Look before you leap

A frontline assessment of fraud risks involving PE portfolio companies in India is provided by Alvarez & Marsal managing directors Dhruv Phophalia and Vikram Utamsingh. 

In 2013 private equity investors committed $10.6 billion to 755 transactions in India. However, in the first half of 2014, private equity deal activity declined. Investor confidence has been impacted by fraud and accounting scandals involving private equity portfolio companies in India. Such frauds are perpetuated by fictitious documents and other deceptive practices, often making it difficult for auditors to detect. Occurrence of frauds also creates potential liability for the private equity representatives who serve as directors in portfolio companies which generally results in extended disputes and complicates investors’ exit strategies. However, enhanced pre-transaction diligence and appropriate post-investment monitoring can help in mitigating such fraud-related risks.

Illustrative cases 

In 2013, the private equity arm of a large European bank claimed that it had invested approximately INR 3,300 million ($55 million) based on forged documents/false representations that were made by an Indian portfolio company. Allegedly, a con man posed as the portfolio company’s customer to falsely show that the portfolio company had won a large contract. In another case, a US private equity firm invested approximately $107 million in an infrastructure equipment company, where the promoters of the company allegedly showed related parties as clients, inflating revenue and showing faster sales growth. In addition, the promoters allegedly forged bank statements, showed equipment purchases at inflated prices and siphoned off funds. Similarly, two US based private equity firms alleged accounting fraud by a children’s clothing retailer in India. In this case, a Big-4 auditor was sued for “fraud, aiding and abetting fraud, negligent misrepresentation, and unfair and deceptive trade practices…”  According to one of the GPs, the Big 4 auditor's dual roles as the portfolio company's advisor as well as the auditor represented “a clear conflict of interest.”

High-risk fraud areas 

Fraud schemes are generally planned and executed in great detail and involve setting up fictitious transactions and related document trails. Some of the key high risk fraud areas include related party transactions, revenue and expense management, integrity/business practices of promoters and management, conflict of interest and weak internal control environment. Addressing the risk involved in related party transactions, UK Sinha, chairman of Securities and Exchange Bureau of India (SEBI) recently commented: “Abuse of related party transactions is rampant in this country. There has to be some mechanism to curb it.”  In order to make a business look attractive to investors, a typical fraudulent scheme may involve inflating revenues and inflating expenses and purchases (in order to fund the fund the inflated revenues); all with the help of sham third parties and/or fictitious documents.

Due diligence should be conducted as an integrated exercise. In addition to financial, tax, legal and commercial due diligence, GPs should ensure that due diligence procedures cover: integrity / reputation of promoters and target, nature of assets and other entities owned by the promoters, anti-corruption-related processes and controls, and enhanced due diligence for high risk areas.

While pre-transaction due diligence is essential, post-investment monitoring is even more critical. Post-investment, GPs should build a monitoring framework that considers: implementation of strong internal controls and systems, identification and tracking of unusual transactions and/or high risk areas—especially those involving related parties, independent fraud and corruption risk assessments, and monitoring adverse news about the portfolio company. Finally, protective covenants regarding a target’s duty in implementing effective anti-fraud and anti-corruption environment must be included in the investment agreements as well as viable exit options in the event that a fraud is detected.

Dhruv Phophalia is a managing director with Alvarez & Marsal and leads the firm’s ‘Global Forensic and Dispute Services’ practice in India. Vikram Utamsingh is co-Head of A&M India and a managing director with Alvarez & Marsal’s 'Transactions Advisory Group' in Mumbai.