Forensic approach to avoid shocks

Mergers and acquisitions (M&A) and private-equity (PE) investments are growing consistently across industries in India. The underlying rationale for these transactions is to derive competitive advantage and increase the overall business value for the investor.

However, in the recent past, there has been a steady increase in cases of fraud and misrepresentation in M&A transactions resulting in immediate erosion of value for the investor.

Consider the following:

An investor into a tower company discovered that number of towers were significantly lower than according to the books (considered for valuation and investment);

Post-investment , a PE fund realised that inventory and fixed assets were only 64 per cent of the value disclosed according to the books;

Post-acquisition , the investor company discovered dummy sales to the extent of 45 per cent of reported sales; and

An multinational company (acquirer) realised that a substantial portion of the contracts were garnered by improper and unethical means by the target company.

In all these cases the investment value was substantially eroded immediately or within a short period after investment.

Further, in few cases, the acquirer or investor also had to deal with reputational and regulatory issues.

Some of the key areas of concern noted during M&A transactions are overstatement of revenues and profit, non-existent or obsolete inventories, round-tripping of sales and purchases, non-existent assets, dummy employees, underreporting of actual expenses and liabilities, conflict of interest situations, undisclosed-related party transactions and advances to non-existent vendors.

Forensic Due Diligence

Forensic due diligence (FDD) covers the risks of fraud, corruption, unethical business practices, conflict of interest situations and related party transactions. In the absence of forensic due diligence on these aspects, the investor could be exposed to reduced revenues, increased costs, reputational damages or even regulatory actions.

Typical forensic due diligence procedures include detailed background check on target and its promoters, review of corporate governance practices to assess the corporate culture and “tone at the top,” fraud risk diagnostic to identify red flags and any significant pre-existing frauds, detailed forensic investigation procedures on specific areas where fraud risk diagnostic indicated significant red flags, and site visits to confirm existence of customers and vendors where red flags are identified.

How prevalent is corruption?

Considering the increased regulatory focus globally, one area which is receiving specific attention as part of forensic due diligence is bribery and corruption.

FDD helps an organisation understand areas of target's business which could be dependent on potentially corrupt practices, especially in geographies or industries where corruption is highly prevalent.

An investor must proactively assess the future reduction in value resulting from discontinuance of business segment which is dependent on unethical practices.

In addition to factoring this in the valuation, the investor needs to evaluate the potential compliance risk that could devolve on them on account of these improper practices.

Trust but verify

In several transactions, it is noticed that complete reliance is placed by the investors on investee management.

In the current environment, it is essential to arrive at a fine balance between complete reliance and applying professional scepticism in your interaction with investee management to protect your own business interest.

Risk of fraud has increased substantially in the current volatile economic environment.

Incorporating forensic work steps as part of the overall due diligence process would help an investor in avoiding future shocks or surprises and ensuring that the investment rationale is not defeated on account of pre-existent fraud and corruption at target entity. In several cases it helps the investor in arriving at the right (lower) valuation.

(The author is Partner, Fraud Investigation and Dispute Services, Ernst & Young

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