It is generally believed that private equity (PE) companies are focused on revenue and profit generation as their long-term plan is to sell their companies at a high profit.
As a result, matters of ethics and compliance tend to take a back seat as their benefit on the bottom line is usually not visible, at least as part of the short-term financial strategy.
However, with domestic and international regulators constantly on the watch, compliance issues have become a real threat to investment funds. Further, the risks for PE investors can be significantly high, especially if the target operates in high-risk geographies or industry sectors.
In 2015-16, the Securities and Exchange Commission had announced that it had filed 868 enforcement actions, which included the highest ever number of cases involving investment advisers or investment companies at 160, and the highest ever number of independent or standalone cases involving investment advisers or investment companies, accounting for 98 firms.
In today’s compliance and enforcement environment, it is inevitable that PE companies will be caught in the firing line if they fail to embed an adequate compliance structure in their portfolio companies.
As in the case of many rapidly developing economies, while there are opportunities for considerable wealth creation in India, these opportunities bring in compliance challenges. From an anti-bribery compliance perspective, some of the common challenges that PE companies experience in India stem from lack of awareness regarding compliance requirements, especially in relation to international anti-corruption laws (Foreign Corrupt Practices Act, UK Bribery Act) and the impact and severity of non-compliance with such regulations.
In many instances, while the transaction may be well intended, the documentation supporting the purpose and evidence of activity is not robust, in other instances there may be masked accounting transactions. Lack of supporting evidence often leads to questions around the genuineness and justification of underlying activities.
There may also be business-driven factors such as need or high dependency on third-party ‘agents’ or ‘intermediaries’. However, target companies may not have a strong mechanism to manage such third parties and the risks arising from the actions of such third parties.
Significant bribery and corruption risks associated with the potential target’s operations could lead to financial, regulatory and reputational risks to both the buyer and seller. It is, therefore, important for investment firms to be aware of the risks well in advance to effectively mitigate them.
Thorough anti-bribery and corruption due diligence enables early identification of potential bribery and corruption risks, thus allowing PE firms to weigh the risks associated with transactions – both successor liability risks and ongoing or future risks.
If the diligence identifies red flags, depending on their severity, steps to protect and remediate the compliance environment may need to be determined. This may involve including adequate clauses on anti-bribery and corruption representation and warranties, indemnity and/or closing conditions to comply with relevant and applicable regulations in contractual arrangements. Subsequently, one needs to ensure a compliant business environment in the post-investment entity aligned to investors’ standards on the compliance framework.
Therefore, compliance has become essential and non-negotiable in the market today. Lately, it has been noted that while target businesses pass the valuation criteria, deals eventually break down when companies do not have a robust compliance programme or the mindset to implement one. It is time to change the perception of compliance as merely a cost of doing business to that as a business enabler.
PEs need to develop a compliance model that is robust as well as flexible and can be adapted to their overall portfolio. This will allow companies to build a strong corporate compliance culture over a period of three to five years, thereby increasing trust among employees and building their goodwill and reputation with external stakeholders.
In light of the overall benefits, compliance is a short-term cost that will bring long-term protection and enhancement to business value during the investment lifecycle – from acquisition to exit.
The author is partner, forensics, PwC India.
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