Originally published July 14, 2023

 

Investment Company Act. False Claims Act. Securities Act. Advisers Act. These and many other compliance regulations exist to prevent fraudulent activities on the part of private equity firms and their portfolio companies. Yet, every year there are hundreds of cases and millions of dollars in private investment fraud. The 18-month total of $1.7 trillion between 2021 and 2022 produced the strongest year-and-a-half the industry had ever seen.

When it comes to investments, a company’s financials aren’t the only measure of success. Numerous other factors can make or break the success of an investment and are crucial to know ahead of time — that’s where due diligence comes into play. Enhanced due diligence will not only bring to light any financial concerns, but will also help to proactively identify any legal, regulatory, and reputational issues. A deal may look great financially, but without proper enhanced due diligence, investors may miss underlying problems that can lead to significant legal costs and reputational damage.

The Landscape of Private Equity (PE)

Globally, private equity managed to post its second-best year ever in 2022, riding a wave of momentum coming off the industry’s record-breaking performance in 2021. But spiking interest rates caused a sharp decline in deals, exits, and fundraising during the second half of 2022. After showing some signs of stabilization in Q4 2022, US PE dealmaking in Q1 2023 delivered a mixed verdict, with deal count faltering by 9.3% and deal value rising by 11.4%.

While the long-term PE outlook is fundamentally sound, the downturn has resulted in challenges for partners who are forced to look more closely at their current portfolio and future investments. The industry’s rapidly expanding focus on Environmental, Social, and Governance (ESG), human rights, anti-bribery and corruption (ABAC), and other compliance standards further heightens the need for close scrutiny of any investments. PE managers have had to adjust to make deals happen and keep the leveraged buyout (LBO) machine functioning. Those adjustments can come in many forms, such as making deals smaller and easier to finance, and, unfortunately, softening due diligence standards to push deals through. Private equity firms, particularly those invested in healthcare and pharmaceutical businesses, continue to face exposure simply by being associated with — let alone recklessly disregarding — a portfolio company’s potential violations.

In the last three years alone, our professionals have observed requests from Private Equity firms for Enhanced Due Diligence (EDD) on much more than just high-risk industries and jurisdictions, but throughout the entire PE ecosystem. We see approximately 70% of these engagements initiated with full open-source public records research and analysis.

Private equity investments are drawing new scrutiny

While private equity investments have been scrutinized more closely by regulators and governing bodies in recent years, recent headlines centering around failed investments and executive corruption have caught the public’s attention as well. In the wake of the FTX debacle, where numerous well-known PE firms were duped into investing large sums of money, many are keeping a closer watch over how firms are investing, building their portfolios, and conducting due diligence. Selcuk Yorgancioglu’s recent debarment from the World Bank — which we’ll discuss more later — for misleading the International Finance Corporation has also drawn negative attention to the world of private equity.

With stories like these, as well as reports of PE investments hurting industries such as nursing care and housing, public sentiment toward PE firms can easily shift and place a higher degree of pressure on firm managers to make successful and safe deals happen. This, coupled with regulator’s renewed interest in how PE investments affect stakeholders in new markets, adds new complications to investment due diligence beyond financial returns.

Shifting valuations and timelines

In today’s tumultuous PE environment, which has been impacted by inflation, geopolitical events, and economic downturns, among other factors, it’s becoming increasingly difficult for investors to discern whether an investment will be their next big success or their next significant burden. To complicate matters further, current economic conditions are impacting valuations  for companies that may have seemed like prime investment candidates only months prior. Digital payments processor Stripe Inc is a prime example. Over the past two years, the startup’s valuation has steadily declined by nearly half, falling from a valuation of $95 billion in early 2021 to its most recent valuation of $55 billion in the latest round of fundraising.

However, as deal volumes adjust and turnaround times lengthen in the current PE environment, firms are presented with a unique opportunity to conduct more thorough due diligence before proceeding with investments or co-investments, which are expected to continue strong over the next year, according to data from Private Equity International.

Taking the time to perform enhanced due diligence on financial, legal, and ethical aspects of an organization and understanding how past revenue reports will impact an investment must become a top-of-mind activity for firm leaders.

Lack of Private Equity Due Diligence in the Real World

The SEC filed 760 enforcement actions and recovered a record $6.4 billion in penalties and disgorgement in 2022, a nine percent increase from the prior year. This includes enforcements against PE firms and their portfolio companies, as well as private fund advisors and associated partners.

