The concept of due diligence is probably as old as trade itself. These days, no conscientious management team would proceed with any investment without conducting due diligence addressing the risks that a potential transaction could pose.

Due to the business model’s risk-intensive nature, private equity firms present a high bar for due diligence requirements. This is true not only for private equity firms themselves, but also for parties considering allocating funds to private equity firms.

In today’s market, the rapidly expanding focus on Environmental, Social and Governance (ESG), human rights, anti-bribery and corruption (ABAC), and other regulatory compliance standards heightens the need for enhanced due diligence (EDD). The goal of EDD is to uncover risks that can elude conventional due diligence practices. One example is that appropriate EDD can help prevent the flow of “dirty” money – obtained from money laundering, terrorism, or fraudulent activities – from ending up in a private equity fund’s ecosystem and potentially being channeled into a portfolio company. Case in point: Chinese online classifieds platform 58.com, which was taken private in 2020 by a syndicate led by Warburg Pincus, has come under heavy criticism in China after a Chinese national said he was tricked by one of its job advertisements to become the victim of a human trafficking ring in Cambodia.

A look at some additional, recent examples sharply illustrates the hazards lurking for private equity firms, as well as corporates, that fail to apply enhanced due diligence before signing off on an investment or project.

Skimping on EDD: Lessons Learned

 

Case 1: Minding the G in ESG

Failing to recognize and address ESG factors surrounding the target company of an acquisition can expose a private equity firm (or any buyer) to substantial risk, including a threat to the long-term value of the business they are acquiring. That message has gotten through. In a recent letter to CEOs, BlackRock CEO Larry Fink predicted a fundamental reallocation of capital towards investment strategies that place sustainability and compliance at the center of the investment approach.

State Street, T. Rowe Price, Vanguard, and other large fund managers have followed suit, stating that ESG-focused companies create long-term value for investors and companies alike. These and a rapidly growing number of firms are committed to assessing ESG risk with the same rigor as traditional measures such as credit and liquidity risk.

In 2018, Dubai-based Abraaj Capital, which had until this time dominated the emerging markets private equity sector, was accused of using its investment fund to support the business of its founder, Arif Naqvi. The fund’s money mostly came from large institutional investors, including the Bill & Melinda Gates Foundation. Numerous allegations of conflicts of interest, related party transactions, financial mismanagement, and fraud ultimately led to the collapse of Abraaj. The firm, which managed $14bn in assets and was the driving force behind some of the largest takeovers in emerging markets, left private equity experts exploring the lessons for investors and advisers alike. As reported in the Financial Times, June 26, 2019, Abraaj’s travails were a “wake-up call,” according to Ludovic Phalippou, a finance professor at the University of Oxford’s Saïd Business School. “People should not be naive about the contracts auditors sign with private equity managers,” says Phalippou, author of a textbook, Private Equity Laid Bare. “[The Abraaj case] shows how much freedom there is for investors to be proactive. If they had been more proactive, [the alleged mishandling of funds] would not have gone unnoticed.”

Abraaj liquidator PwC found that the firm had a large funding gap and, as a result, spent beyond its means. By the time the scandal broke, executives and investors say, it had used other people’s money to fund that gap. This mishandling of investor funds was not immediately spotted by its auditors, KPMG. Experts have said that a frequent change of auditors might help avoid this type of financial collapse. Overall, the serious lack of governance and oversight at Abraaj might be the biggest lesson from its fall from grace. Ongoing due diligence that includes audit rights, frequent check-ins on investments and operations, and independent, non-biased board members aids in avoiding these types of failures.

Case 2: Portfolio Company Liability Risks

Intensive deal activity in private equity-backed healthcare transactions has opened the door to problems that draw heightened attention to EDD (or a lack thereof). Private equity firm HIG Capital last year agreed to pay nearly $20 million to resolve claims a mental health company it owned billed Massachusetts’ Medicaid program for services provided by unlicensed and unqualified staff. The settlement was the largest of its kind with a private equity firm in Massachusetts.

Similarly, in 2016, Och-Ziff Capital Management Group LLC agreed to pay $213 million in criminal fines in connection with a widespread scheme involving its wholly owned subsidiary, OZ Africa Management GP LLC and the bribery of officials in the Democratic Republic of Congo (DRC) and Libya. The case marked the first time an investment fund had been held accountable for violating the Foreign Corrupt Practices Act.

Diligent exercising of an EDD process prior to the companies’ acquisitions of the subsidiaries, including a standard check for licensing compliance among employees and histories of corruption, would have revealed the violations and helped both HIG and Och-Ziff avoid legal debacles. In addition, these examples reveal the importance of actively monitoring the risk management activities and posture of each company in an investment firm’s portfolio. Evidence of a strong compliance and oversight program at the investment fund level will help mitigate any liability if and when a portfolio company experiences potential risks.

Case 3: Human Rights

In some quarters, private equity firms have been characterized as slow to recognize the importance of applying EDD in rooting out cases of human rights abuses when vetting potential investments. In Britain, there are currently no laws that specifically hold private equity firms liable for human rights abuses by portfolio companies.

Meanwhile, at the corporate level, two recent Supreme Court rulings in Britain, one against Vedanta Resources over pollution from a mine in Zambia and another against Shell over its pollution in the Niger River delta, have established that a parent company may have a “duty of care” relating to overseas subsidiaries.

In the first case, Vedanta Resources agreed to settle all claims brought against it by Zambian villagers following pollution by a copper mine run by Konkola Copper Mines Plc (KCM), a subsidiary of Vedanta. The claim was brought by more than 2,500 Zambian villagers against KCM, Zambia’s biggest private employer, and parent company Vedanta.

In a historic ruling in early 2021 against the oil giant Shell, a Netherlands court found in favor of four Nigerian farmers, along with environmental activists, in an oil spill case that was first filed in 2008. In the verdict, the appeals judge sided with the farmers in finding Shell’s Nigerian subsidiary responsible for four out of six pipeline leaks covered by the lawsuit, as well as declaring that the parent company, Royal Dutch Shell, had violated its duty of care.

The cases call attention to the vital role of EDD, in these cases for corporate entities, in uncovering harmful or illegal behavior by a subsidiary or, in the case of Shell, conscientious monitoring of far-flung business units and prompt response in the event of a problem.

A Solution for Enhanced Due Diligence

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 has become a cost of doing business.

Staying ahead of ESG, ABAC, human rights, and other compliance concerns – before signing on the dotted line – is why Enhanced Due Diligence with IntegrityRisk is considered an essential tool in any investment process.

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

EDD with IntegrityRisk

Determining the full scope of all types of exposures is readily available through Enhanced Due Diligence with IntegrityRisk. This includes negative mentions in the media and on the Internet broadly, corporate registration records, regulatory and litigation records, as well as global public records research and analysis.

 

Integrity Risk includes discreet inquiries with knowledgeable, in-country sources regarding an entity’s background, business practices, and reputational status. Integrity Risk goes even further in providing not only a technological solution, but also in-house experts to provide in-depth guidance.

Our team of research analysts hail from a variety of backgrounds and can address the full scope of EDD, from low-level matters to complex assignments worldwide.