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Investment banking: Do more due diligence

Consultants hired by banks to help vet potential clients for initial listing say some investment banks are spending less than ever on due diligence, even as more fraudulent companies are exposed. Might investors in their deals suffer? Lawrence White reports.

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.

Tad Kageyama, head of Asia at Kroll – one of the better-known investigative firms – remembers working for a US investment bank that was considering helping a Japanese company raise some cash with a structured finance deal. The investment bank’s deal team had a problem: their internal lawyers, accountants and other risk assessors had all cleared the potential client, but several bloggers online persisted in claiming that the company was a fraud. "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."


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.

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

Joel Perlman, Copal Partners

Joel Perlman, president and co-founder of outsourced research and consulting provider Copal Partners


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.

It is important at first to understand that the term due diligence does not define a distinct set of practices, but rather a range of investigative techniques, from a simple search of public records through to a month-long investigation of a company that involves hundreds of interviews, anonymous site visits and detailed forensic accounting.

There is no codified set of rules for what constitutes due diligence, and the scope of an investigation on any given deal will be agreed beforehand by the client and the consulting firm. Often this will be limited by what the client is prepared to pay: they will agree a fixed fee rather than pay by the hour for the investigators’ work.

Conflict of interest

There is an apparent conflict of interest at this stage: the firm that is in the best position to advise the client on how much diligence might be appropriate, given the nature of the company to be investigated, is also the firm that stands to be paid for doing more work. The client will naturally be suspicious when told it ought to spend more to dig deeper; furthermore – although this is changing – the deal team at the investment bank or fund has a vested interest in seeing its deal completed, and are therefore not incentivized to kill it by finding out bad things.

Not every bank is like this, say people who work at strategic consulting firms. The better firms give their internal risk officers great authority and status to interrogate deal teams about the suitability of their clients and build a culture of due diligence as a core practice rather than a box-ticking exercise.

"Fraudsters go after soft targets," says Kroll’s Kageyama. "And while some banks will spend four to eight weeks on diligence for an IPO and really do a thorough job, others will throw $15,000 at a consultant and say: ‘Do your best’. That makes them a soft target."

Other banks have become very aggressive about trying to drive costs down, calling many strategic consultants to ask for quotes and focusing more on the cost of the investigation than its outcome.

"I have noticed an increase in the number of potential clients who call me to ask for a quote without disclosing who the subject is," says an industry veteran. "If I’m asked: ‘What will it cost for DD on three managing directors at a Chinese company?’ I can’t provide you with a quote because the scale of work involved would vary tremendously. You could be talking about a start-up with no history or paper trail, or [Chinese conglomerate] Sinochem."

Due diligence work is important in deals where Chinese companies list overseas, says Violet Ho, head of Kroll’s Beijing office, because there is a tendency in the country for these companies to apply a decorative gloss to their appearance for marketing purposes.

"There is a saying in China that talks about IPO packaging, where companies that are genuine and honest still want to put their best foot forward and will hire intermediaries to help them show their prettiest side to investors," she says. "There’s nothing illegal or unethical about it, but we try to help investors peel away some of these decorative layers."

The losers when a listed company turns out to be less than it claims are seldom the investment banks that have brought a deal to market. There have been some class-action lawsuits launched in the US, but generally investors lose out, and recovering money from the directors of the company itself – who are usually the parties legally responsible for any fraudulent statements the company may have made about revenues or accounting – is often difficult.

So, what are a bank’s due diligence obligations when it is preparing to help a Chinese company list? Unlike the legal or accounting professions, both of which have standardized codes of practice in the form of the law itself and accounting regulations such as GAAP, what constitutes due diligence is not clearly defined. Listing rules also vary from jurisdiction to jurisdiction, with many industry practitioners believing that Hong Kong’s stricter treatment of the reverse merger process by which some Chinese companies list overseas might account for the lack so far of the scandals that have plagued US-listed Chinese companies. In Hong Kong, companies that list via the reverse merger process are still treated as being new listings and are therefore subject to more stringent disclosure than is needed in the US.

"Hong Kong Stock Exchange and the SFC are very proactive in vetting companies to list here," says Chris Betts, partner at law firm Paul Hastings. "As soon as these overseas-listed China stock cases began to emerge, the list of vetting questions they sent to deal teams began to include more interrogation of the steps that sponsors have taken to verify company accounts."

Box-ticking exercise

Betts says that a key change came in January 2005 when HKSE distributed Practice Note 21 to combat the perceived failure of sponsor banks to vet their clients properly by setting down a standardized list of required due diligence measures.

"The note seemed helpful at first, in that it set out a guide for what constitutes reasonable due diligence for a sponsor," says Neil Torpey, another partner at Paul Hastings. "But the downside is that it has come to be seen as something of a box-ticking exercise. As the lawyers on a deal, part of our role is to remind sponsors to look at other things that may not be on the list."

Most due diligence experts interviewed for this story agree it would be impossible to set out a comprehensive list of standard due diligence principles: they would vary too much according to whether it is individuals or a company being investigated, what track record the subject of the investigation has, where the company is based and many other considerations. This holds true whether for the due diligence a sponsor might conduct into a potential client, for a company looking to hire a new employee, or for a company conducting due diligence on vendors or customers.

Jack Clode, a partner at strategic consulting firm Blackpeak

"Price pressure in this industry is huge and getting worse. I’ve been doing this for 15 years and some banks – not all – are spending less than they used to"

Jack Clode, Blackpeak

Furthermore, the costs of due diligence can rise in some cases to be impractical, as Blackpeak’s Clode says: "In the case of an FCPA [Foreign Corrupt Practices Act] due diligence on behalf of a US company, the company has to show it has done its best to check the integrity of all the distributors in its network. It could have hundreds of those companies, and a proper FCPA check on each could cost say $5,000, so I can sympathize there with the US company. You have to find a middle ground as to what’s a reasonable level of DD."

Some investment bankers interviewed for this piece rejected the idea that corners are being cut in due diligence, saying that, if anything, practices have become more stringent.

"I wish you could sit in on one of our risk committee meetings," says the head of China investment banking at a leading firm. "They are pretty gruelling. The project leader on the deal will present his case as to why [our firm] should work with this client, and then risk people and legal, with no incentive to see the trade done, will rip into them. They’ll ask about due diligence: did you look into background of the major shareholders? did you look at related party transactions? the business model, everything?"

One change the banker says he has seen in the past couple of years is a slight increase in the number of deals his firm will turn down if it is unable to satisfy itself as to the integrity or honesty of the potential client.

But the percentage of deals killed by problems discovered in the due diligence stage is still low, he concedes, and with investment banks’ revenues under pressure, it is hard to imagine that they can afford to be too selective about which deals they work on.

For potential investors into these deals, then, the conclusion is clear. Relying on the word of a company, or on the word of a bank trying to sell that company, is foolish. Kroll’s Kageyama says: "The message I want to convey to anyone considering an investment, not just in China but anywhere, is: ‘You could do more.’ That doesn’t necessarily even mean hire a Kroll or another consultant, but go there yourself, talk to customers, talk to suppliers and rivals, just do more than sit at your computer."

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