‘India is not unique in having accounting frauds, but the problem is more severe here’
Sarika Malhotra Last Updated: December 10, 2013 | 22:19 IST
Non-executive directors at Indian firms have not proved effective
Reshmi Khurana, MD, Kroll India
Private equity funds have become more vigilant in tracking precisely why some of their portfolio companies are not doing well. At least two cases of alleged fraud by the companies invested in doctoring of books or fudging the minutes of meetings are well known.
In 2011, PE firms Bain Capital and TPG Capital dragged Lilliput Kidswear to court over alleged accounting fraud. This year, private equity firm SAIF Partners alleged that home-grown kids’ wear retailer Catmoss was cooking its books. However, not all investigations PE firms engage in are to detect or pinpoint fraud.
Often it is because of lack of quality information on the performance of their portfolio companies.
Reshmi Khurana, Managing Director of Kroll India, corporate investigations and risk consulting firm Kroll Inc’s Indian arm, tells Sarika Malhotra that post transaction investigations have grown 50 per cent from 2012 to 2013 at Kroll, led by an increase in the PE firms’ desire to know more about investee companies. Edited excerpts:
Q. What are the reasons for such frauds going up in India?
A. The poor corporate governance environment combined with intense competition for investment encourages promoters to manipulate their financial performance. It is not often detected with the level of due diligence that is currently being seen. The numerous recent cases of fraud in the private equity industry suggest that while a forensic review of the internal financial data of an investment target can identify red flags, it cannot be relied upon to uncover fraud.
It is equally challenging for private equity investors to understand the performance of their portfolio companies once the investment is complete. The majority of investors hold minority positions and promoters treat private equity funding not as a strategic partnership but as another source of capital that they can control.
This leaves investors with very limited tools to monitor the performance of portfolio companies post investment. With corporate governance standards still evolving and auditing standards that have not fully matured, private equity investors in India face serious challenges when applying due diligence and risk mitigation practices from developed markets to India. Simply put, these practices do not work when investing in India.
Q. How would you compare the PE frauds scenario in India with the global PE fraud scenario?
A. India is not unique in this regard but the problem is more severe here because corporate governance culture is still evolving and accounting and regulatory standards are not fully matured. At Kroll, we have seen similar frauds in the Middle East and Latin America because those PE markets are also characterized by minority stakes where fund managers have limited say in the management of the company and there is a general lack of information post-investment.
For example, we have seen a portfolio company in a Latin American country where executives had created bonus and pension plans more or less concealed in the numbers and not discovered until an executive retired and was being paid a fairly rich pension. That is very different from a typical Kroll investigation in more developed markets where frauds relate to theft of intellectual property or employees creating fictitious vendors. In emerging markets, it tends to be more subtle and more embedded in the corporate governance culture of the company.
Q. What kind of companies see maximum frauds?
A. The areas where Kroll has seen the biggest increase in fraud-related investigations in the private equity industry are export-oriented industries where the customers of the portfolio companies are based abroad and it is difficult for PE funds to identify conflicts of interest. Businesses that rely on government approvals and are dependent on cash transactions such as real estate and infrastructure as well as businesses that are not generating sufficient cash despite growing top and bottom lines are more vulnerable to fraud.
Q. What can be done to reduce frauds by investee companies?
A. Regulatory oversight mechanisms in India are still evolving and the complex judicial system makes it difficult for investors to enforce agreements and punish non-compliance. Tools available in developed markets – such as efficient courts, arbitration systems, bankruptcy proceedings and distressed debt funds – cannot be relied upon to resolve disputes or recover investments.
As a result, it becomes difficult for private equity investors to exit from poor deals in a timely manner. The new Companies Bill is a promising start. It will make acquisitions, mergers and restructuring easier for companies and that should empower private equity investors to enforce agreements and increase transparency by checking misuse of funds by promoters.
Q. What can be done to allow greater access to company management and internal information?
A. India offers widespread investment opportunities, but private equity firms must understand that routine due diligence does not work well in this environment. If they want to make decisions with more confidence and protect their investments-before and after a deal-they must employ a due diligence process that is rigorous, comprehensive and truly independent.
While there is no ‘one size fits all’ strategy for all funds, in our experience the most effective pre-investment due diligence approach incorporates the following best practices that include selecting due diligence providers on a no compromise basis to ensure that providers are truly independent and the integrity of the due diligence process is maintained.
To make sure that there is seamless cooperation and synchronization between different due diligence elements so that problems can be fully unraveled and investigated. There should be greater rigour in the due diligence process by allowing due diligence providers greater access to management and internal information of the target company. Wider access to management brings out conflicts and issues which are otherwise not uncovered. Red flags or other symptoms of poor performance should be fully investigated pre-investment.