Private Equity Risk: What You Don’t Know Can Hurt You

Private Equity Risk: What You Don’t Know Can Hurt You

That stupid saying “What you don’t know can’t hurt you” is ridiculous. What you don’t know can kill you. If you don’t know that tractor trailer trucks hurt when hitting you, then you can play in the middle of the interstate with no fear – but that doesn’t mean you won’t get killed. — Dave Ramsey

According to McKinsey’s 2021 Private Markets Annual Review, private equity has outperformed other asset classes and experienced less volatility than any year since 2008. 

The review suggests that more institutions and wealthy individuals are turning to private equity (PE) to supplement and bolster the returns of their traditional investment portfolios as the markets remain largely unpredictable. 

Increased levels of activity can lead to a host of new challenges and private equity risks, as the appetite for dealmaking forces a sense of urgency – meaning that due diligence can at times be overlooked or under-executed. 

 

New Challenges for PE Investment Firms

Deloitte predicts that global PE assets will reach $5.8 trillion by 2025, significantly above the $4.5 trillion at the end of 2019. The significant increases in PE funds inevitably create new pressures on those responsible for investing the new capital and greater risk for their investors. Here are some of the reasons why:

Demand for rapid deployment of funds
According to MarketWatch, the top 25 private-equity firms had $509.8 billion in uninvested cash at the end of the 2nd quarter of 2021. Some claim they have more money than potential investments. 

With “excess” funds and a demand for deals, firms are diversifying into new industries and geographies with limited experience.

Increased competition
The number of private equity firms raising investor funds and seeking investments has increased on average about 7% each year since 2013, with an estimated 9,000 globally in 2021. The number of completed investments has been stable since 2015, while investment totals have increased. 

While demand for high-return investments has grown with the new investment totals, the supply of potential investments capable of delivering such high rates has remained stable. 

The PE firms compete for the desirable opportunities, driving up valuations and increasing risk. Simply stated, too much money is chasing too few deals.

Reduced client management responsibility
The open checkbooks of PE firms encourage excessive risk and over-spending by client companies. Iana Dimitrova, CEO of FinTech start-up OpenPayd, has warned, “Investors are increasingly writing higher and higher checks. Frankly, I see that as detrimental to the long-term sustainability of our industry because businesses are not focused on generating value, they’re focused on burning and deploying cash.”

Increased risk data
For firms willing to embrace enhanced investment due diligence, there is a new level of insight into risk data available. The reputation of a firm and its senior management has never been more critical. Firms don’t want to invest in businesses or individuals with bad reputations or troubled pasts. 

Emphasis on ESG goals
PE firms and their investors are increasingly conscious of a prospective investment’s environmental, social, and governance goals. Elias Koronis, a partner at Hermes GPE, suggests that sustainability is now as big a factor as other risk data; “The big mindset shift is that now ESG risk is as important and as central to a company as any other type of financial risk, such as leverage risk”.

ESG Investing & Due Diligence – Q&A with Brendan Bradley

Limited analytical resources & experience
The experience and expertise necessary to analyse potential PE investment opportunities typically takes years to acquire. 

Analysis of the character and backgrounds of client company management is especially critical and adding capable, experienced staff amidst current market conditions is increasingly difficult. As the workload grows for analysts and PE decision-makers, shortcuts in due diligence are inevitable.

 

The Importance of Due Diligence

Private equity investment is considered high risk in normal economic periods. The existing market conditions escalate the risk for investors and justify continuous emphasis on investment and reputational risk management.

Client Management Team Importance

Few investors dispute the importance of the management team in the success of a business. Private equity firms understand that the value of a company is not a “good idea,” but management’s ability to transform the idea into reality. 

No matter how revolutionary the concept, the management team’s performance is critical to success.

Of the many factors that affect the investment decision, management due diligence – evaluating the quality and skill of management – is the most difficult due to its intangible nature. 

Inexperienced analysts fail to recognise that search engines index only a small portion of available online information (4% to 6%), consequently omitting masses of data that could provide valuable insight about a company or its executive reputations, work histories, values, and abilities.

Under competitive pressures to quickly determine whether an investment is warranted, private equity analysts are tempted to minimise reputational risk in their due diligence, especially when a cursory search confirms their subconscious biases. 

An open-source internet search – enhanced by machine learning and natural language processing – provides independent, unbiased information about the attitude and aptitude of individuals and firms, ensuring they comply with regulatory guidelines and identify potential conduct or financial crime risks.

PE Analysts Limitations

Private equity analysts are especially adept at reviewing quantitative financial and industry data necessary to confirm or modify prospective investments’ pro forma statements, valuations, and cap tables. 

