By Carol Der Garry and Derek Patterson at FRA, the international consultancy that provides forensic accounting, data analytics and data governance expertise, helping businesses respond to regulatory investigations in an increasingly regulated global environment. FRA is backed by UK private equity house, Dunedin.
The COVID-19 pandemic continues to impact all facets of the global economy, disrupting supply chains and work forces, reducing liquidity and straining contractual relationships between businesses. These conditions have created a stressed environment that is ripe for fraud and temptation to resort to fraudulent practices. Private equity-backed businesses are far from immune and, in fact, may be more susceptible to fraud, given that they may be highly leveraged, may also face significant liquidity challenges and potentially may not qualify for government-backed COVID-19 assistance.
Fraud risks impacting private equity-backed businesses can affect aspects of governance, financial reporting, asset misappropriation, and corruption. Some red flags to watch for include: weak governance oversight and tone-at-the-top; inadequate preventative and monitoring controls for fraud and corruption; less than rigorous evaluations of going concern, valuation and impairment judgments; and unusual or questionable financial reporting items.
These issues impact both the assessment of private equity portfolio companies’ ongoing performance, as well as the due diligence process when hunting for high return investments and making sure they do not turn out to be liabilities.
One financial reporting area that should be scrutinized in these turbulent times, and that has long been subject to scrutiny by regulators and standard-setters, is the use of alternative performance measures. Such measures include non-GAAP or non-IFRS adjustments to net income or loss that significantly improve earnings reported under Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).
Non-GAAP and non-IFRS measures can mask or make it more difficult to ascertain a company’s true financial position. EBITDA, or earnings before interest, taxes, depreciation and amortization, and adjusted EBITDA are common alternative performance measures—especially for private equity-backed companies—and determine valuation and drive capital structure, such as leverage, ranking, and distributions. For example, higher EBITDA figures allow companies to borrow more and make overall leverage levels appear lower.
Adjustments to EBITDA must be closely scrutinised to determine if their purpose is to manipulate financial results and whether they fairly reflect economic impact on a business. Management teams frequently use adjusted EBITDA to suit their narratives and views of the business, and to direct attention away from earnings before taxes and even unadjusted EBITDA. During stressed markets, management may be tempted to use overly aggressive adjustments.
Negative impacts resulting from aggressive financial reporting practices may be exacerbated in times of tight liquidity. And, access to liquidity may be aggravated if private equity-backed businesses are denied or limited access to government support monies during the COVID-19 fallout; this is something for which the industry is aggressively lobbying. The liquidity crunch for companies may also incentivise management to present the best possible position to encourage further private equity support during the crisis. Conflicts, including post-acquisition disputes, litigation and investigations, will arise between private equity managers, management and lenders and potentially create more pressure to succumb to fraudulent financial reporting.
In these strained times, the importance of a forensic approach to financial controls reviews cannot be minimised. A robust, well-designed internal control system and ongoing monitoring are crucial to ensure accurate financial reporting and that decisions around judgmental issues are fully supported. Some cost-effective approaches to internal controls include:
- Establishing a strong governance tone at the top;
- Requiring periodic compliance certifications, including on fraud and corruption controls, from management;
- Taking advantage of built-in computer system and software controls; and
- Using data analytics to identify outliers or red flags in financial information.
In order to proactively address fraud risks at private equity-backed businesses, some practical considerations and preventative compliance tips include:
Acquisitions and disposals – compliance risk due diligence and risk assessment
- Evaluate preventative fraud and corruption controls and procedures, including for FCPA, UKBA and AML regulations, during compliance risk due diligence
- Perform compliance risk evaluation of fraud and corruption inherent and control risks based upon data-room information
- Perform compliance gap, anti-bribery and corruption risk assessments combining criteria derived from leading risk assessment standard bearers
- Implement risk-related program designed to mitigate, monitor and test risk exposures
- If fraud is suspected, perform fraud and corruption investigations to standards required by international regulators including SFO, FCA, DOJ, SEC and others
- Implement data governance over the most sensitive matters, including those requiring the management and navigation of international data privacy laws
- When conducting a fraud investigation, consult experts with deep experience with cross-border risks, and appropriate means to conclude investigations
- When disputes arise, engage with professionals who offer expertise in:
- Addressing the appropriate stage of the investment life cycle, such as stages related to due diligence, negotiation or post-acquisition;
- Operating in a wide variety of dispute resolution settings; and
- Assisting in pre-dispute negotiation assistance, completion accounts dispute expert determinations, and arbitration/litigation damages and quantum modelling, including expert services and fraud and indemnity investigations, calculations and claims.
- Design world-class corporate governance oversight and monitoring
While there is not a perfect solution to eliminating fraud risk, actions can be taken to minimise risks and their consequences. FRA experts are well poised to help clients understand, monitor and avoid fraud risks and also address fraud, should it arise. FRA excels at providing customized expertise to help private equity-backed businesses in protecting and maximising value.
This topic was also covered by FRA in Private Equity News
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