Private equity investors in the developed markets, particularly those in the US, tend to take for granted the sheer volume of information available as a matter of public record in their home countries. Upon venturing overseas, GPs may find themselves at a loss in terms of gathering the less easily accessible information, operating in an unfamiliar business setting and dealing with mindsets and standards that differ from what they are used to.
This scarcity of information can have a material impact on a private equity firm's ability to conduct background checks on management of potential portfolio companies or business partners. The stakes on accurate information are high. Setting aside potentially bad investments, US companies doing business abroad must adhere to the Foreign Corrupt Practices Act, which forbids US firms active abroad from bribing local officials for the sake of starting or continuing business activities in international markets.
Background checks of potential partners and acquisitions have become an integral component of the due diligence process and serve as a very important component of reducing the risks associated with investing abroad. A Deloitte Financial Advisory Services LLP survey conducted in November of last year showed that red flags raised by background checks caused 70 percent of the survey pool – which included mostly private equity firms – to call off an investment in the emerging markets.
Depending on the GP, such research could be conducted in-house and by relying on one's established network of contacts in the target region. Or, the task could be outsourced to professional investigators, which may be a sensible option for those firms with little previous exposure to an area or those firms who are concerned that their own biases will influence the assessment and therefore want the balanced judgment of an outside party.
?Not only does this sort of investigation involve finding the relevant information in public records, but it also involves finding the right people and getting them to talk to you, which can be difficult if you do not have access to local sources who have the relevant contacts,? who may often be former law enforcement officials or journalists acting as subcontractors, says Thomas Fedorek, a New York-based director at consulting and accounting firm BDO Seidman's litigation and fraud investigation practice.
The premium on having pre-established interpersonal relationships grows as one moves further down the continuum from the developed markets where information is plentiful and accurate to less developed environments where information scarcity and unreliability can be an issue, he adds.
Experienced private investigators will also know how to manage against overzealous or duplicitous subcontractors. ?Almost every case I have heard of where there was a serious problem, it involved a runaway or renegade subcontractor. So you need to have an experienced, ethical professional managing the investigation,? Fedorek says.
Given these risks, it is important to ?second- or triplesource your work,? which often bulks up the costs of conducting the investigation, regardless of transaction size, says Fedorek. There is often a ?disconnect? between the size of the deal and the size of the investigation.
?The goal is to mitigate risk. You could have a two million dollar deal where a problem could later cost you two million dollars in legal fees,? says Fedorek.
The investigation can allow the client not only to find out whether someone has a reputation for fraudulent activities, but ?sometimes you find out something about their personality and what it's like to do business with the person,? says Fedorek. These factors can have a profound impact on the ease and profitability of the venture in question.
Finally, Fedorek points to the common misconception that GPs tend to have about investigative due diligence. There is no ?solid? and ?incontrovertible? threshold of evidence required in order to prove something one way or another, says Fedorek. ?We provide an informed assessment of the risks to the client for them to make a decision based on their own context or strategy. At the end of the day, it's a judgement call.?