Knowing is half the battle

Private equity firms frequently use background investigators in emerging markets. These risk consultants need more than just local contacts to be effective.

Most GPs built their businesses handshake by handshake, tapping their network for deal referrals and talent. With Western private equity firms expanding swiftly into relatively far flung places like Asia and Africa, there is less time for a patient courtship. Professionals who conduct background checks ? and commonly refer to themselves as risk consultants ? offer a shortcut in determining the competence or integrity of local partners.

Most of these consultants tout how their local relationships provide proprietary intelligence. However, due diligence involves both gathering and analyzing information, so the provider should demonstrate a methodology applicable to the given inquiry. One of the best indicators of that methodology is the backgrounds of the case managers themselves. GPs should be careful to review the exact nature of a provider's experience in the target's geography.

Risk consultants typically gather information from various sources willing to speak privately. They pride themselves on having access to sources who are rarely found in a partner's BlackBerry. These can vary from former politicos to local police officers; namely, the sort of professionals privy to the ?unofficial? version of events.

?The fact that a New York case manager knows a cop in Malaysia isn't valuable by itself.?

Rattling off an array of picturesque characters can make a compelling case for a consultant, but having such sources doesn't guarantee a quality report. ?Don't rely on a firm for their Rolodex,? says Nick Day, CEO of risk consultancy Diligence LLC. ?The fact that a New York case manager knows a cop in Malaysia isn't valuable by itself. Normally local law enforcement has little knowledge of the inner workings of a company and a minority of frauds ever come to the attention of the authorities.?

The sheer size of a risk consultant's network is not valuable in and of itself. The network must have relevancy to the project at hand. ?You want sources that are informed on the industry and/or the personnel in question,? says Steven Fox, a managing partner at Veracity Worldwide, an information intelligence firm.

One GP active in Eastern Europe noted his diligence firm provides terrific intelligence but rarely discovers criminal activity or outright fraud. In most cases, the diligence firm is verifying that the locals have the clout or track record they've claimed. Where a potential partner's story doesn't quite equate with reality, the GP explains, such seemingly white lies can represent a major threat to the bottom line, as incompetence sinks investments more often than a full-fledged fraud.

Uncovering these ?soft? exaggerations doesn't require Hitchcockian intrigue, but often perspective from industry insiders, or even executives that have worked with the parties in question. A risk consultant may brag about having contacts with, for example, former KGB officers, but while this is fascinating, a former KGB officer may not have the most informed opinion of a given CEO.

History repeats itself
Diligence firms warn of weighing ?connections? too heavily in selecting a provider. Even if a firm has willing sources of intelligence, there is the challenge of determining what is relevant to the proposed investment. In most markets, even those not so ?emerging,? sources don't always provide quality intelligence.

Veracity's Fox stresses that his firm gives equal weight to both the gathering and analyzing of information in the diligence process. It is difficult to do due diligence on these human capital due diligence firms, however, because they are usually not at liberty to reveal who past clients are. Instead, both GPs and diligence firms suggest reviewing the bios of those responsible for the proposed project to discern what their approach might be.

If, for example, the staffing of a given project are all ex-CIA agents, there's going to be a fairly uniform approach to how data is gathered and analyzed. This may not be ideal. ?The best analysis involves multiple perspectives. Ex-intelligence agents will look at the information in one way, whereas journalists might ask a completely different set of questions,? says Peter Turecek, a managing director with the risk consultant Kroll.

Many consultancies offer a team from diverse disciplines that can include forensic accounting, investigative journalism and law. Given that most projects requiring an outside risk consultant involve vetting rumors, multiple viewpoints are can prove invaluable.

Even with several voices weighing in on the project, there will be one case manager leading the initiative. ?One of the primary questions to ask is who, exactly, will be managing this case?? says Fox. The case manager's bio is of particular relevance as they'll be determining which data, and which experts' analysis is included in the final report.

