ODD in the PE space has come leaps and bounds in the past three years - even though there remain enduring gaps (third party administrators, independent valuation agents and effective governance anyone?) However, in the PE space, diligence at the manager level is just start of what will become an ever more intensive process. What about the underlying portfolio companies?
OK, let's start with the basics. Does the underlying portfolio company and the stated assets actually exist? PE managers are often stunned when we ask this basic question - with the eventual answer typically being a variant of relying on deal lawyers to check title and assets during deal due diligence (at US$1,200 an hour or more, with the costs incurred by investors, we would hope they have.)
In emerging markets, which may lack G7 style property registers and legal procedures, title risk may be significant - Sino-Forest may have been a public company, but the underlying asset is similar to those held in other private market closed ended vehicles. Sino-Forest was, of course, happily audited by a Big 4 firm for several years.
2. SPV Structures - where is the cash?
Also taken as a given in PE land is the use of complex webs of SPVs created for tax reasons. Using such structures across various jurisdictions (Luxembourg, Ireland, Malta, Cayman, Singapore etc. etc.) can result in the appointment of a wide range of banks within each SPV structure. While JP Morgan may be named in the Manager's DDQ as the bank appointed at the "parent" level, all JPM may do is handle contributions and distributions at the "topco" fund level - with the action taking place further down in each chain of SPVs. As an investor, are you sure you do not have a PE manager which has appointed Danske or Swedbank - with their AML risks - somewhere in their structures when investing in Eastern Europe?
Also, who has signing authority over SPV bank accounts? It is common for PE managers to appoint a web of corporate secretarial companies in different jurisdictions to manage local SPVs. Staff at these local firms (not the manager's own team) may have signing authority over bank accounts within the SPV structure.
Talking of AML risks, has the PE manager completed a thorough AML review of target companies? This is particularly the case for "alternative credit" funds - are lenders entirely certain of the ownership structure of each borrower?
4. Reputational Due Diligence at the portfolio company level.
Yes, an institutional investor owns LP interests in a "flagship" PE vehicle. However, it is their capital which ultimately owns an interest in each underlying portfolio company.
What happens if that company's Indonesia manufacturing plant has an industrial accident causing worker deaths, with the cause being found to be numerous workplace safety violations? What if a retail workers' union invests in a PE fund which owns a major retail chain which subsequently goes bankrupt, with thousands of retail redundancies? What if the CEO of a portfolio company resigns after allegations of sexual harassment and toxic workplace culture? What happens if a defined benefit pension fund invests in a PE fund which seeks to close underlying portfolio company DB plans to boost returns? Can the DB investor justify the investment to their own plan members, especially if members are unionized?
The starting point for reputational due diligence is real time media monitoring - yet we find that many investors do not have a systematic process to monitor underlying investments in their PE portfolios. This is not a trivial undertaking as, if each PE fund owns 10 positions, a book of 100 funds creates exposure to 1,000 portfolio companies.
As an extension to the above issue, what about broader ESG issues? Can the PE manager provide reliable information about the carbon footprint of underlying portfolio companies, and is the PE manager focused on imposing strategies which enhance environmental performance at each company? Is the PE manager enforcing greater gender equality on underlying portfolio company boards and management teams? Is the PE manager impacting social criteria - such as demanding training and improved corporate behaviour around anti-discrimination and diversity in recruitment and promotion?
No institutional investor wants to find themselves holding a piece of a portfolio company which is subject to a front page expose as a poster child for corporate misbehaviour.
ODD asks about cyber at the PE manager level (with what we might describe as - ahem - mixed results!) But, what about cyber at the underlying portfolio company level? Could a PE manager looking to cut costs at a portfolio company veto spending on improved cyber protections, after which there is a value destroying cyber breach? Does the PE manager report to investors if an underlying company does suffer a cyber breach, with estimates of impact and cost?
As one recent example, Bloomberg reported that EmCare Inc. recently learned an unauthorized party obtained access to a number of employees’ email accounts that contained the personal information of as many as 60,000 individuals, 31,000 of which are patients. KKR & Co. acquired EmCare parent company Envision Healthcare in October 2018.
These are just some of the questions that are coming on the radar for investors in the PE industry. Again, we agree that the investor owns an interest in a partnership - but for many institutional investors, reputational risks flow directly through to the underlying asset. Put another way, claiming that an investor has "nothing to do" with underlying portfolio companies is unlikely to satisfy stakeholders (let alone journalists!) looking for information in response to an event at a portfolio company.
We often say that the first rule of due diligence is not to be surprised. To avoid those surprises, we expect to see much more attention to underlying portfolio companies as diligence in the private market arena moves to its next stage of maturity and effectiveness.
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