Due diligence: art, science and self-defense

15 July 2013

Edwin Sim, Managing Director of Human Capital Alliance looks at current due diligence trends.

With Thai companies recovering robustly since the devastating 2011 floods, many are expanding locally and globally with capital markets’ funding.

Concurrently, many investors are now going back to basics when they are considering buying into emerging economy companies.

They want to be assured that the companies they acquire have the management ability and human resources to achieve expected growth plans. They are also vitally interested in the current and future management team’s overall integrity and ability.

A recent McKinsey Quarterly article by David Cogman entitled “Due diligence in China” art, science and self-defense” reminded me of similar situations in our region.

The article said that many private-equity and strategic investors in China didn’t initially detect accounting fraud despite conducting detailed, professional due diligence.

“The problem is surely not limited to just Chinese companies, though they are at the center of investor concerns today given the importance of that country’s growth and stability to the world economy.”

Overcoming investor concerns—in China, the author said may mean going back to some investing basics.

“Diligence is, after all, as much about developing a sense of trust in a company as it is an exercise in finding and checking facts.”

Financial, portfolio, and corporate investors are now looking beyond usual statutory and regulatory disclosures for less direct indicators of trouble in areas such as governance, management, financing, market context, and partnerships.

Although such indicators are not conclusive in themselves, nor are they replacements for other aspects of diligence, they provide valuable clues that something unpleasant is hiding under the surface, even when everything looks healthy on paper.

Governance

Corporate governance, the article said merits serious attention for a variety of reasons. “To start, when it’s weak, the floodgates open for unscrupulous management teams.”

Blatant misappropriation of company resources may be less common than it once was, but it was a factor why some Chinese companies delisted in the United States recently.

“In one case, for example, the board chairman transferred ownership of company assets to himself just prior to raising funds from US investors and conspired with the CEO to avoid disclosure.”

Governance arrangements also reveal how the top team thinks about its rights and responsibilities.

“Senior management demonstrates its understanding of them in myriad small and large ways that sometimes serve as early-warning signs.”

Minor things, such as small transactions between the company and the controlling shareholder, he said can reveal much about shareholders’ attitudes toward the company. “Do they see it as something to which they have a duty of trust or as an extension of their personal property?”

“Do they understand and respect basic boundaries between company and personal business? Have they gone out of their way to treat minority shareholders fairly during corporate restructurings—something that is easy to avoid doing?”

Halfhearted governance-compliance efforts, the author said may be a leading indicator of deeper problems—even outlandish ones, such as questions that arose about the very existence of an oil and gas exploration company’s operations after it was listed.

Management

Having been burned often, investors in Thailand today constantly look for management warning signs that extend beyond the top team and its compliance with governance standards.

For instance, many investors have asked me to examine a company’s professional management team bench strength before making an acquisition and have also requested that we map out potential external candidates that will be available to help their acquisition’s expand.

They want to ensure that a strong pipeline of competent operational managers is available so that their revenue and bottom-line projections can be realized. Management talent depth, they said indicates that a company has been built to last.

Another warning sign, they said is a mismatch between a company’s management capabilities and its growth plans.

For instance, several of my clients that acquired control of large local companies initially analyzed whether the current finance teams had the size and experience to follow through on future growth. If not, replacements were brought in.

Companies intending to expand manufacturing capacity in their future growth plans must also ensure they have enough plant managers to run existing facilities as it ramps up new ones?  Again a serious mapping of potential external candidates is often needed to placate nervous  investors.

Many investors are also asking Thai companies locating manufacturing overseas, whether they have general managers who can work in foreign-language environments. If they are unsure, a candidate mapping exercise is undertaken.

Although these questions may seem obvious, they often go unasked.

The McKinsey article also pointed out that operational management quality is another area where on-the-ground scrutiny is worthwhile.

Good plant discipline, the author said is hard to develop and harder to fake, and its absence is typically visible to the trained eye on a single site visit.

“Even a one-hour walk-through, if used carefully, can provide validation of staffing levels, inventory levels and age, and plant utilization. If a company resists a walk-through, that should sound alarm bells.”