GPs should ask, does the case manager have experience within the inquiry's industry or geography? How senior are they in the organization, and how much experience do they have in actual due diligence? While there's no ideal profile for a given project, the answer to such questions inform the style and competence of the process.

Another element to verify is the firm's use of subcontractors, a common and often necessary facet of emerging markets investigations. Subcontractors work with risk consultants on a project basis usually due to their close ties within a given locale. Diligence firms will outsource to these professionals even in a country where they've established an office, if a city or subject is particularly sensitive to foreign or otherwise unknown investigators.

The use of subcontractors does carry some risk. A client rarely has a bio of every subcontractor, even if they know the case manager personally. In this case, what a private equity firm doesn't know can hurt their interests. Some subcontractors have employed tactics well outside the ethical boundaries of the risk consultant, which can prompt nasty consequences ranging from publicity for an investigation, to criminal proceedings for the subcontractor, affiliated with the firm a GP hired.

?They can spoil your entry into a given market,? explains Peter Woglom, the director of business intelligence and investigations at the consultancy Control Risks. ?And not necessarily by engaging in unethical behavior, but by simply misunderstanding the nature of an investigation.? Control Risks prides itself on a substantial-enough local presence in several countries, which it claims diminishes the need for subcontracting.

There is also the danger that a subcontractor may conduct due diligence for one firm bidding on a deal, only to sell that information again to a firm's competitor on the transaction. And third, some firms have been known to use subcontractors as a principal analyst on the report, especially when they don't have other managers in a region or country.

?No firm can do it all,? says Fox. ?Look for a firm that is willing to admit it can't cover the entire world. Otherwise, they may be relying too heavily on local subcontractors, not just for gathering data, but for analyzing it at well.?

Several diligence firms stated that their subcontractors sign agreements not to repackage existing data or resell their intelligence to other parties. The agreements are substantiated with compensation rich enough to dampen any temptation to pitch other buyers. The diligence firm may not be able to retain a subcontractor full-time, but they should provide sufficient economics to warrant some fealty. Finally, while their identities may need to remain confidential, it's important to inquire as to how a risk consultant vets its subcontractors. What background checks are employed? What's the referral process? What are some discoveries that would prompt passing on a candidate? These questions can be answered without compromising the integrity of the subcontractors.

Relevancy, above all
A recurring theme in choosing risk consultants for emerging markets is the importance of relevancy. Consultants should have the skill set and geographic focus for the task at hand. Verifying political connections is one task, while exploring the competence of a local executive is quite another. Few diligence firms answer the full range of inquiries, across the globe.

?Our priority in employing outside firms tends to be for due diligence on reputational issues,? says Hurley Doddy, the COO of Emerging Capital Partners, a Washington, DC-based private equity firm dedicated to African opportunities. ?Given that we're focused on the private sector exclusively, we want to make certain that enterprises are not too closely linked with a particular government.? That diligence task requires less commercial acumen, but robust political connections and the ability to evaluate hearsay.

Most GPs use referrals to drive the selection process, but is that referral coming from a firm active in the same geography? Did the source of the referral employ that provider for a similar inquiry? There needs to be something to argue for their expertise within the region in question. Risk consultants are tapped to provide the local expertise not yet in-house. There's little reason to hire someone to simply outsource to a third party.

Offices in the region or country are a good indication, as they'll have a good grasp on the broader political risk. Turecek suggests that political risks are a major blind spot for many foreign firms. ?It may not appear terribly relevant within the confines of a given inquiry, but they can all too quickly become a decisive factor,? he says. Naturally the firms with roots in a locale will be best poised to evaluate such broader risks.

Even after evaluating their connections, their bios, their subcontractor relationships, and their experience in a given geography, risks will remain. Emerging markets involve several factors outside of anyone's control, and investing in these regions remains a gamble, even if it's an informed one. The best a firm can do is the inverse of Ronald Reagan's foreign policy adage: ?Trust, but verify.? For firms tapping risk consultants, they've little choice but to ?verify, and after that?trust.?