Investors are diving deeper to rigorously assess their business targets before sealing a deal
High-profile corruption cases have left investors feeling jittery about inking deals in India. Accounting irregularities, financial mismanagement and corrupt dealings have stifled corporate appetites for quick deals, forcing investors to take extra care when making assessments of the companies they intend to partner with, or purchase.
Instead of just relying on traditional accounting and law firms for due diligence when evaluating prospective investment opportunities in India, many companies are turning to forensic accounting firms and other investigative agencies to uncover potential investment risks.
“Clients are asking for a more nuanced and sophisticated due diligence product in addition to the usual financial and legal due diligence,” says Mumbai-based Richard Dailly, managing director of the consulting services group of New York-based investigative consultancy firm Kroll.
“There is a huge market for background checks on promoters and we have [retired] professionals from the police or intelligence bureau to do due diligence work,” says Vikram Hosangady, an executive director of KPMG in Mumbai. Over the last four to five years, Hosangady says consultants have begun investigating business issues, rather than just legal and financial factors that could affect a deal. “Ten years ago we were [unconcerned] about business forecasts … today we even analyse political risks, like the fallout of the demand for a separate Telangana state in Andhra Pradesh,” he says. “We are not just checking business figures, but finding out what is driving those numbers.”
Assessing the fundamentals
However, companies still focus largely on financial and legal assessments – the most basic forms of due diligence – to examine the foundations of any deal. Buyers are keen to secure the accounting files of a target company to analyse its financial stability and compliance track record.
The big four international accounting firms, PricewaterhouseCoopers (PwC), KPMG, Ernst & Young, and Deloitte Touche Tohmatsu, have a presence in India and have all conducted due diligence assessments for foreign investors looking to seal deals in the region.
Shashank Jain, an associate director of the transactions group at PwC India, says that some foreign companies have made use of accounting and tax diligence to optimize the deal value of their recent investments in India. Among these are McCormick, a US processed food company; American Tower Corporation, a wireless communication sites operator; Astro All Asia Networks, a Malaysian media group; Legrand, a French electrical components manufacturer; and Valeo, a French auto components maker.
Foreign companies are particularly interested in a target company’s quality of earnings (the proportion of income it earns from its main business activity), its computation of net assets, working capital, various forms of debt, accounting discipline and control, and key factors affecting revenue and cost. From Jain’s experience, aggressive tax positions, inadequate investment in controls systems and personnel, and off-the-books sales are some of the problems that have been identified during a regular due diligence exercise.
In a normal due diligence exercise, says Gautam Khaitan, the managing partner at OP Khaitan & Co, all transactions involve executing the term sheet, conducting due diligence, negotiating, drafting and finalizing the business transfer agreement and the share sale purchase agreement, and handing over the closing documents.
Legal and financial due diligence are conducted parallel to one another, which makes the assessment process a collaborative one. “If we spot a dispute, we pass it on to the law firms, and [law firms send us queries if they come across any issues] where a liability is probable,” says Sanjay Mehta, a partner at BMR Advisors in Gurgaon.
Mehta explains that lawyers will evaluate the probable outcome of the dispute in order to help accounting firms compute their financial impact. “Lawyers help us understand disputes, litigation or any open issues that could be a matter of claim,” he says.
The initial background checks on a target company and its promoters begin with searches on the internet and commonly available databases. Dailly says sometimes individuals within the target company and industry experts are approached. “The key risk factors in India are corruption-focused where middlemen – particularly those with government backgrounds – are involved,” he says. “Sectors which involve land and licensing are considered to be of high risk.”
Khaitan says that alarm bells ring during the due diligence process with the discovery of unusual transactions, discrepancies in accounting records, activities or transactions which are outside a target company’s normal course of business, companies failing to pay employee benefits, and tax evasion.
Other issues that are picked up on include contingent liabilities, money laundering, ghost employees, support for banned charities, underworld links, overvaluation of sales and underreporting of profits.
The level of investigation required for any deal depends on the objectives of the investor. Strategic buyers with a long-term perspective that want to integrate a target company with their core business “evaluate their synergies in much more detail”, says Mehta at BMR Advisors. Private equity firms on the other hand, tend to look only for the possibility that a target company can grow and guarantee promising returns, although they too appear to be taking a more stringent approach towards due diligence than in the past.
A family affair
Mehta says that it is often harder to properly evaluate companies that are family owned or promoter driven: “It is a challenge to properly understand their business with all its variables as they have issues of corporate governance, transparency and decision making.”
It can be tricky even to obtain data from some of these companies. Mukesh Bajaj, a partner at CreditCheck Partners, a due diligence consultancy firm in Mumbai, suggests that poor transparency standards are to blame. In addition, the availability of data at many Indian companies is relatively limited and so due diligence professionals are left with no choice but to visit the companies concerned in order to access their operational systems and interact with the employees.
