Emerging Markets, Emerging Risks

Emerging markets may expose private equity firms to greater corruption risk. Mushtaq Dost explains the implications

The anti-bribery and corruption movement has been one of the most enduring symbols of 2012. The connection between corruption and private equity (PE) may not appear immediate and obvious, but with PE firms “seeking alpha” in emerging markets it assumes greater significance. Emerging markets present strong growth opportunities for PE firms, where potential returns can outstrip those possible in more developed markets. However, these markets also expose the firm to a greater degree of corruption risk as they frequently lack anti-corruption infrastructure.

With anti-bribery laws and enforcement tools beginning to spread across the globe, it is clear that anti-corruption enforcement is here to stay and will affect more companies doing business in high risk markets. PE firms are amongst those currently introducing or enhancing their anti-corruption controls, but what risks do they need to address, and what are the particular implications of anti-corruption legislation for the PE firm?

The legislation

Led by the US Foreign Corrupt Practices Act (FCPA) and the UK Bribery Act (the Act), anti-corruption legislation is fast becoming a major investment impediment when acquiring and operating companies in emerging markets, significantly raising reputational and financial risks for PE investors. Given the possible criminal and civil sanctions that may result upon triggering either of these, PE firms from both sides of the Pond have become extremely cautious when investing in foreign companies.

Both pieces of legislation have broad extra-territorial powers. The FCPA, for example, has jurisdiction over US individuals and companies for acts occurring both within and outside the US, and over foreign entities for acts within the US. During 2011 (a record year for prosecutions and fines) 31% of enforcement actions were against foreign companies.1 Rewards for identifying illegal activities, contained in various new whistleblower provisions, are expected to further encourage this trend of FCPA enforcement action.

The FCPA potentially exposes a PE firm, its portfolio companies, and their directors and officers to penal sanctions if the targeted foreign company has been directly or indirectly involved in bribing or unduly influencing a foreign official. Although no formal charges have been bought against a PE firm, investigations have provided a timely caveat to the industry. Allianz Capital Partners was investigated in 2011 by the US Securities and Exchange Commission (SEC) for irregular payments made by one of its portfolio companies. While the SEC reportedly decided to drop its charges (citing lack of access to information) the action strongly suggests that the SEC is beginning to take corruption at the investment company level seriously.2 Although as a “passive” investor of a foreign company a PE firm may not have the same level of control over the day-to-day operations of its portfolio company, as per a normal parent-subsidiary relationship, any knowledge or wilful blindness on its part to corrupt payments could lead potentially to liability.

Similarly the Act criminalises the act of giving bribes by a firm or an “associated person”, with the offence extended to firms established outside of the UK which “carry on” a part of their business in the UK. PE firms often have some personnel sitting on the boards of their portfolio companies who could be construed as being ”associated people” and whose actions can create direct liability for the firm. Section 8 of the Act defines an associated person as an entity or individual who performs services for or on behalf of a commercial organisation in any capacity, including as employee, agent, contractor or subsidiary. UK authorities have made it clear that the level of control PE firms have over their portfolio companies (even if they aren’t aware of the bribes) will affect the enforcement of the corporate offenses under the Act.3

For the PE firm, knowledge and the precise level of control are the two critical themes emerging here. PE firms are advised to be careful when placing officers or directors at the portfolio company. The presence of even a single representative can create liability under standard agency principles, even though the overall investment is passive.4

Risk exposure

Potential anti-corruption violations can create significant risks for PE firms by impacting the value (and marketability) of their investment in the targeted company. Examples include; the termination of revenue producing contracts procured via corrupt practices, debarment from public procurement

contracts, and large fines and costs that may result from potential criminal or regulatory investigations. Moreover, PE firms forced to address any violations must also deal with accompanying disruption to operations. This might include delays in closing the deal through the identification of “successor liability” arising from corrupt historic activity of the target. Any remedial action (termination of a lucrative business relationship for example) may require the PE firm to make significant changes to the targeted company’s business model, potentially impacting future growth and its ability to divest and exit from the investment. Clearly, any corruption issues will negatively impact the reputation of the PE firm, potentially making it difficult to attract capital for future investments.