Unfortunately, they rarely have the search and database query skills and experience required to complete enhanced due diligence (for risk & compliance), investment (or management) due diligence, or specific functions, including ESG

Their lack of experience can overlook indications of questionable actions – allegations of discrimination and abusive behaviour, data leaks, fraudulent behaviour, and corruption – by the potential investment candidate or its founders.

Case Study: ESG Risks Uncovered In Investigation For Global Private Equity Firm

 

Time To Know More

In this hyper-competitive PE period following the pandemic, private equity risk is exceptionally high. The combination of increased client expectations and higher investment amounts forces PE firms to identify, analyse and confirm investment decisions on tighter deadlines and in a saturated market.

Simultaneously, the global increase of social activism exposes companies to new risks – with sustainability and culture at the heart of reputational vulnerabilities. 

While no strategy is failsafe, a thorough and complete due diligence process, including reputation and management, can help lower overall investment risk while relieving pressure on internal resources.

For more information on lowering investment risk, schedule a call with our team here.

Using Open Source Intelligence To Enhance Online Reputation Management

Using Open Source Intelligence To Enhance Online Reputation Management

While reputations can be built, sometimes crafted, over many years, they can be tarnished in an instant. The value of a reputation should not be underestimated and it’s imperative that brands use all of the tools at their disposal to protect and bolster their reputation.

Deloitte have previously determined that up to 75% of a company’s value can be considered intangible. This translates to three quarters of a business’ overall value being vulnerable to reputational damage.

Employing the right technology as part of online reputation management can help brands proactively protect their reputations, mitigating risks and solidifying market perception.

 

The Evolution Of Risks

In a global economy, risks are more varied in size, location and damage potential than ever before. The online world presents limitless opportunities and risks for brands who are now expected to be available and vigilant 24/7. 

These are just some of the types of reputational risks to brands that can be found online:

 

Consumer & Worker Voice 

The internet has granted previously unheard consumers a platform to share feedback, evaluation and criticism. 

Consistently negative consumer feedback will undoubtedly reflect poorly on a brand. Monitoring and evaluating consumer feedback can serve as a reflection, at least in part, of the “voice” of a company’s customer base.  

Company workers have been granted a similar platform through online review sites such as Glassdoor. Similarly to consumer voice, public employee feedback can act as a barometer for company performance and culture, and will certainly influence the public perception of a brand if a negative news cycle begins to build.

 

Internal Threats

Internal business threats can come in a host of forms, including confidentiality breaches and personnel misconduct.

Reviewing a management team’s online footprint can help highlight potential risks including damaging behaviours and misconduct – all of which can negatively impact the reputation and value of the target company in the present and future if left unchecked.  

Case Study: Online Screening Of Senior Manager Reveals Internal Confidentiality Threat

In a previous case we discovered damning allegations of sexism and derogatory behaviour from staff towards their company’s CEO. Upon reviewing the report, our client decided not to continue with the deal – a decision that was reaffirmed when the CEO of the target company hit the press a year later.  

 

International Risks

Brands that operate internationally need to be aware of the risks that can come with global supply chains, where they may have limited control but could still be vulnerable to reputational damage.

For those brands operating internationally, threats to reputation should also be monitored and considered in different languages. While many online tools claim to give oversight of online and global brand threats, not using a multilingual approach can lead to unnecessary exposure to threats. 

 

Social Media, Brand Ambassadors Brand Values

As has been made very public over recent years, social media has the potential to come back to haunt the reputations of high profile businesses and personnel.

It can reflect poorly on a brand to be associated with individuals who are not seen to represent their values and culture. Australian rugby player Israel Folau lost a number of his endorsement deals after a series of homophobic social media posts, with sponsors announcing that Folau’s views “are not aligned” with their own values. 

While in Folau’s case, the brands were forced to be reactive, proactive screening can help lower the risks of brand damage.

We wrote previously of the impact of sport and social media, with England cricketer Ollie Robinson now irrevocably linked to a damaging news cycle surrounding racism and historic social media posts.

Had Robinson’s profile been screened ahead of his selection for England, or in fact ahead of his first professional contract, his employers would have been aware of the posts and could have taken proactive steps towards rehabilitation or punishment for the player, while avoiding a future scandal altogether.

 

A Recent Example: Driving Ambassador

In a recent case working with a major advertising agency, we conducted open source background checks on a selection of potential ambassadors for an upcoming campaign for an automotive brand.

We conducted searches on a number of high profile names, checking traditional risk behaviours, as well as thematic references focusing on vehicles, driving and similar related themes.

Amongst the findings were behavioural red flags that may have been reputationally challenging for the automotive brand. For one subject, we uncovered a previous driving related conviction that had escaped public attention to date, while another had previously shared derogatory content towards drivers on social media.

Selecting either individual as an ambassador for a global campaign could have caused serious reputational damage for the brand, had they not been fully vetted.