HIG Capital

In October 2021, private equity firms HIG Capital and HIG Growth Partners paid nearly $20M to settle a fraud case involving portfolio company South Bay Mental Health Center. The latter was accused of hiring unlicensed and unqualified staff and fraudulently billing federal and Massachusetts health care programs for services as though they were provided by licensed and qualified professionals.

While HIG’s mental health company acquired South Bay in 2012, it appeared that the institution had been submitting false claims to the state of Massachusetts as early as 2009. The investigation only took place after a whistleblower and former South Bay employee filed a lawsuit under the False Claims Act. Had HIG conducted thorough due diligence before bringing South Bay Mental Health Center into its portfolio, including boots-on-the-ground conversations with current and former staff, they may have been able to see the misconduct that was taking place and make the informed decision to pass on the investment that cost them $20 million down the line.

Oppenheimer

In an alleged $110M Horizon Private Equity III Ponzi Scam, Southport Capital owner and ex-Oppenheimer stockbroker John Woods was accused of defrauding investors, including Oppenheimer clients. Despite Oppenheimer being uninvolved in the suggested Ponzi scam, the Financial Industry Regulatory Authority (FINRA) identified that the company failed to appropriately supervise Woods. 

Had Oppenheimer understood the regulatory consequences of Woods’ actions and performed enhanced due diligence on behalf of their clients and investors, it may have been able to detect the fraudulent behavior and steer clients away from Southport Capital.

Abraaj Group

An April 2023 announcement of debarment from the World Bank raised interest in the topics of private equity and due diligence. Private equity executive Selcuk Yorgancioglu has been debarred by the World Bank for a period of 24 months for misleading the International Finance Corporation. Yorgancioglu and any firms he controls are ineligible to participate in World Bank Group projects during the debarment. The investment team he was part of, the Abraaj Turkey Fund I Project, omitted to disclose “material and relevant facts” about the financial situation of one of the investee companies, which misled the IFC and constituted a fraudulent practice.

Yorgancioglu is still listed as a Partner at Bluegrove Capital Management, a private equity firm based in London, allowing his debarment scandal to bring negative attention to the firm. Given the Abraaj Group’s recent history of fraud and hefty fines, including a $135.6 million fine for the firm’s founder Arif Naqvi, a more thorough investigation should have been launched regarding Yorgancioglu’s time spent with the company before bringing him on as a board member. Private equity firms are not exempt from the perils of executive hiring and thorough background checks for executives and partners should be considered non-negotiable — especially when their previous firms have a spotty track record.

Where else is PE due diligence lacking?

While financial and legal due diligence are often obvious steps for investors, other more nuanced types of diligence are becoming increasingly important in the shifting landscape of expectations and deadlines. Investigations related to reputational due diligence are now just as important and impactful, as negative public sentiment and reputational damage can create long-lasting adverse impacts for PE firms.

However, even when these investigations are conducted, they often rely on information available through the public record, such as infringement notices, disputes, sanctions, enforcement actions, and instances of directors involved in insolvency proceedings. In today’s business environment, where organizations often withhold information related to internal dysfunction, poor financial performance, unethical behavior, misrepresented data points, and shaky business relationships, deeper investigations that go beyond the information available on public record are often necessary.

With this in mind, a surface-level due diligence process is not always thorough enough. An enhanced due diligence program that can penetrate bureaucratic obstacles requires a combination of advanced due diligence technology and discreet human intelligence gathering into the reputation of the subjects under review.

Enhanced Due Diligence with IntegrityRisk

Private equity is a highly specialized industry of its own, with distinctively wide-ranging considerations when it comes to due diligence. Investing in enhanced due diligence protocols designed to identify actual or potential issues across the risk spectrum is no longer a luxury — it’s a necessity.

Enhanced Due Diligence with IntegrityRisk helps PE firms stay ahead of compliance concerns and reputational risk before closing the deal, making it an essential tool in any investment process. EDD with IntegrityRisk creates a successful in-house program that includes:

 

    • Support: Consistent and supportive approach at the highest levels to ensure the implementation of appropriate due diligence on every investment

    • Process: Documented process for EDD based on the type of transaction, location and other reputational “risk factors” employing a risk-based approach where the scope of research and inquiries matches the use case and level of risk

    • Centralization: All due diligence data and insights in one centralized location, exactly when and where you need it

    • Communication: We communicate and empower PE firms to communicate globally and share lessons learned

To learn more about how IntegrityRisk can maximize the effectiveness of due diligence performance, contact us today.