Some local practices in emerging markets, that would be considered violations under the FCPA and the Act, may be viewed as “normal” ways of doing business, regardless of whether they comply with local law. Consequently, relying on the target`s management and employees to “do the right thing” is fraught with danger. One of the biggest risks for the PE firm comes from failing to vet the management team and key employees of the target.

These risks, should they be realised, can quickly shrink the total value of the investment target. A thorough value assessment of the target company should include anti-corruption due diligence before and after the deal has been concluded.

Due diligence

The due diligence phase represents a golden opportunity for the PE firm to manage and reduce risk. Here, a comprehensive review of individuals associated with the target, the compliance risks presented by the target´s industry, and its business relationships can help identify any red flags. Red flags could include: the ethical standards of the target’s management, the level of government regulation, its use of agents, brokers or other third parties, the risks raised by its customer base (including sales to governments or state-owned enterprises), and whether the target conducts business in any jurisdiction with a reputation for corruption.

Greater attention during the due diligence phase can enable PE firms to make an informed decision on whether to proceed with the investment. The level of due diligence should be tailored to the target’s overall risk profile. Whether the due diligence efforts are adequate will depend upon whether the steps taken can be demonstrated to regulatory authorities should any unexpected issue arise.

Take proper steps

In some cases, the identification of a potential corruption problem may not be a reason to pull out of an investment. At a minimum, due diligence enables the PE firm to fix a problem or be more selective in the investment into which it enters. While all red flags should be fully investigated, the existence of corruption risk or deficient anti-corruption compliance programmes at the target do not necessarily mean that violations have occurred.

If risks have been identified, findings at this stage may provide an opportunity to identify the extent of the problem. It may be an isolated occurrence involving a single employee or indicative of a larger problem. Here the PE firm can exert its influence and ensure that proper steps are taken to manage the risk. It can, for example, demand self-disclosure by the target as a condition to proceeding with the deal, as well as ask that they account for any potential fines and additional liabilities that may impact the value of the target. It can further insist that the target:

• issues instructions to all affiliates, employees and third parties to cease all improper conduct

• suspends senior management and implicated employees (pending the outcome of any investigation)

• implements a system of internal controls and compliance procedures designed to detect and prevent future anti-corruption violations. The costs of developing and implementing the compliance programme should be built into the deal.

Post closure

For the PE firm, researching and understanding all anticorruption issues before a deal closes can dramatically decrease the economic risks associated with an investment. Where risks have been noted, early reporting to the regulator is crucial. The PE firm may well be able to work with the regulator to negotiate an agreement which allows it to proceed with the investment whilst protecting it from or limiting its liability.

It is best practice for the PE firm to have a fully resourced, specialist anti-corruption compliance team, to work with the invested company post closure. Besides compliance, this team could include legal, internal audit and, where necessary,

external forensic accountants and experts. The priority here is to ensure that proportionate controls are in place and monitored. The management and employees of the newly invested company will also have to be trained. An appropriate zero tolerance code of conduct, supported by senior management of the portfolio company, will help set the tone and integrate the new company into the overall compliance culture of the PE firm.

While most PE firms are becoming increasingly aware of the issues, and have anti-corruption compliance programmes in place, these should be continually reviewed. PE firms should proactively call in outside experts to benchmark the quality of their anti-corruption compliance programmes. Given the speed with which private equity deals are reached and consummated, it is critical that real and meaningful due diligence procedures and compliance programmes are in place to deal with this evolving area.

Mushtaq Dost is Principal / Managing Director of Trafford Consulting SL, a specialist private equity / venture capital consultancy. He can be contacted at: + 34 93 268 82 82 or dost@traffordconsulting.com.

´´Anti-corruption Considerations for Private Equity´´, 1. Ernest & Young 2012, Accessible at: http://www. ey.com/Publication/vwLUAssets/Anti-corruption_ considerations_for_private_equity_firms/$FILE/Anticorruption-Considerations_V07.pdf

“SEC to limit charges against Allianz,” Thompson 2. Reuters, Accessible at: http://newsandinsight. thomsonreuters.com/Securities/News/2011/11_-_ October/SEC _to_limit_charges_against _Allianz/, October 14, 2011.

“The impact of the UK Bribery Act 2010 on the 3. private equity industry” Norton Rose Group, August 2011

“Private Equity Firms May Be Covered by Bribery Law, 4. SFO Says,” Lindsay Fortado, Bloomberg, June 23, 2011