Deep due diligence needed in emerging markets deals

Deep due diligence needed in emerging markets deals

CFOs need to be comfortable with the integrity of the financials, management, and employees of the target company in emerging markets deals.

As slow domestic economic growth and continued globalization drive expansion into emerging markets, businesses limiting their transaction due diligence to traditional financial and tax areas may miss more significant exposures to fraud and bribery compliance problems.

The risk can be especially acute in today’s deal environment, as companies frequently look beyond mergers and acquisitions to alternative transactions like joint ventures, strategic equity stakes, marketplace alliances, and business combinations. In attempting to reduce investment risk, companies may actually create financial and compliance risk.

While violations of laws like the Foreign Corrupt Practices Act (FCPA) are a concern to CFOs, they aren’t a central focal point. But just as CFOs need to understand valuations associated with transactions, they also need to be comfortable with the integrity of the financial information, management, and employees of the target company relied upon for those target company valuations. The critical safeguard integrity that due diligence can provide is something more and more companies expect their CFOs to manage, but often don’t arm them to execute.

Expanded due diligence is an imperative, yet faces several longstanding challenges: intense time pressures; antitrust laws that may prohibit access to competitively sensitive information; confidentiality obligations; the lack of access to granular accounting data necessary for anti-corruption diligence pre-close; and, deal-team silos, positioning accounting and tax personnel to perform their respective diligence, which is typically independent of any fraud and FCPA-related reviews.

How can CFOs help deal teams widen the aperture of their due diligence lens?

They can bring a forensic focus to pre-deal diligence. Leveraging the work of the accounting/tax and FCPA teams, integrity due diligence allows much deeper dives into such things as data regarding cash, revenue, expense accounts, customers, and suppliers. An integrity due diligence team can apply a forensic filter to observations generated by the accounting and tax team, helping CFOs and other leaders to decide where deeper analysis is needed to understand certain risks before the deal closes.

 A forensic lens

CFOs and their teams should be engaged early in transactional discussions to imbed a forensic lens into interviews with management. For example, finance chiefs need to supply the accounting team with forensic-and fraud-specific questions about the target or ensure FCPA-focused investigators are not just focused on bribery, but on broader integrity issues as well.

When accounting or tax diligence teams find issues in the books and records (which they usually will), they should share that information with your forensic team to help ensure there are no greater concerns than sloppy accounting. The key is recognizing fraud and integrity risks and knowing what to do once you identify them.

But where should this forensic capability be applied to deals? Following are 10 areas where issues commonly arise relating to fraud in emerging markets:

  • Off-balance-sheet bank accounts.
  • Cash advances to management and employees.
  • Loans to and from unrelated businesses
  • Fraudulent transactions aimed at cleaning up aged trade receivables.
  • Significant use of third parties to mask fraudulent or corrupt transactions.
  • Sale of business units or subsidiaries at net book value or at a loss to hide the true value of underlying assets,
  • Overly complicated offshore structures, such as legal entities in locations where no business is conducted.
  • Multiple sets of books, such as for tax, accounting, JV partners, and potential buyers.
  • Inadequate or inappropriate documentation to support transactions.
  • Significant volume or size of transactions with multiple related parties.

Data analytics can also help CFOs analyze potential fraud in emerging market deals. It is an important component of integrity due diligence, often shortening the deal team’s review time and facilitating deeper analysis when necessary. With target-company ERP data aggregated into a single, usable form, the team can apply a combination of forensic analysis techniques, including random sampling, judgmentally based risk criteria, and analytically aided selections chosen with predefined risk algorithms.

Visualization tools aid the process by painting a revealing picture of risks at a broader company level, while indicating where a drill-down to the individual vendor and transaction level may be appropriate. Today’s technology allows all of this to happen far faster than in the past.

Red flags

In guiding integrity due diligence activities, here are several red flags to look for:

If something seems too good to be true, it probably is: spot-on effective tax rates, immaculate documentation, the perfect aging of trade receivables, continuous increase of sales with static gross product margin – these issues beg for closer scrutiny.

An upfront admission of inappropriate behavior: target company executives may point to a fraud they self-detected or a bribery scheme they committed, under the guise of “coming clean.” In reality, it may be the tip of the iceberg.

Local management integrity: it’s important to look for signs that call into question the integrity of the people who will run the local business post-transaction – the tone they set will impact the acquirer’s business going forward.

High turnover rates in the target’s finance and accounting functions, especially CFO or controller: why are they leaving, and what is it they don’t want to be involved in?

Frequent change of auditors, or offshore auditors located nowhere near the business they audit: these scenarios can indicate opinion shopping or inability to secure a viable audit due to poor financial records.

CFOs know more can always be done when it comes to transaction due diligence. But extreme time pressure is inherent to the process, so deal teams need to be keenly aware of potential red flags and to ask those penetrating questions to gain greater certainty.

The forensic insights that integrity due diligence can produce, aided by today’s analytics tools, can allow deal teams to quickly follow their instincts with more analytical rigor. In this way, growing companies can take an even closer look before they leap, assessing whether what lies below the surface could turn an attractive transaction into a disaster.

 Source: CFO – By Rob Biskup and Bill Pollard