THE RISK WATCH COLUMN: Dr Alan Waring
No, this article is not about the risks of HIV or other social diseases. Nevertheless, there are some uncomfortable analogies when it comes to protecting oneself and one’s company from the hidden toxic effects of otherwise apparently desirable business partners, co-directors, joint venture companies, merger-and-acquisition targets, capital investment opportunities and even potential and actual employees. Get into bed with any of them without prior due diligence on your part and you may rue the day. Yet, the lack of due diligence by most companies, including SE listed companies, is staggering.
Some case examples are both instructive and sobering.
The Capital Investment Company
A well-established capital investment company, part of a global brand, has a large portfolio of technology-related investments in businesses in Asia. Some involve venture capital for start-ups whereas others relate to expansion and development of existing companies. In at least two recent cases, principals of investment targets disappeared with the funds running into hundreds of millions US$. The company’s due diligence checks on applicants amounted to little more than obtaining evidence of financial standing from a credit rating agency!
The Hotel Group
A global hotel chain routinely enters into joint ventures with local partners who fund and run one or more hotels but under the hotel group’s name, brand, livery, standards etc. Sometimes the local partners will also contribute to or run hotel refurbishment and upgrade projects. In a number of cases, local partners have failed to complete such projects on time or to budget or to quality – or at all. In others, local partners have failed to run the business competently and profitably. The hotel chain has suffered significant losses, both financially and to reputation. It emerged that the hotel group had no discernible due diligence evaluation system before entering into such joint ventures, other than routine financial and legal checks.
The Slick Operator
Here in Cyprus, I was approached by a highly plausible gentleman (not Cypriot) who stated in writing and in numerous discussions that, as part of his business consultancy work, he was the official regional representative of a large and well-known European company. His office was also adorned with framed photos of himself in the presence of world leaders and state presidents. He name-dropped shamelessly. As a matter of routine, I carried out a due diligence background check on him to verify that he was who he said he was and that his CV, his claimed business experience and his credentials were all accurate and complete. Also, were there any instances in his background or behaviour that reflected badly on his integrity and honesty? It transpired that much of his legend, including being the official regional representative of the well-known European company, was bogus.
The Oil Refinery Project
A privately-owned company with plans to build two oil refineries in an Asian country formed a partnership with an American company, whose primary role was to help raise the initial US$ 8 bln finance for the first project. Unbeknown to the Asian principals, who had failed to carry out a due diligence check, the CEO and main shareholder of the American company (a charming man whom I met in the course of my work) was the subject of an official investigation in the USA for fraud. He was accused by the Securities and Exchange Commission of raising US$14.5 mln from over 900 investors through the fraudulent and unregistered sale of securities, based on his claim to own valuable licences for the refinery construction. He promised investors returns of as much as 1000% and assured them that funding to start construction was imminent. According to the official court papers, he cited to investors the following sources of funding: ‘a financial windfall from letters-of-credit or other bank instruments provided by a wealthy contact; a vault filled with gold bullion and guarded by tribal elders; and the largesse of the Saudi royal family’. In fact, his claims were completely baseless. Predictably, the promised financing never materialized. Moreover, he ‘used $millions of investors’ funds to pay his personal expenses and support his lavish international lifestyle’. The Asian principals were amazed when we revealed to them the extent of his duplicity and fraud.
Barings and Soc Gen
How was it possible, for example, for the ‘rogue trader’ Nick Leeson ever to have been appointed by Barings Securities when he already had a criminal conviction for dishonesty? Clearly, due diligence checks were not carried out. Further, he was then promoted and given greater and greater latitude to ‘run his own show’ and all without any checks by his superiors or by any corporate integrity system as to whether he warranted such trust. Referring to his C-level bosses, Leeson commented in 1996: ‘The only good thing about hiding losses from these people was that it was so easy. They were always too busy and too self-important, and were always on the telephone. They had the attention span of a gnat. They could not make the time to work through a sheet of numbers and spot that it didn’t add up’. Barings suffered the ultimate consequences of this failed due diligence when the whole bank collapsed on 26 February 1995.
Moving forward to the end of 2007, how was Jerome Kerviel, the young trader at Société Générale, able to rack up €4.82 bln in unauthorised transactions that were bad? The signs and symptoms of his reckless gambles and his stressed-out behaviour patterns were eerily reminiscent of Nick Leeson. While not benefiting financially from their respective frauds, both got hopelessly out of their depth and trapped with no way out yet were also driven by the intoxication of the process and the next ‘one last trade’ that might just cover their tracks. Both have admitted as much. Yet, checks by Kerviel’s superiors or by any corporate integrity system that might have spotted these aberrations and raised the alarm did not occur. Due diligence was absent.
Corporate Due Diligence – The Only Way Out
Due Diligence as such is not new or revolutionary. Much DD does go on but it is usually examination of a limited range of risk exposures. For example, prior to mergers and acquisitions and JVs, due diligence checks usually concern only company finances and legal/regulatory matters, yet it is other risk exposures that may be of crucial importance to the future viability and performance of the post-transaction entity. How would you know, for example, that your new corporate partner has supply chain vulnerabilities such as single-source supplies of critical components, suppliers who are fronts for organized crime or who are dominated by corrupt politicians or protection racketeers? How would you know that the underlying values of the counter-party and its employees differ substantially from your own to the extent that post-transaction it would be a ‘marriage made in hell’?
What about pre-employment checks? If they are done at all, they usually rely heavily on searches of electronic databases. They rarely take a universal view of the candidate including an integrity interview at the candidate’s home, interviews of former employers, business associates and referees and full examination of the candidate’s finances. A person whose lifestyle and assets far exceed his declared income, for example, requires closer examination as does the person with all-too-glowing references who mysteriously flits from one job to another every 12-18 months. Traditional due diligence is deceptively scant and creates a false sense of protection.
Due diligence for major investments should take a holistic and integrated view of all significant risks. Not only should finances and legal/regulatory risks be examined but also business process, value chains and supply chains, physical assets, environmental exposures, major hazards, product safety, people/HR risks, intellectual property and integrity risks.
Proper due diligence should play a strategic and active role in the decision processes of M&As, JVs, corporate partnerships, capital projects, entry into new territories or new products/services and recruitment of personnel. The due diligence examinations should precede decisions to go ahead, so as to inform and justify the decision and reduce uncontrolled gambles that assume everything will be OK because it looks OK.
Remember the homily: Marry in haste but repent in leisure.
©2009 Alan Waring
