The global economy is emerging from the most severe economic jolt since the Great Depression, but the fallout continues to be felt around the world. Firms can fold with little or no notice and, while a business may be in good condition, counterparty risk or sudden closure of a key element in the supply chain may damage the entire enterprise. These risks particularly apply to private-equity funds and hedge funds that have taken significant but perhaps non-controlling positions in firms in Japan and the Asia-Pacific region.
While investors may have regular access to their investee firms’ financial reporting, this data tends to be historical in nature. Reading about how bad a given situation may be, some three months after the event, is of no practical use in protecting corporate value or investments. This situation is compounded by the hard fact that, during the frothy period before the financial collapse, many investors failed to do adequate due diligence. Also, some Asia-based firms had never faced an economic downturn, and their senior management may have lacked the experience required to handle what to them was a new situation.
What is required is a retrospective due diligence investigation followed by enhanced, discreet and regular monitoring of the investee firms. Investors must at least ensure that each investee firm, its subsidiaries and key principals are conducting business to the highest standards of corporate governance.
This is especially relevant during times of economic pressure when the temptation for management to cut corners or to inflate financial results may be strong. Such a situation is often exacerbated by the geographic distance between the investor and the investee firms — making improprieties more difficult to detect.
Our experience shows that for retrospective due diligence or an “investment assurance exercise” to be effective, the focus should be on 10 key points:
- Recent or unreported changes in corporate structure
- Recent or unreported changes made to licensing
- Comments by auditors or their sudden resignation
- Comments by associated stakeholders, such as bankers, vendors, suppliers and competitors
- The current business interests of key staff and, if they appear to be under financial stress, also perhaps seemingly unrelated investments
- Litigation involving the firm, its staff or their family members
- Pertinent labour issues or the sudden loss of management or key business generators
- Suspicions of fraud or other corruption-related concerns
- Legal and regulatory issues that could have an impact on the business
- Environmental or other social compliance issues
In the event that serious concerns are raised during the due diligence/assurance exercise, swift decisions need to be made as to the best way to mitigate risk and expeditiously recover or protect funds. Generally, there are three avenues open:
- Negotiated settlement
- Legal action against the parties concerned
- Liquidation or insolvency of the parties/entities concerned
Clearly an early, negotiated settlement is preferable if an acceptable level of financial recovery can be achieved.
Legal action is always expensive, often slow and the outcome generally uncertain. Therefore, before advising clients to take legal action or to move to the third option above, I would recommend a thorough asset search into the investee firm and its key principals.
Personal guarantees are also often involved and experience shows that individuals can redistribute and conceal their assets in anticipation of future action against them.
Therefore, it is important the institution or fund concerned has the most up-to-date and accurate information on the disposition of the assets of an opposing party. In many cases, once the parties concerned are made fully aware of the bank or fund’s knowledge as to the extent of their assets, a reasonable settlement can be made without extensive legal action or insolvency.
There is no perfect way to guarantee corporate value, let alone in an environment as fraught as that of the past year or so. But failing to take proactive steps at an early stage would mean investors constantly playing catch-up rather than driving events, pre-empting unwanted surprises and successfully safeguarding corporate value.