear it secondhand from management – even after the transaction is closed, there is still a lack of visibility,” says Violet Ho, a senior managing director for investigations and disputes on Kroll’s China team. “For a lot of the PE firms that hire firms like ours in the post-transaction setting it’s mostly about validating whether what the management is telling them can be relied upon.”

This does not necessarily mean that GPs are looking for outright deception from investee companies. Investors are typically concerned more about overly optimistic managers setting unrealistic goals, especially in the case of start-ups whose founders may have more enthusiasm than industry experience, and with budding issues that managers might downplay in order to alleviate investor concerns.

“It really depends on the stage of their investment. If there are potential warning signs, it enables them to discuss and attempt to resolve issues early on with the company directly, and it also allows them to prepare themselves for any adverse press reporting,” says Stuart Witchell, a managing director at Berkeley Research Group (BRG) based in Hong Kong. “Over the longer term, if it’s something major, they may need to decide how they can exit that particular transaction.”

While to some extent this information imbalance is unavoidable for minority investors, some industry participants have begun to use independent research firms to help even the scales. However, the idea of calling in outside consultants on a regular basis is more accepted in some markets than in others. Intelligence professionals active in multiple regions say investors working in Western markets are far more likely than their Asian counterparts to ask for their services.

“We’ve been asked increasingly, particularly by London-based firms, to conduct a more rigorous review and monitoring of their portfolios. That sort of change of thinking hasn’t come to Asia quite yet,” says BRG’s Witchell. “There are some firms that do this, but it’s not standard at this point.”

Cultural differences may account for this divide to some extent; Ho, of Kroll, notes that US-based GPs tend to have more robust portfolio management teams with extensive industry experience, while employees at Asian firms typically have a background in finance. For this reason, GPs in Asia may feel more inclined to take a passive role and rely on investee companies for their information.

Asian experience

More important, though, is the dominant sense among Asian GPs that in-depth research by third parties is largely unhelpful in light of ongoing portfolio management activities they already undertake. Tuck Lye Koh, co-founder and CEO of Shunwei Capital Partners, a VC investor in China, says that while his firm is aware of the risk of blindly accepting investee companies’ assessments, it has its own procedures for verifying information.

“We may sometimes do an independent check on our portfolio companies to validate management’s explanation for exceptional good or exceptionally bad performance,” Koh says. “But most of the time these are simple checks that we can do ourselves.”

The reasons for investigating exceptionally bad performance are self-explanatory. Exceptionally good performance also requires attention to determine whether its cause really matches the explanation given by management, or if there is some other reason. For example, a software developer might trumpet a surge in new customers while minimizing the impact of advertising and promotions the effect of which could be only temporary.

“It could be they are making a really good product, they’ve kept on improving the product and the good news is spreading by word of mouth,” says Koh. “But they could also just be spending a lot of money recruiting new users that have a very short retention time frame.”

Leon Meng, founding partner at China-focused Ascendent Capital Partners, is also skeptical about the ability of outside consultants to bring something to the table beyond what the firm can accomplish on its own. The GP’s investment approach emphasizes providing businesses with growth capital in conjunction with advice and solutions, and Meng sees its tight collaboration with portfolio companies as a more than adequate solution to the information issue.

“For every company that we’ve invested in, every week we do an internal review of what’s happening in the industry, what’s happening in the company, and what are the recent data,” says Meng. “So we don’t need to hire a third party; we do it ourselves.”

Such an approach is not without its challenges, though, and may not be appropriate for all investors. Ascendent can devote significant amounts of effort to maintaining its understanding of portfolio companies and their industries because it makes only a few investments per year. Firms with a more active investment cycle could easily find themselves overwhelmed with the level of portfolio management that Ascendent targets.

It is GPs with large numbers of portfolio companies and relatively limited internal resources that service providers believe might benefit the most from outside help. But it could still take some time to convince Asian private equity firms that they have a positive contribution to make.

Where regional GPs have moved toward reinforcing their portfolio management skills with outside contribution, it is often in response to specific stimuli. BRG, for example, has seen interest from several investors in detecting early warning signs of corruption scandals among Chinese companies – such as a company’s senior management suddenly leaving together for an unscheduled offsite conference.

“It could mean general operational issues with the business, but we have seen recent instances where this was a result of active government investigations,” Witchell says. “You don’t always find a smoking gun, but you can quite easily pick up early hints of potential adverse issues from sources in the industry.”

Investigators may also be summoned in response to concerns about more generally unusual patterns of behavior. In one case, an Indian investor asked due diligence and fraud investigation service provider Alea International Consulting to investigate following the departure of four members of a company’s senior management team in the space of four months. The suspicion was that there had been a falling out among the company’s leadership and this could lead to trouble down the road.

In this case the investigation actually turned up no cause for alarm – the executives had independently planned to leave for unconnected reasons, and the timing was a coincidence. But Alea’s clients still considered the exercise worthwhile: without the information it provided they could have made a mistake in a rush to judgment.

“You can’t get too aggressive and demand anything, but you are concerned because you’re hearing rumors that may have a material impact on the reputation of the investee company or a financial problem of some kind,” says Deepak Bhawnani, founder of Alea.

Lessons unlearned?

Such incidents can help demonstrate the usefulness of outside portfolio management service providers, but industry participants say their impact is usually somewhat limited. While the firms directly involved may view the process more favorably afterward, other investors may not find out – and even if they do hear about situations, there is no guarantee they will take the lesson for themselves.

Indeed, though there are no shortage of tales illustrating the importance of post-transaction monitoring – from the widely publicized fraud scandals around Chinese forestry firms to the deception perpetrated by the CEO of former Navis Capital Partners portfolio company ECO Industrial Environmental Engineering – many say such stories have a hard time moving the needle as long as GPs can find ways to separate themselves from the funds involved.

“The more horror stories that are out there, the better,” says Kent Kedl, managing director for Greater China and North Asia at Control Risks. “But any time something like that hits the news, the reaction from the investment community often still is, ‘I’m glad that won’t happen to me,’ and feeling a bit of schadenfreude, as opposed to saying, ‘If it happened to them it could happen to anybody, so we’d better pick up on things.’”

However, observers also admit that such warnings can seem hollow to GPs that have attained success with their current approaches to investment and portfolio monitoring. Moreover, many investors instinctively feel that hiring a third party to investigate one of their own portfolio companies is a signal of a breakdown in their internal processes, and building a genuine relationship with investees that includes stakeholders at all levels should provide all the information they need.

“Each of these touchpoints is valuable content to validate what we know about the company. So in that regard it is ongoing due diligence, it’s just not a formal process where we send in accountants and lawyers,” says Shunwei’s Koh. “In that regard it’s actually very valuable: an intensive one or two weeks’ due diligence may only tell you what’s happening in the company over that period of time, but ongoing monitoring with multiple points of contact provides multi-dimensional checks and balances.”

Originally published in Asian Venture Capital Journal on 27 September 2017. (subscription required)