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Honest deal: PE, VC firms seek trust in firms they fund
No deal can advance without mutual trust. Enhancing trust is achievable by implementing higher governance standards, clear communication, ethical practices
Private equity (PE) and venture capital (VC) funds have seen it all: A booming economy in 2019, abrupt helplessness during Covid-19 in 2020 and 2021, elementary steps for recovery in 2022 and the “new normal” of 2023 and 2024 (but not before a long funding winter and extended deal cycles). Add to this, the complexities of certain investments going bankrupt and instances of financial fraud, mismanagement, and poor corporate governance in investee companies. The changing landscape of over the last five years has meant that they need to tweak their investment strategies constantly.
Corporate governance is a key aspect of company building: It should not be viewed as simply a legal/regulatory requirement but as a value driver for the business. Ideally, corporate governance standards should correlate to the size, scale, and maturity of the business. PEs/VCs need to address whether they have the wherewithal to periodically assess where the investee company stands, as well as the ability to take proactive steps to ensure readiness for stringent corporate standards as the company scales.
Key themes from investee firms that recently had governance issues include:
> Inadequate financial and integrity diligence procedures vis-à-vis the sector, scale, and maturity of business of the investee companies and its founders/promoters
> Minimalistic or no practice of periodic monitoring of financial health
> Mismatch in goals between investment firms and founders of the investee company
> Lack of a corporate governance management structure or team which acted as a second line of defence
While conducting pre-acquisition compliance audits and deeper forensic/integrity checks dovetailed with financial diligence is gaining traction, many PEs have also initiated periodic voluntary post- acquisition due diligence exercises or compliance audits to pre-empt any potential reputational risks.
The above practices have also gained traction in cases of larger follow-on funding rounds. Timely identification of fraud risks, anti-corruption risks, or violations of the code of conduct by employees can help PE/VCs strategise and augment their response mechanisms to deal with a situation appropriately.
A common fraud has been the lack of disclosure of conflict of interest. Businesses seek the help of their relatives as vendors or key suppliers in the initial stages. Despite having the best of intentions, promoters may not disclose such relationships to their investors for multiple reasons (including a lack of understanding of the coverage of the term ‘related parties’). The lack of controls aimed at protecting the investee company’s intellectual property rights has also been a cause for concern among investors. PEs/VCs have, at times, faced risks emanating from promoters misusing the company’s resources for their own personal interests.
PE/VCs are considering implementing a customised early warning signal (EWS) system to monitor the financial and non-financial data of their investee companies. Implementing EWS can help identify unusual patterns and leading indicators (such as skewed financial ratios and significant changes in key metrics such as account receivables, inventory, bad debts, write-offs, and inter-company deposits) that could denote certain anomalies and potential instances of fraud. EWS can help predict red flags in an investee company that could potentially lead to a fall in their financial net worth and reputation in the future.
Both investors and investee companies concur that no deal can advance without mutual trust. Enhancing the trust score is achievable through the implementation of higher governance standards within the organisation. Open and clear communication (specially around financial parameters), consistent ethical practices, collaborative decision-making, long-term relationship building, responsive conflict resolution, proactive risk management, and alignment on shared vision and goals are crucial in nurturing trust between investors and their investee companies.
The writers are partner and leader, and partner-forensic financial advisory, Deloitte (India)
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Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper