By some estimates, more than $500 million worth of private equity (PE) investments in India are embroiled in legal disputes. Kroll’s experience in the country suggests that such disputes represent only a fraction of the situations where investors are in serious disagreement with the owners of their investee companies. Even the most seasoned PE 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.
Today, there are various investigative tools available to PE investors that can help them minimize potential post-acquisition losses should such disputes arise.
Often, disputes are triggered when PE investors suspect fraud in a portfolio company. The majority of deals in India are minority investments where promoters control the business and the flow of financial information even if a PE investor is present. This, combined with the fact that corporate governance standards in India are still evolving (especially in small and mid-sized companies), certain practices of the promoters may not necessarily be aligned with the interests of the PE investor. This includes related-party transactions and diversion of funds for other businesses. In such cases, it becomes difficult for a minority PE investor to understand the true performance of the portfolio company.
These are the tell-tale signs of potential fraud at a portfolio company:
- Performance starts deteriorating shortly after the PE investment is completed.
- Funds from the PE investor are not used in the manner that was agreed prior to the investment.
- PE investor is denied access to good-quality financial information and to the management of the company.
Disputes between PE investors and promoters can also arise due to differences in valuation, 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, which has impacted returns and lead to the potential for further disputes. In cases of fraud, we see that erosion of value in a portfolio company can occur within the first six months of the PE fund’s investment.
While a forensic review of the financial data of an investment target can identify red flags, it cannot necessarily be relied upon to uncover fraud. 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 pre-investment, on a “no-compromise basis” to ensure that the diligence is truly independent.
Although most PE funds embed management information systems (MIS) and other business intelligence systems immediately after the investment is completed, these are often not enough to identify and root out problematic areas. Investors can take a more active and investigative approach to understanding the true business practices and controls in the portfolio company.
When a PE investor suspects fraud in a portfolio company, usually the first thing they want to find out is the true situation on the ground in the company. This depends on their ability to access the financial systems and management of the company. Because of the minority nature of the investments, the only access to financial information that PE investors typically have is through monthly MIS reports, which may not provide an accurate picture of the true performance of the company.
PE investors can avoid surprises by conducting in-depth and independent due diligence on the target company.
In these circumstances a PE investor can conduct a discreet, “outside-in” investigation of the portfolio company. This can provide useful indications of poor business practices or malfeasance; 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. PE investors often use the information gained through this exercise to negotiate greater access to the financial systems of the company.
When some or all of the company’s financial systems are accessible, the PE investor can conduct a full forensic audit of the company. 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.
One of the challenges of conducting investigations in India is that the bar is set high for what constitutes evidence of fraud in a court of law. Second, once in court, it can take years to settle disputes, by which time the value of the investment may have significantly eroded. These factors explain why PE investors are usually not keen to go to court immediately following a dispute.
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 and take a successful court action. At other times, they can use the information to negotiate with the promoter, up to and including the threat of naming and shaming.
Corporate governance standards in India are evolving in positively. The new generation of entrepreneurs knows the benefits of following sound corporate governance practices and they have experienced how transparency in their financial reporting helps them make the right business decisions. What remains to be seen is how entrepreneurs will withstand the external pressures that often accompany growth.
The author is managing director at Kroll India.