By some estimates, over $500 million worth of private equity (PE) investments in India are embroiled in legal disputes.1
Kroll’s experience in the country suggests that disputes in the legal domain represent only a small fraction of the actual number of situations where investors are in serious disagreement with the owners or management of the investee companies. In our work supporting PE investors in such disputes, even the most seasoned PE investors who understand the Indian business environment have executed deals where they are unable to maximize the potential of their investments due, in part, to a dispute with the portfolio company.
Reshmi Khurana, Managing Director and head of Kroll in India, explains the various investigative tools available to PE investors that can help them minimize potential losses post acquisition should such disputes arise.
The majority of deals in India are minority investments where promoters continue to control the business and the flow of financial information after a PE investment.
Q – What are the various circumstances in which PE investors in India may enter into disputes with a portfolio company?
A – Most disputes are triggered when PE investors suspect fraud in a portfolio company. The majority of deals in India are minority investments where promoters continue to control the business and the flow of financial information after a PE investment. Additionally, corporate governance standards in India are still evolving, especially in regards to small and mid-sized companies. As a result, promoters may be following certain business practices which may not necessarily be aligned with the interests of the PE investor, such as related party transactions and diversion of funds for other businesses. In such situations, it becomes difficult for a minority PE investor to understand the true performance of the portfolio company.
PE investors should be alert to these tell-tale signs of fraud risk:
- Performance of the portfolio company starts deteriorating shortly after the PE investment is completed
- Funds from the PE investor are not used in the manner that was agreed to prior to the investment
- PE investor is denied access to good quality financial information and to the management of the portfolio company
Disputes between PE investors and promoters can also arise due to differences in valuation practices (with respect to shares) and shareholder rights as well as exit options. Indian promoters have been relatively slow in delivering exit options to PE investors over the last few years, and PE investors in India often own companies for five, seven or even 10 years. This has impacted their returns and leads to the potential for further disputes.
Q – Given these difficulties, what should PE investors do to mitigate or avoid such potential disputes with promoters of portfolio companies?
A – While investigating fraud in portfolio companies, we see that the greatest erosion of value in a portfolio company occurs within the first 18 to 24 months of the PE fund’s making the investment. Whether promoters are diverting funds out of the company (through illegal cash kickbacks from vendors) or manipulating financial data, our experience suggests that fraud occurs soon after the investment.
While a forensic review of the financial data of an investment target can identify red flags, it cannot necessarily be relied upon to uncover fraud. In Kroll’s experience, perpetrators often cover their tracks with false documentation and transactions that appear genuine and do not raise alarms in the pre-investment review. PE investors can avoid surprises and disputes by conducting in-depth and independent due diligence on the target company. This means fully investigating red flags or other symptoms of poor performance that are identified pre-investment. They should select due diligence providers on a “no compromise basis” to ensure that such providers are truly independent and the integrity of the due diligence process is maintained.
Most PE funds embed management information systems (MIS) and other business intelligence systems immediately after the investment is completed. We believe this is not enough to quickly identify and root out problematic areas that could erode the potential value of the investment. Investors should take an active and investigative approach to understanding the true business practices and controls in the portfolio company and use various fraud prevention tools to ensure their interests are protected.
Q – If a PE investor does suspect fraud in a portfolio company in India, what should it do?
A – Usually the first thing a PE investor wants to find out in such a situation is what is going on in the portfolio company. The PE investor’s ability to answer this question depends on its access to the financial information and management of the portfolio company. As mentioned above, because most PE deals in India are minority investments, typically the only access to financial information that PE investors have is through monthly MIS reports, which may not represent or give an accurate picture of the true performance and practices of the company. Additionally, PE investors in India do not like to challenge promoters in court early on because of the generally slow pace of the judicial system in India.2
In these circumstances a PE investor can conduct a discreet, “outside-in” external investigation of the portfolio company. This can provide useful indications of poor business practices or malfeasance on the part of the company; the promoter’s reputation in the market as well as their conflicts and assets; and whether the promoter or management are known to be involved in fraudulent practices and if so, what these practices are. PE investors often use the information gained through this exercise to negotiate with the promoter to gain greater access to the financial data of the company before the deal is done.
Q – Where should PE investors focus if they obtain access to financial data?
A – In some instances when some or all of the company’s financial data is available, the PE investor can conduct a full forensic audit of the company’s operations. The review can be conducted onsite or offsite and may include access to the company’s ERP systems and management. The typical areas of focus include understanding the gap between book profits and cash profits, capex overload, revenue recognition methods, and review of policies, SOPs, filings, etc.
Q – Do these findings constitute evidence in India and how can this information be leveraged effectively?
A – First, the bar is set high for what constitutes evidence of fraud in a court of law in India; second, once in court, it can take years to settle disputes, by which time the value of the investment may have significantly eroded.
These factors explain why PE investors are usually not keen to go to court immediately following a dispute. That said, there are various ways that PE investors in India have used the information gathered during the investigation to overcome the challenges of the existing legal framework. They can use the information to negotiate with the promoter, up to and including the threat of naming and shaming. And of course, sometimes the information can be used to take a successful court action.
Q – How do you see the corporate governance environment in India evolving in the future?
A – Corporate governance in India is evolving in a positive way, and this is being led by a new generation of entrepreneurs. They have experienced the many benefits of following sound corporate governance practices, from being rewarded by investors to seeing firsthand how transparency in their financial reporting helps them make the right business decisions.
The question is, once these businesses grow to a particular size and scale, will these entrepreneurs and the corporate governance foundation they are establishing be able to withstand the external pressures that often accompany growth?