China - Identification And Mitigation To Enhance Portfolio Company Value.
Legal News & Analysis - Asia Pacific - China - Regulatory & Compliance
26 May 2020
As China’s economy begins to recover gradually from the lingering effects of COVID-19 with the easing of its two-month lockdown in response to the pandemic, a plethora of investment opportunities will make now an opportune time for investors to assess their fraud and anti-corruption mechanisms. Given the current economic situation in China, many companies’ revenue, sales and cash flows have plummeted, resulting in ever-increasing instances of fraud and corruption as a result. It is imperative companies ensure their fraud and anti-corruption mechanisms are effective in mitigating the heightened risks many firms will confront.
While China’s government was the first to launch a nationwide lockdown, a measure that has been adopted by governments around the world, the Asian economic giant still has been hit hard by its social isolation efforts and could enter recession for the first time in decades this year. It is highly likely that not only will China but most other major economies will enter a recession. Cognisant of this, Beijing is pivoting its efforts on tackling the virus’ economic fallout, with reports emerging of plans to allow greater local government borrowing to spur infrastructure development.
In this new economic landscape, there will likely be an abundance of investment opportunities, whether in the form of distressed asset sales or insolvency. However, to capitalise fully, investors need to understand and address their exposure to fraud, bribery and corruption (FBC) issues. The impacts of fraud can cause grave financial and reputation harm, leading to long-lingering financial and reputational issues that may never be fully resolved. Companies that have experienced instances of FBC can suffer both substantial financial and reputational loss and a significant erosion of market capitalisation. An investor’s reputation is one of the most important assets it has on its balance sheet, and one that takes a significant amount of time and capital to build—but one that can be decimated in an instant. The impact, then, of such an occurrence on portfolio company value pre-exit and on the investor firm itself cannot be undervalued or understated.
Before the COVID-19 crisis, the Chinese government was working actively to not only introduce reforms that streamlined the investment cycle, but also ramp up efforts to stamp out instances of corporate fraud. The China Securities Regulatory Commission (CRSC), for example, vowed in January of this year to step up its crackdown on fraudulent initial public offerings (IPOs), financial fraud, insider trading and market manipulation. The regulator made the pledge between the revised Securities Law’s approval in December 2019 and its implementation on March 1, 2020.
While the Securities Law cuts bureaucratic red tape surrounding IPOs—with offerings, for example, no longer needing CSRC approval—there is an increased requirement for transparency and accuracy around financial reporting. In all, the revised law has fourteen chapters that outline regulations relating to securities issuance and trading, the takeover of listed companies, information disclosure and investor protection.
As China continues to embark on reviving its economy, there will be unique opportunities for private equity investors, with distressed asset deals likely to dominate the financial landscape in the coming twelve to eighteen months. While investors may need to assess and mitigate an array of FBC risks—from managing the direct risk of internal violations to interactions with sovereign wealth and pension funds—managing risk in the lifecycle of a portfolio company investment will be seen increasingly as of overriding importance.
A typical private equity investment lifecycle is composed of five distinct phases: deal identification, due diligence, 100-day plan, holding and exit. Mitigating FBC risk successfully evolves throughout this investment lifecycle, but gains additional importance during the due diligence, planning, holding and exit phases. Missteps during any of these phases can and will have long-lasting repercussions on both corporate reputation and value.
Once a potential target has been identified, the company in question, as well as its business partners, agents and other key third parties, should be investigated thoroughly to identify and assess the potential FBC risks they pose. The target company should be required to provide warrants related to fraud and anti-corruption, information on related issues or allegations, and the company’s anti-bribery and corruption compliance programmes. It is also essential to assess whether a target company’s senior management and board of directors have established a top-down culture that promotes ethical values, such as fair and honest competition, and sets the correct tone at the top for the entire organisation. Due diligence activities must establish whether violations or allegations of misconduct have been put to the audit and/or ethics committees to ensure proper board oversight regarding fraud, bribery and corruption.
A review of key transactions prone to fraud, as well as of financial reporting controls, also heightens understanding around the target company’s overall fraud risk profile. Standard financial due diligence reports only go so far in helping to identify fraudulent activities, which makes an independent review of key controls relating to financial reporting, revenue recognition, cash management and reconciliations critical.
Robust and enhanced due diligence should assist to mitigate risk during the acquisition phase of the investment lifecycle, but this serves only to form a baseline understanding of the target asset’s FBC risk profile. The initial 100-day planning phase following acquisition needs to involve the development of a value creation plan oriented around FBC compliance.
This plan should involve the development of a fraud and bribery roadmap, which is crucial to define the portfolio company’s fraud and anti-bribery culture during the span of the investment. This should include internal audits of the asset’s policies and controls, developing enhanced controls related to FBC, integrating new compliance training where necessary and implementing and refining the company’s incident response process.
This roadmap should additionally outline a multi-phased approach to developing the correct tone at the top and one that is resistant to instances of fraud and corruption. While senior management needs to roll out anti-FBC programmes, it also needs to ensure their adoption and usage by the rest of the company. Achieving the desired results depend on the commitment of senior management and the clarity, practicality and accessibility of the company’s policies, procedures and training programs.
Portfolio companies should prioritise implementing a code of conduct, regulatory and compliance policies and third-party due diligence, as well as risk-based training curriculums that deliver customised training and communication to employees, third parties and vendors. Third parties, however, must be required and able to demonstrate their own training and compliance initiatives while providing fraud certifications.
Implementing regular reviews and audits, while using recommendations to drive new training and compliance programs, can mitigate fraud and asset maleficence, thus improving cash flows and working capital. This improves asset value when investors are ready to exit an investment.
A robust FBC framework can enhance the asset’s value regardless of exit strategy and could even improve sale multiples. In the run up to a proposed exit; however, investors would be advised to perform a readiness assessment in advance of the exit to avoid negative impacts in the wake of the sale. During this readiness period, the company can conduct a detailed audit of the portfolio company’s policies, internal controls and reporting mechanism to ensure effectiveness and compliance while securing third-party warranties and confirmation for the entire investment lifecycle. This readiness assessment should also allow for an in-depth review of the portfolio company’s financial reporting, balance sheet and income statement. This review can shine a light on areas that may require additional disclosure or explanation while arming investors with the answers to difficult questions that potential buyers could pose.
In summary, a strong FBC framework not only enhances asset value but also demonstrates ethical culture and strong leadership. In addition, it can mitigate the reputational risk to both the portfolio company and its investors, while ensuring that no regulatory issues or violations occur.
For further information, please contact:
Steven Parker, Principle, Berkeley Research Group