Ivan R. Lehon and Gregory E. Wolski are partners at Ernst
& Young
This article originally appeared in Financier Worldwide
Recent media reports highlight a number of significant business transactions gone awry, with the collapse of Sallie Mae's sale to JC Flowers – the most recent failed mega buyout. In September, the KKR and Goldman Sachs deal for Harman hit the rocks. As this article went to press, The Wall Street Journal reported Cerberus citing "poor conditions in the debt markets" for its withdrawal of a proposed $6.2bn purchase of Alliance Computer.
Notwithstanding recent market tumult, strategic and financial buyers remain active across the US and Europe. Recently, financial markets saw a piece of Home Depot taken private at a valuation 17 percent lower than expected, and then witnessed KKR significantly restructure its bid for First Data. The re-priced transactions seemed to suggest a step back toward rationality and reasonable purchase prices, attended by a necessary caution about debt levels.
The prevailing mood still seems to be to get good deals done. Fundraising is at historic highs, the amount of capital pouring into private equity funds in Europe has even outpaced that in North America during the last two years, and hedge funds continue to grow in both markets.
The size of private equity war chests alone seems to ensure that acquisitions continue at their present rate into the foreseeable future – even if at multiples slightly less inflated than recently. With more opportunity to wring financial value and strategic advantage out of less mature European markets, strategic will arguably move faster in Europe than in the US.
Just as debt financing set the tone in the past few years, supporting ever higher purchase price multiples and driving the perception that values would continue to increase, the recent pullback in debt augurs a different conception of risk and reward. As purchase price multiples fall, leverage and risk profiles also change. It becomes all the more pressing for both financial and strategic buyers to determine acquisition value.
Investors are increasingly aware of factors that diminish acquisition value post-close. Principal among these are fraud, corruption, and the failure of an acquired business to comply with key regulations governing financial conduct, financial controls, and reporting.
The discovery of fraud or a serious regulatory violation after closing is one of the fastest ways to lose value after an acquisition, and potential losses can exceed the original investment. For a strategic buyer, fraud and/or illegal acts pose a barrier to operational efficiency and can be an expensive drain on resources. For a financial investor, it not only erodes the ongoing Internal Rate of Return, but can also savage realisation on an exit.
Mitigating fraud losses or helping a company come into compliance can be expensive, tying up resources in investigations, compliance audits, financial restatements, or litigation after the close. In some cases, corruption takes years to combat, involving wholesale changes to business practices, revamped communications, and implementation of rigorous procedures for internal audit.
Globalised business and the resulting flow of capital across borders make assessing the risk of fraud and illegal acts more pressing in the period leading up to a transaction, especially where subsidiaries or business units operate in economies with less developed regulatory standards or where enforcement is historically lax, such as in Brazil, Russia, India, and China. The risk is heightened as calls for more regulation increase, especially of the hedge fund sector. It has become all the more important to manage fraud and regulatory risk before investing.
In short, the exposure of fraud and the recently heightened focus on it have altered deal dynamics – investors are more sensitive to fraud's serious potential to damage the value of the business. Buyers are not the only ones at risk. Sellers must understand their company fully, including the implications of past business practices in an operating unit to be spun off. If nothing else, a forensic investigation alerts both sides to potential problems. In the best case, the two sides resolve a problem before damage is done or disputes can occur. A disciplined, comprehensive approach to forensic due diligence has become a prerequisite, before the buyer and seller sit down at the closing table.
For a global company involved in an acquisition, the US Foreign Corrupt Practices Act (FCPA) is at the forefront of compliance risk, as enforcement of FCPA has become increasingly stringent.
FCPA enforcement in the US is only part of the risk. Efforts to enforce anti-corruption statutes have become increasingly pronounced in Europe and Asia. International accords such as the Organisation for Economic Cooperation and Development (OECD) Anti-Bribery Convention, the UN Anti-Corruption Convention, the Council of Europe Criminal Law Convention on Corruption and other similar initiatives and regulations have strengthened the framework to deter and prosecute fraud. In other cases, countries have updated their own domestic statutes and enforcement apparatus.
Corruption is particularly difficult to pinpoint and prevent. But certain specific actions of employees or characteristics of a company's business may be indicators of FCPA compliance risk. Companies with operations in emerging markets will benefit from forensic due diligence, as will those with public sector contracts or poorly documented consultancy and other professional services agreements.