 

Limited By Online Tools

Although many brands already employ online reputation management tools, many online tools rely on manual searches, or are only able to focus on specific keywords. The limitations of these processes are plain to see, with a restricted view of potential risks. 

Traditional online searches are limited by the data sources that they are able to canvas. General internet searches only cover 4-6% of available online data, meaning that online brand management tools only access a small portion of potential risk data.

Using open source intelligence, thereby accessing 100% of available online brand risks, broadens the risk management strategy to include social media, all online activity, adverse media checks and more.

By broadening searches to include thematic or industry-specific terms, like driving or vehicles in the example above, we are able to paint a more complete picture of brand risk no matter the industry. 

Lastly, by using tools such as Neotas’ AI powered platform, we can process risks in over 200 languages, granting even stronger protection for international businesses.

 

Easy To Lose, Tough To Win Back

Countless examples prove how difficult it can be for brands, businesses and personnel to win back reputations once they’ve been damaged.

Market perception and reputation are perhaps the single most significant external factor in influencing a brand’s overall value. A positive, strong reputation can create value for shareholders, while also improving confidence and trust in the brand for the public and for customers.

Introducing a proactive approach to online reputation management, including the introduction of open source background checks and brand reputation management checks can help limit exposure to potentially damaging threats.

For more information about protecting your brand and online reputation management, schedule a call and speak with our team today.

The Pandora Papers have changed the world of due diligence forever

How The Pandora Papers Changed Due Diligence Forever

The Pandora Papers leak – the latest in a series of off-shore data leaks in the past seven years – has exposed nearly 12 million financial documents to the public eye.

As with previous leaks, this public scandal damages the reputations of those involved and raises larger questions about trust, risk and the world of due diligence.

Business that was once hidden behind complex corporate structures has now been brought to light. With it comes millions, possibly billions of intriguing data points for financial investigators, lawyers and police officers to pore over.

Panama, Paradise, Pandora

The Pandora Papers leak is the latest significant data drop from the International Consortium of Investigative Journalists. Previous leaks including the Panama and Paradise Papers, as well as smaller leaks, shed light on the shady dealings taking place in “complex off-shore structures”.

One of the many side-effects of the previous off-shore data-leaks – especially the highly publicised Panama Papers in 2016 – was that it revealed fresh evidence of hidden assets.

In 2015, two ex-wives won a US Supreme Court battle to challenge their settlements after the court found their ex-husbands had misled the courts and failed to disclose property that had been revealed in the leak. This is just one example of how undisclosed assets can impact the legal course of action.

Another, possibly more significant side effect was that they also revealed how many “complex” business structures were, after thorough investigation, discovered to be better described as money-laundering schemes.

Nothing to see here – so far

So far, there have been no allegations of financial wrong-doing in the Pandora Papers. This was also the case following the publication of the Panama Papers.

Fast forward four years however, and the Cologne public prosecutor’s office issued international arrest warrants in 2020 for the partners of law firm Mossack and Fonseca.

In 2016, the firm had responded to journalists saying they followed “both the letter and spirit of the law”. And just as then, so it is now.

No allegations of criminality have been made to date and the off-shore services providers implicated in the Pandora Papers have, so far, claimed to have operated fully within the law, as was the case in 2016.

Alcogal, Asiaciti Trust and Fidelity were all named in the latest leak.

Alcogal has claimed no criminal wrongdoing, stating its due diligence policies “follow the standards set by the laws in the jurisdictions in which it operates”.

Asiaciti Trust said its offices had “passed third-party audits for anti-money laundering and counter-financing of terrorism”. Fidelity said it conducted “relevant due diligence” on all its clients.

All three remain under intense scrutiny from regulators, watchdogs and the public eye.

The times are changing

The new Anti-Money Laundering Act (AMLA) in the USA may change all that. It specifically prohibits politically exposed persons (PEPs) from falsifying the source and ownership of funds & assets, and allows US law enforcers to subpoena bank records from foreign financial institutions.

Under Section 6403 of the Corporate Transparency Act, all corporations, LLCs and banks will be required to submit beneficial ownership information to the newly formed Financial Crimes Enforcement Network (FinCEN) at the US Treasury. It also revises Customer Due Diligence Requirements for Financial Institutions.

The times are changing. Where once the Treasury was unable to enforce AML laws, US law enforcers will now be more aggressive in checking a company’s due diligence and KYC policies. Isn’t it time to minimise your risk?

Regulators across the financial industry are already regularly reinforcing the idea that firms need to do more. Just doing the minimum required due diligence will no longer be appropriate when risk data is available but not being considered.

Adopting tech-driven, enhanced due diligence practices that connect the dots between disjointed database searches and open-source data can help minimise those risks.

If you want to discuss due diligence or risk management, our team are here to help. Feel free to get in touch or schedule a call here.