Investment banking: Do more due diligence

EVERY PERSON WORKING in the due diligence industry has their favourite horror story. There’s the one about the private equity group that invested in a Chinese manufacturer, then became suspicious about the relationship between the firm and its customers, and hired a third-party firm specializing in due diligence investigations to take a look. The consultant went to the listed headquarters of one of the company’s main customers and found that it was not a huge business park but a residential address – and that one of the directors of the manufacturer lived there.

Then there’s the hedge fund manager who hired a consultant to investigate a Korean firm he was investing in, who in turn discovered that the chairman had a fraud conviction. The consultant pocketed his fee and walked away happy with a job well done, only to receive a call a year later from the fund manager saying: "You remember that Korea deal...?" The consultant says: "You didn’t, did you?" And the hedge fund manager ruefully concedes that yes, he did go through with the deal anyway and lost $25 million.

"I started by asking each of the groups – lawyers, accountants, the deal team – to tell me exactly what due diligence they had done so far," he says. "It all sounded sensible: visits to the company, going through the accounts, the usual. But I could tell just by how many people were in that meeting that they were very worried: usually in this kind of consulting it’s more of a discreet meeting with the C-suite [the company’s chief executives]."

Kageyama and his colleagues began to perform their own investigations of the company, interviewing suppliers and customers, visiting the addresses where its various businesses were listed, asking questions everywhere.

"Almost immediately we found issues," he says. "The company’s growth plan seemed completely bogus, a supposed R&D centre was a rice paddy; vendors and suppliers told us the company regularly missed payments. Finally, Japanese law enforcement told us that they were keeping an eye on the company for potential links to organized crime."

Corroboration

That’s a fairly comprehensive list of problems. While it is in Kageyama’s interests to play up the value that his company provides clients in investigating their potential business partners, what’s striking is that it didn’t take long to uncover a lot of these problems. When asked about this, Kageyama offers a further delicious detail: "When I went back to the client and told them about the rice paddy where an R&D centre should be, their response was: ‘No, that can’t be right. We visited the R&D centre two weeks ago.’ I did some follow-up work and, of course, it turned out that the site they had visited was not where the company claimed this R&D centre to be, and the centre was made up. Three months later, the company was raided by the police and delisted."

The essence of the work is not complex, says Kageyama – it is about corroborating what companies and executives claim about themselves by seeking out independent sources.

Joel Perlman, president and co-founder of outsourced research and consulting provider Copal Partners, offers a typical example. A client is investing in a company that claims to sell 20,000 units of its product a day. Copal will send teams of investigators – typically graduates who can be hired to work on these projects as needed – to the retailer’s outlets to record how many of the given item are sold in a day, and then extrapolate from there whether the 20,000-units-a-day figure is feasible or not.

"It’s about not taking what the company tells you at face value but also not relying on what others have published about the company," says Perlman. "We do a lot of work that’s independent verification of reports written by so-called industry experts."

Banks, hedge funds, private equity groups and individual investors all do their own work investigating potential partners or clients before signing a deal, but many of them also make use of companies such as Kroll or Copal. The exposure in the past two years of dozens of (mainly overseas listed) Chinese companies as being less than they claimed to be has served to highlight what many in this due diligence industry have been saying for some time: some investment banks are spending less on due diligence than they used to, and the results show.

"Price pressure in this industry is huge and getting worse," says Jack Clode, a partner at strategic consulting firm Blackpeak. "I’ve been doing this for 15 years and some banks – not all – are spending less than they used to."

The phenomenon is especially noticeable in pre-IPO work, says Clode, perhaps because the average number of banks on a given deal has risen in the past few years and banks are therefore getting paid less for their work.

As mentioned, firms such as Kroll and Copal have a vested interest in selling the notion that banks and funds should spend more on due diligence, but the evidence of the past few years suggests there is truth in it.