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Business News/ Opinion / How due is the diligence in private equity investments?
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How due is the diligence in private equity investments?

There are dozens of PE funds that have been worried at the quality of the due diligence they receive within closed doors of their offices

Photo: Pradeep Gaur/Mint Premium
Photo: Pradeep Gaur/Mint

For some time now concerns have been expressed that the quality of governance in Indian firms might simply make private equity (PE) investing unattractive, if not unviable, in the long run. In the past private equity funds have claimed to have incurred losses due to the lack of sound advice they received. There are dozens of private equity funds that have been worried at the quality of the due diligence they receive within the closed doors of their offices.

Why do investors fret over such malfeasance? One reason is the sheer pervasiveness of the problem. The other is the criticality of good accounting information to their existence.

Good investment decisions rely heavily on reliable information about the historical financials of the enterprise for two reasons.

One, it is a health report on the financial situation of the investee at the time of making the investment. Equally, the past helps the investor form a view on the future.

Due diligence is a part of the care expected of fund managers to ensure that they base their investment decision on accurate information. It helps address the concern that the quality of disclosure in a privately owned enterprise might be of relatively poorer quality, influenced as it is by tax and other extraneous considerations. By contrast, publicly listed enterprises are expected to deliver better information, thanks to the disclosure standards mandated by the Securities and Exchange Board of India, the capital market regulator.

The reasons many due diligence reports do not uncover the inaccuracies in the accounting disclosures are numerous and complex.

First and foremost, the staff in many accounting and audit firm is highly overworked, thanks to the profitability compulsions of their employers. This can often lead to an inadequate scrutiny of the books during due diligence, although the accountants charge fees that will make a Supreme Court lawyer feel jealous.

Second, the high level of concentration in the accounting and audit industry makes conflicts of interest almost inevitable.

An audit firm that is carrying out due diligence on Company A, which is part of Business Group B, might be providing highly profitable consulting services to Company C in the same Group B. This casts doubts over the independence of the due diligence, claims about Chinese wall type mechanisms notwithstanding. Such conflicts are simply not easy to resolve.

Thirdly, often the distinction between creative accounting and fraud is blurred in India. For example, real expenses are concealed or imaginary revenue is accounted for on the basis of fictitious sales documents. No amount of auditing skills can unearth such wrong accounting.

Lastly, and perhaps most importantly, the investment industry is also to blame. Fund managers court an entrepreneur even after the latter is found to have a dodgy reputation. In their anxiety to put money to work, fund managers imagine that due diligence by an international audit firm, followed by a bulky contract choking with representations and warranties, will make a mendacious owner-manager change his spots.

As long as funny money, the never-ending quest for high returns among investors, and hubris among fund managers for fees and carried interest dominate the private equity industry, no amount of due diligence will pre-empt the sort of investment loss that we have seen in the recent past.

G. Sabarinathan is chairperson, NS Raghavan Centre for Entrepreneurial Learning at IIM Bangalore.

Comments are welcome at otherviews@livemint.com

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Published: 19 Aug 2014, 05:43 PM IST
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