Putting the spotlight back on governance practices in private equity3 min read . Updated: 06 Jun 2018, 09:13 AM IST
Kroll's 2018 report says one out of every four Indian firms surveyed was fraud-hit due to conflict of interest
The fraud at Punjab National Bank (PNB) reignited the question whether the ownership of public sector banks makes them harder to govern and hence more vulnerable to fraud. While the challenge is more systemic in the banking sector, the debate on the link between ownership structure, governance and performance is a critical one for the Indian private equity sector as well, where the bulk of private equity investors have minority stakes in their investee companies and the companies tend to be run by promoter families that are notorious for controlling their businesses closely.
India remains a promoter-led business community where often their interests vary from that of investors. As per Kroll’s Global Fraud Report 2018, one out of every four India companies surveyed suffered fraud due to conflict of interest. Since 2007, several PE deals in India went awry because of fraud and governance issues. It is thus impossible for PE investors to ignore the link between governance and performance.
While a large number of PE funds in India still believe that “promoters know best", a growing number of funds are playing a greater role in influencing the corporate governance practices of their investee companies. The proportion of buyout transactions as a percentage of PE investments in the country is rising where the fund is taking control of the business and either working with the existing promoters or completely overhauling the management. In 2018, the buyout market is estimated to be 18-20% of the total PE investments in India as compared to low single digits in the late 2000s and about 10% in 2014. Even in transactions with minority shareholding, PEs are taking increasingly active interest rather than being a board member who is occasionally involved in critical decision making. There are several motivations for that:
Being vigilant and engaged allows funds to protect their investment. In a market like India, governance cannot be relegated simply to complying with laws, having tight shareholder agreements and demanding veto rights on boards. During disputes and fraud, such rights do little to protect investments, given India’s legal environment. The only way PE investors can protect their investments is by driving transparency and running the boards effectively.
Relying purely on information shared by the management remains a high risk in India with reporting standards still inadequate and questionable internal/external audit process. The quality of reporting remains weak with very limited disclosures. The recent non-performing loan problems in India reflects poorly on the promoters and how they have fraudulently managed third party funds. Kroll’s Global Fraud report 2018 suggests that 22% of respondents suffered fraud due to internal financial fraud and 20% were a victim of fraud due to misappropriation of company funds.
An involved and engaged fund helps protect the credibility of the fund and the company resulting in value creation, which leads to smooth exits.
Given the opaque investment environment in India, it is the responsibility of the PE funds to promote strong governance practices in their investee companies. Further, PEs need to be diligent throughout the investment cycle and not just at the time of entry. Our experience of investigating frauds and disputes in PE-led investments clearly suggests that funds let their guard down after three to four quarters of strong performance by the investee companies. However, funds which have consistently outperformed remain engaged and vigilant through their investment life span.
Some of the best practices adopted by the PEs include:
Pre-investment — understand the true business practices of a company. Apart from carrying out the financial analysis, conduct background checks on the company, promoters and management, focusing on their reputation and business practices.
Post-investment — most investment decisions are made based on financial data and interactions with the promoters. There is, however, limited access to data prior to the investment. A quick 90-day assessment post investment to better understand conflicts of interest and other risks which they could not assess from the outside before the investment would go a long way in building trust and confidence in the investment. Further an ongoing independent check at frequent intervals and especially prior to exits ensures that there are no unpleasant surprises.
Reshmi Khurana is MD and Head of South Asia, investigation and disputes, Asia Pacific, Kroll and Tarun Bhatia is MD, investigation and disputes, Asia Pacific, Kroll.