Other conditions that heighten FCPA risk include contingent sales commissions, excessive travel, gift, entertainment or miscellaneous expenditures, and operations in industries such as construction, service, manufacturing, and other highly regulated industries. Conditions to consider also include: the history of incidents or significant allegations of bribery or corruption; financial results in one or more countries or operations that are starkly out of line with expectations historical benchmarks, and/or the results of competitors; Transparency International (TI) corruption perception rating for country; use of third party intermediaries, such as brokers, agents, distributors, consultants, etc.; group/institutional sales; ownership structures and/or newly acquired operations; high growth areas, including expanded operations or licensing agreements; the culture and commitment to compliance of the business and its operating units; financial controls; and past audit findings and the frequency of internal audits.
When assessing these factors, the team conducting FCPA due diligence would assess the occurrence of past violations, and seek to assess the possible impact of increased compliance oversight or enforcement. This includes assessing and quantifying risk, identifying red flags, and developing – even if only in thumbnail – a post-close compliance program.
FCPA non-compliance is one risk that can negatively impact transaction value. Others include regulations about competitive practices, rules governing international trade, industry specific rules and regulations, and local country and EU regulations.
As the movement to internationalise financial reporting standards and accounting practices gathers steam, the impetus to share best practices for safeguarding shareholders is likely to accelerate.
A history of non-compliance should be of real concern to the buyer, as the acquirer assumes the risks of the target's less desirable history and/or inadequate anti-fraud and corruption policies. The new owner may also be held liable for not dealing swiftly and appropriately with these issues at the time of acquisition.
Justifiably, the party planning an acquisition will be concerned about the costs of due diligence, but these expenses need not be inordinate. While a detailed pre-acquisition review of exposure to fraud and regulatory compliance risk will contribute to the cost of due diligence, it will prove far less expensive than achieving compliance after the fact. A forensic due diligence investigation allows a buyer to evaluate potential future loss in value resulting from inappropriate or illegal business practices, based on identified revenue streams that rely on such business practices.
In conducting pre-acquisition forensic review, the acquirer can see three benefits. First, they learn in advance what obligations, liabilities, or operating issues they could assume post-acquisition, and what steps need to be taken after the transition to achieve compliance. This helps anticipate costs and may also provide something of a regulatory 'safe harbour'– a good faith conversation with regulators about findings may stand the company in good stead as it moves to full compliance. Second, limited partner investors in a private fund can take comfort that the due diligence considered risks beyond the balance sheet and income statement. Third, in the event fraud is uncovered, acquirers have increased leverage in unwinding potential acquisitions.
Corruption is particularly challenging to investigate because of the generally limited evidence within the company itself. During an acquisition, forensic due diligence must proceed on a timeframe that does not threaten to derail the deal.
For these reasons, a simple process is best. Two areas are particularly relevant: first is having proven investigative interviewing techniques and adequate software and methodologies for investigating electronic data, email in particular. If these are not rigorous, the investigation is unlikely to be effective in discovering inappropriate practices.
To facilitate efficient review, the buyer should embed a team of forensic professionals within the financial and tax due diligence teams, so that forensic procedures are woven into the process and conducted concurrently with that work. Depending on the sensitivity of the situation – especially where there is high likelihood of exposure to fraud or regulatory risk – the forensics team may or may not be identified to the target by the buyer.
At a minimum, the forensic review will: scrutinise historical fraud or incidents of noncompliance; analyse and read fraud awareness programs and hotlines; test accounts with high levels of management discretion, such as reserves and accruals, related-party transactions, travel and entertainment expenses, consulting expenses, and other discretionary spending; test controls on areas such as cash disbursements,cash receipts, segregation of duties,signatory authorisations, and journal entry approval; and discuss audit procedures, reporting,and results with the target's independent accountants and, where possible and necessary, with internal audit.
The final product is a detailed report that considers actual, likely, and conceivable exposures. Depending on the buyer's requirements, the report could be integrated into the results of traditional due diligence and, in the case of a financial investment, made available to investors as part of full disclosure. When circumstances warrant, it can be delivered to the acquirer confidentially as a stand-alone report.
In either case, the benefits of forensic due diligence are manifest. The buyer receives a report on compliance risks and possible exposure to fraud, including a roadmap for enhancing controls, addressing operational risks, and corrective measures to be taken post-acquisition. In an environment where information regarding fraud and compliance related exposure has so much potential value, a proper forensic analysis can be vital to achieving deal success.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