PwC India conducted a financial due diligence exercise on a promoter-driven Indian auto components manufacturing company and discovered that employees’ retirement benefits had not been adequately covered, and both depreciation calculations and capitalization of expenses were incorrect. The company was unable to understand why these non-cash accounting adjustments would lead to a reduction in its valuation.
According to Ashish Sonal, the CEO of Orkash, a Gurgaon-based operational risk management firm, some family owned companies also struggle with succession issues, power sharing and sibling rivalry, which can “lead to disruptions in business operations or problems during the transfer of titles”.
Investigating listed companies
According to Rabindra Jhunjhunwala, a partner at Khaitan & Co, insider trading regulations of the Securities and Exchange Board of India require that no unpublished price sensitive information (UPSI) of a target which is listed may be provided to the acquirer. These regulations are meant to prohibit dealing in securities that are based upon UPSI of a target entity.
SEBI has proposed an exception to this rule in a concept paper on the regulation of alternative investment funds published on 1 August. It suggests that private investments in public equity funds, commonly known as PIPE funds, looking to acquire securities, could be given access to non-public information under a confidentiality agreement for the purpose of conducting due diligence.
Sectors at risk
Financial, accounting and corporate irregularities often threaten to derail real estate and infrastructure deals in India.
A major Indian infrastructure company was planning to invest in a 100-kilometre highway project in south India and hired Orkash to investigate unexpected protests launched by local villagers against the project. The project had been underway for years and there had been no reported discontent among the local population. Orkash’s investigation revealed that the protests were “organized by an influential local politician who wanted to make imprudent financial gains from the project,” says Sonal.
While this politician was in power, he had routed the highway through his electoral constituency and purchased large areas of farmland around the proposed road using “benami” or false identities. He had expected the price of the land to shoot up once the project was completed, but a new government assumed power and changed the routing.
After receiving Sonal’s report, the Indian construction company was convinced that the protests were not genuine and thus went ahead with the project.
Timelines, costs and teams
Mehta estimates that 85% of commercial deals signed in India are valued between US$50 million and US$150 million and financial due diligence for such deals takes four to six weeks. Deals over US$500 million could take eight to 12 weeks. A typical due diligence exercise involves three to four partners who handle financial, business and tax due diligence separately. The number of analysts under these partners depends on the scale and complexity of the investigation.
Khaitan says legal due diligence can take between two to six weeks to complete. A typical team, he says, would consist of six to 10 lawyers, but the team size depends largely on the transaction and the size of the law firm being engaged.
From Mehta’s experience, fee structures for due diligence are normally customized and depend on how long the work takes. He says that financial due diligence costs US$80-100 per hour, which is less than one-third of the rate one would expect to pay in Europe. Rohitashwa Prasad, a Gurgaon-based partner at J Sagar Associates, says that law firms are more agreeable to fixed fees for due diligence rather than hourly charges.
Prasad says that due diligence exercises are becoming more process driven thanks to the improvement in general record maintenance at many Indian companies. Operations at these companies are more streamlined and management teams have become more adept at interacting with, and responding to the queries of, diligence teams. In terms of legal due diligence, Prasad says “it now takes relatively less time than five years ago.”
One of the biggest reported due diligence teams was put together by Reliance Industries in 2009, in relation to its proposed US$14 billion acquisition of LyondellBasell, a financially troubled Luxembourg- based chemical company. According to documents filed with a US bankruptcy court in southern district of New York, Reliance and its advisers requested more than 1,000 items from LyondellBasell, which constructed an electronic data room that was accessed by hundreds of Reliance’s advisers and personnel.
The filing also said that LyondellBasell and its advisers made “full teams available to guide in-person visits [by Reliance] to over 20 of the company’s key facilities worldwide”. However in the end, Reliance’s offer was rejected by the target company despite an increase in the offer price, with LyondellBasell contending that its own restructuring plan to exit bankruptcy was “superior” to Reliance’s offer.
Lawyers, accountants, investigators and others involved in due diligence processes all emphasize that the aim of the exercise is not to scuttle a deal. “We try to identify key risk areas and work with clients on mitigating and lowering the risk,” says Dailly. “Very often, information which we uncover can be used by investors as a negotiating tool.”
Findings during the due diligence process may alter an investor’s view of the value of a deal, leading to more rounds of negotiations between the parties. For example, says Mehta, if a target company has a huge receivable and an acquirer is not confident that it will be collected, the target company can put the same amount in an escrow account and if the receivable is not collected in, say, six months, the money in the account will be turned over to the buyer.
However, there are also situations that demand cancelling a proposed deal. Khaitan says: “Some risks may be legally remote but difficult to repair, and if a target is seriously flawed, the acquirer should be prepared to look elsewhere.”