Beneath and beyond: Enhanced Due Diligence v. legal and accounting due diligence

The story and numbers may appear sound but it pays to investigate for investment surety.

This article originally appeared on Fraud Intelligence. 

Loosely speaking, “Due Diligence” is the term, in business, given to carrying out checks to ensure the integrity of a proposed investment. In 2010, the term came very much to the fore courtesy of the then impending Bribery Act via which company directors became criminally liable if they failed to take reasonable steps to prevent persons associated with their company from bribing (an)other person(s) on the organisation’s behalf.

The Act caused a furore at the time but also prompted many organisations to take stock and bring in new procedures to reduce the opportunities for bribes to be paid and, most importantly, to be able to demonstrate they had taken positive steps to prevent bribery. This was, in effect, their “get out of jail” card insofar as if an organisation can be seen to have taken all reasonable steps to prevent then they have a workable defence.

As law and regulation have tightened, banks and other financial institutions have, over the years, enhanced their Know Your Customer/due diligence checks to minimise opportunities for money laundering. Thus the days of suitcases full of cash buying properties are, thankfully, a thing of the past.

Venture Capital companies

For Venture Capital companies, due diligence has always been an integral part of the investment or acquisition process. In many cases, you may be managing a merger or acquisition and seem to be dealing with the most robust, financially strong company where medium and long term planning is in place and the future looks rosy.

You instruct legal and accounting due diligence and the resultant reports are good. All looks fine. But then you ask yourself – is legal or accounting due diligence likely to pick up any issues that do not feature in the company’s books or in public records? So you submit a series of questions to the CEO or FD of the target company. The answers are all pristine and give no clue that things may not be all you want them to be. Well that’s it, isn’t it?

What more can you do to find out whether your investment is sound or just a glossed over pig in a poke? Well, as it happens, you can do quite a lot but maybe you should have done it earlier.

Let’s go back to Day 1

You have identified an acquisition or investment target. Early soundings result in positive overtures. You carry out some initial basic research and public information checks. No problems are identified and so far expenditure has been minimal. However, if a specialist Enhanced Due Diligence (EDD) consultant said to you, “Look, for approximately £10-15,000, my company can go beneath the surface and find out whether there are any undisclosed issues that the target company Board will not want you to know about”, you may well want to consider his offer. Issues typically identified by EDD include:

• secret plans of key directors to leave and set up in competition;
• covert shareholdings in competitor companies;
• low staff morale, drug or alcohol abuse problems, gambling tendencies;
• high staff turnover;
• product inadequacies.

If that same specialist EDD consultant said his delivery would be complemented, through subscription database searches, by crucial information about key executives, such as:

• bankruptcies and/or insolvencies;
• regulatory breaches;
• criminal offences (where this information is available publicly);
• past or pending civil litigation;
• financial problems and/or unsatisfactory credit history

then you may well ask yourself, “Why shell out tens of £thousands for legal and accounting due diligence if I can firstly take steps to check whether there are any issues that may stop the deal in its tracks anyway?” You might just conclude that the £10-15,000 that could uncover the above, and terminate any deal prior to massive investment, would be money well spent.

The fact is that most Due Diligence goes nowhere near discovering the skeletons in the cupboard, which executives, looking at a £multi-million pay-day, are never going to disclose.

In many cases where EDD has uncovered undisclosed “warts”, deals have still gone ahead but often at a far lower investment price than was initially proposed. This is simply because the added knowledge resulting from EDD enables the investor to negotiate from a position of power.

After the Deal

In some cases, (often after a few years), we are retained to find out why deliverables by a VCC investment company are not what they should be. In these cases, the VCC usually has physical access to the VCC investment, which enables those charged with uncovering the reasons for failures to deploy computer forensics, i.e. capturing mirror images of the desktops, laptops, tablets, etc of any executives who are under suspicion. Subsequent keyword analysis of the forensic images will often flush out evidence of wrongdoing, e.g. a business plan to set up in competition, sales diversions to competitors, exporting proprietary information to external private email addresses, etc. The post-deal computer forensic work is invariably complemented by techniques similar to those used pre-investment, (as above) as a part of our probe to discover what is going wrong in the VCC investment company.

Findings from post-deal EDD have often enabled the VCC investor to make informed decisions as to how the issues can be rectified. In a recent case, EDD uncovered the fact that the CEO of the VCC investment had refused to listen to the genuine concerns of sales staff who had pleaded with him to update product. His failure to recognise the truth, coupled with a determination to seek to make short-term savings by failing to update, had led to a massive haemorrhage in sales to competitors. Fully briefed as to the reasons for the slump in sales, the investor took appropriate action to get the company back on track.

In another case, a post acquisition investigation discovered that the CEO had a covert shareholding (via his wife in her maiden name) in a competitor company to which sales enquiries were being secretly diverted. This had led to plummeting sales revenue but, following prompt remedial action by the VCC, the company was quickly back on track with a new CEO and a reinvigorated sales force.

Conclusion

The primary conclusion to be drawn, in regards to EDD, is that it is always better to lift the stones at an early stage to find out what lies beneath. Knowing what the skeletons are at the outset will always best inform the way forward, i.e. whether to pull out or confront and negotiate.

Where the deal has gone through and issues come to the fore, all is not lost as there are discreet ways of achieving clarity, understanding the key issues, re-aligning focus and, as a consequence, improving performance and output.

When the stakes are high, leaving it to chance is just not an option.