There are a number of disputes between private equity companies and promoters currently in court or with other authorities, but experience suggests that these cases represent only a fraction of the cases where investors have serious disagreement with the owners or management of their portfolio companies. Even seasoned investors who understand the Indian business environment have executed deals where they are unable to maximize the potential of their investments due, in part, to a dispute with the portfolio company. PE investors are now making use of the various investigative tools available to help them minimize potential losses post acquisition should such disputes arise.
The majority of deals in India are minority investments where promoters continue to control the business and the flow of financial information after a PE investment. Since corporate governance standards in India are still evolving, especially in regards to small and mid-sized companies, promoters may be following certain business practices which may not necessarily be aligned with the interests of the PE investor, such as related party transactions and diversion of funds for other businesses. In such situations, it becomes difficult for a minority PE investor to understand the true performance of the portfolio company. A large majority of promoters treat private equity funding not as a strategic partnership but as another source of capital that they can control. This often leaves investors with limited tools to monitor the performance of portfolio companies.
How PE Investors can know that things are not what they seem
Some of the tell-tale signs are:
- Performance of the portfolio company starts deteriorating shortly after the PE investment is completed
- Funds from the PE investor are not used in the manner that was agreed to prior to the investment
- PE investor is denied access to good quality financial information and to the management of the portfolio company
- Promoter starts renegotiating what was already agreed in the investment agreement
Disputes between PE investors and promoters can also arise due to differences in valuation practices (with respect to shares) and shareholder rights as well as exit options. Indian promoters have been relatively slow in delivering exit options to PE investors over the last few years, and PE investors in India often own companies for five, seven or even 10 years. This has impacted their returns and leads to the potential for further disputes.
At the pre-investment stage, an investigation of the financial data of an investment target can identify red flags but it cannot necessarily be relied upon to uncover fraud. Experience suggests that perpetrators often cover their tracks with false documentation and transactions that appear genuine and do not raise alarms in the pre-investment review. PE investors can avoid surprises and disputes by conducting in-depth and independent due diligence on the target company. This means fully investigating red flags or other symptoms of poor performance that are identified in the review. They should select due diligence providers on a “no compromise basis” to ensure that such providers are truly independent and the integrity of the due diligence process is maintained.
Most PE funds embed management information systems (MIS) and other business intelligence systems immediately after the investment is completed. We believe this is not enough to quickly identify and root out problematic areas that could erode the value of the investment. The PE investor’s ability to obtain an accurate picture of the true performance and practices of the company depends on its access to the financial information and management of the portfolio company. Investors should take an active and investigative approach to understanding the true business practices and controls in the portfolio company and use various fraud prevention tools to ensure their interests are protected.
What PE investors can do to avoid pitfalls
Usually the first thing a PE investor wants to find out when it is in a dispute is what is going on in the portfolio company. In these circumstances a PE investor can conduct a discreet, “outside-in” external investigation of the portfolio company. This can provide useful indications of poor business practices or malfeasance on the part of the company; the promoter’s reputation in the market as well as their conflicts and assets; and whether the promoter or management are known to be involved in fraudulent practices and if so, what these practices are.
The review can be conducted onsite or offsite and may include access to the company’s ERP systems and management. The typical areas of focus include understanding the gap between book profits and cash profits, capex overload, revenue recognition methods, and review of policies, SOPs, filings, etc. PE investors in India do not like to challenge promoters in court early on because of the generally slow pace of the judicial system in India. That said, there are various ways that PE investors in India have used the information gathered during the investigation to overcome the challenges of the existing legal framework. They can use the information to negotiate with the promoter, up to and including the threat of naming and shaming. And of course, sometimes the information can be used to take a successful court action.
Corporate governance in India is evolving in a positive way, and this is being led by a new generation of entrepreneurs. They have experienced the many benefits of following sound corporate governance practices, from being rewarded by investors to seeing firsthand how transparency in their financial reporting helps them make the right business decisions.
The question is, once these businesses grow to a larger size and scale, will these entrepreneurs and the corporate governance foundation they are establishing, be able to withstand the external pressures that often accompany growth?
(Reshmi Khurana is managing director, Kroll, India.)