A conduit to transparency

Having been the victim of fraud, Conduit Capital now has an ‘in-depth window’ on its Latin American investments via a unique approach to CFO relations. By Judy Kuan

Fraud, particularly collaborative fraud, at portfolio companies is something that can be a major irritant for private equity general partners. One of the key reasons why many GPs prefer to invest within their home countries – or even within their home regions – is because of the difficulties that can arise in trying to oversee and manage the operations of an investment from a distance, including the limited ability to identify occurrences of fraud if they do so arise.

However, one group has found a way to shorten the physical and interpersonal distance from its portfolio companies, and in doing so, positioning itself so that it has greater awareness of the inner workings of its investments.

The group in question is New York-based private equity firm Conduit Capital Partners, which invests in potentially challenging sectors in a region that many investors still view with wariness. Conduit, which spun out from Deutsche Bank at the end of 2003, specializes in backing greenfield power generation projects across Latin America.

Early on in managing its investments across Latin America, one of the questions Conduit chairman Scott Swensen and his deal team had to address was, how could the firm effectively manage and monitor the financial and operational performance of its investments without having ever established a local office in Latin America, a region that is generally perceived as one of the most high risk in the world?

Window on operations
Part of Conduit's response was to adopt the more typical checks that most GPs tend to have in place to monitor their portfolio companies. For instance, each of Conduit's portfolio companies undergoes on an annual basis engineering evaluation, environmental review, and health and safety assessment. Each company is assigned an independent auditor from one of the major accounting firms, and each company has a budget that is reviewed monthly, and in general treated just as a power generation plant in the US would be. In addition, every year Conduit randomly chooses two projects to undergo fraud audit.

However, on top of those measures, Conduit creates what Swensen describes as ?an in-depth window on operations to properly exercise our majority ownership rights of our investments? by creating a situation where the CFOs of each of Conduit's majority-owned portfolio companies report to the firm directly and act as if they were employees of Conduit.

To achieve this, Conduit uses its control over the company's board of directors – gained by generally acquiring control stakes in its companies – to direct that a person of its choice is hired as CFO. ?The bylaws of every one of our portfolio companies specifies that the CEO and CFO must sign every major contract, as well as paperwork for all major financial transactions. Then, we – as the controlling board member – hire one of those people – most often the CFO – and have them report directly to us,? says Swensen. ?Economically, it's the same thing as if we directly hired the CFOs. We do their reviews, we set their objectives, and we determine what their bonus is.?

This structure arose in the 1990s when Conduit- then owned by and named after investment advisory firm Scudder Stevens & Clark – made its first major investment in a Latin American energy asset. After a few months, Conduitbegan to notice some discrepancies in the monthly reports it was receiving from the portfolio company. As part of its response, Conduit installed a new CFO at the company, and soon afterward discovered that the discrepancies were caused by an embezzlement scheme led by the company's general manager. And not only was the general manager involved, but he was organizing collaborative fraud by bribing all eight members of the committee that had the power to approve all outside contracts for the company.

?The incident really shook us,? says Swensen. ?We asked ourselves, should we open an office near this company and in the other countries where we are invested??

However, to open an office in all of the countries in Latin America where Conduithad invested – which currently numbers seven countries but at its high point totalled nine – ?we would have needed nearly more offices than we had investment professionals,? says Swensen, pointing out that Conduit's team of investment professionals has, to date, never exceeded twelve members.

?We had a lot of pushback from our local partners.?

Given the physical and financial challenge of establishing a Conduit office in each country where the fund had operations, the Conduit investment professionals discussed amongst themselves how best to approach the issue. As a solution, they came up with the current CFO incentive structure that has the head of financial reporting at each of its portfolio companies be ?beholden? to Conduit.

These CFOs are now nearly always hired locally, says Swensen. Conduit typically does not install US nationals as CFOs due to the intricacies and costs of doing so and instead employs local talent by using executive search firms such as Heidrick & Struggles, although referrals from its local contacts and personnel at existing portfolio companies are becoming an even greater source of talent.

One of the highlights of this structure, says Swensen, is that since the CFO of each company would have to be paid in any case, there is no notable additional costs to Conduit for choosing this approach to incentivizing them.

Perhaps most importantly, not only is this structure a costeffective way of decreasing the likelihood of fraudulent activities taking place at portfolio companies, but by using this model, ?we can also have a greater geographic distribution of investments or, in other words, greater flexibility in where we put our dollars,? says Swensen.

Pushback gives way to practicality
Conduit's compensation scheme for the senior management of its portfolio companies, when it was initially conceived and implemented, faced a rather chilly reception. When Swensen and his team first tried applying this concept to their investment strategy in the 1990s, ?We had a lot of pushback from our local partners,? including the local investors and developers participating in the Conduit deals, says Swensen. ?However, a couple of years later, they came back to us asking for help in implementing this structure at their other companies.?

Granted, one of the reasons why Conduitcan pull off this kind of structure is due to the nature of its investment focus – power generation plants, which after their initial development, are more straightforward and less effort-intensive to manage than, say, businesses based on manufacturing or consumer sales and services. ?Once a power plant is up and running, it's all about cost control and the structuring of revenue contracts. Therefore, it's much easier to manage from afar,? says Swensen.

However, even for investors managing more complicated businesses, Conduit's approach to CFO compensation or some variation of it is likely to be an effective supplement to risk management strategies at their portfolio companies. What this scheme provides is a greater level of transparency by taking a consistent approach to establishing close ties with the local management who provide not only operational expertise, but who also can be one's ?eyes and ears? on the workings of the company.