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Tuesday, 23rd April 2024
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Integrity due diligence - preventing investment mistakes in emerging markets Back  
Emerging markets can be lucrative, but also risky. David Carson and Craig Bale say that there is a way to minimise exposure to these risks – a comprehensive integrity due diligence process, followed by the necessary response to findings.
For the past seven years, Deloitte has been talking to a sample of Europe’s top infrastructure companies - such as construction firms and power providers - about the precautions they take before investing in the emerging markets of Eastern Europe, Asia, Africa and Latin America.

These markets can present significantly higher risks than the company’s home market, with unprepared investors running the risk of exposure to corruption, poor management and political interference. In response to these increased risks, many companies consider safeguarding their interests by conducting a type of due diligence, called Integrity Due Diligence, over and above that which solely addresses the potential business partner’s or target’s financial condition prior to an investment.

In 1999, in the first survey on this topic, Deloitte found that many companies were neglecting to check important issues such as a target company’s political affiliations and reputation, and thus failing to address their potential exposure to them as investors. This article looks at how the situation has progressed since 1999, and how Integrity Due Diligence now forms a vital part of the due diligence process for investors entering new markets.

Emerging markets can provide great investment opportunities, the costs are low and the host nations are eager to attract foreign investment. In our most recent poll, 40 per cent of companies questioned said that they had been attracted to emerging markets partly by tax incentives, free trade zones, or other investment inducements, with 69 per cent noting that more than half of their investments in emerging markets are meeting or exceeding their revenue expectations. Consequently, it is no surprise that these markets are seeing an enormous growth of interest among Irish investors (such as the Quinlan Group, Sean Quinn, Dermot Desmond, AIB, CRH, Smurfit, Kerry Group and Kingspan). Therefore the issue of Integrity Due Diligence must now be firmly put on the agenda in Ireland.

In addition, whilst our 1999 survey found that investors were generally only expanding into markets with which they had historical ties, the most recent responses show that companies are no longer restricting themselves to such familiar cultures, with businesses right across Western Europe planning to expand into the same key markets, regardless of any historical or cultural ties. Destinations include not only Eastern Europe, but also India (with 17 per cent of companies planning to invest there), China (18 per cent) and Latin America (19 per cent).

While investing in these regions can be highly profitable, it also involves certain risks ranging from political problems to simple differences in business culture. Almost all of the companies we talked to carry out some level of Integrity Due Diligence before they invest. Similarly, investors are now showing a willingness to act on the findings of these checks, with over half (55 per cent) of them having pulled out of a deal in light of their discoveries.
The primary reason for investors breaking off deals is a lack of transparency. This does not necessarily mean that the target company is untrustworthy, but it raises questions over the level of information that was forthcoming during the due diligence phase.

Even if a target company appears to be well run, it could be concealing a history of mismanagement, such as asset-tunnelling or fraud. Overall, 19 per cent of companies said that they had pulled out of a planned deal after hitting unexpected problems over the integrity of a partner.

Another risk for an Irish investor is that the investment may not be as attractive as it appears. For example, even if the business proposition is sound, a prospective partner might have a poor track record in the sector or the local market. Alternatively, it may be hindered by hidden problems with licensing (an issue in 15 per cent of abandoned deals) or asset ownership (20 per cent). The current hot topics of corruption, and the environment of increasingly onerous anti-bribery and corruption legislation, are also issues in the abandonment of deals - 20 per cent of respondents have abandoned a deal when evidence of current corruption was found. These issues explain why 75 per cent of companies, up from 60 per cent in 1999, looking to invest in a foreign venture said that they investigate its integrity, with 51 per cent also examining its local clients and supply chain.

Mismanagement is bad enough, but it is every director’s nightmare to find their company involved in a high-profile criminal investigation. Nevertheless, crime can be a significant risk in emerging markets, and even an apparently well-run and respected business could be involved in money laundering, organised crime or even funding terrorism. Any company unlucky enough to invest in a venture like this could have its reputation severely damaged; its assets frozen or lost altogether; and could even find itself indicted on criminal charges. Therefore, it’s not surprising that the vast majority of respondents said that any evidence of a prospective partner involved in organised crime or corruption would be an instant deal stopper.

It appears that general concerns over crime are not always translated into effective action during the due diligence stage. Eighty six per cent of businesses said that it would be an instant deal stopper if a partner had links to organised crime, yet only 71 per cent of the respondents stated that they conduct checks into partners to establish whether this is the case. Surprisingly, of respondents whose major investments are in Eastern Europe and the Former Soviet Union - where organised crime remains a significant risk issue - 20 per cent said they did not research this issue before investing.

The figures tell the same story over and over again. While 75 per cent of respondents said they would not invest in a company founded on criminal funds, just 51 per cent conducted checks into the source of their partner’s start-up investment. While 80 per cent of respondents consider the discovery of indications that the target’s viability is dependent on political connections or bribes a deal stopper, only 61 per cent of them researched their partner’s political connections and affiliations.

Somewhat surprisingly, of the 13 per cent of respondents reporting unexpected problems with organised crime, every one of them was an investor in the former Soviet Union and Eastern Europe. This is despite numerous media reports over the past few years drawing investors’ attention to this issue. Encouragingly, nowadays 89 per cent of companies investigate the local political situation before investing in a region and 67 per cent of companies say they would refuse to invest if they were not comfortable with the local crime rate.

Other potential country-level ‘deal stoppers’ include an unacceptably high risk of terrorism (65 per cent), excessive foreign equity restrictions (53 per cent) and inadequate legal protections (51 per cent). Even if the region seems ideal for foreign investment, local political and social issues can still present a business problem - 30 per cent of companies said they had hit unexpected difficulties due to a local financial crisis, with 48 per cent suffering from a falling local currency. 32 per cent of respondents said they had hit unexpected problems with local politics.

So how can these risks be reduced? Forty seven per cent of companies said that they had joined up with another company to move into an emerging market, and 81 per cent said they had teamed up with an established firm based in the host country. Of course, even here thorough background checks are vital. When asked why they carried out background checks, companies gave a variety of reasons including compliance with various laws and company policy and even merely because “everybody does it.”

The bottom line is that Integrity Due Diligence is simply good business sense. It helps companies gain a realistic picture of the numerous integrity related risks involved in a proposed venture before they invest. In 1999, 65 per cent of businesses investing in emerging markets found that their investments met or exceeded their expectations. Today, the use of thorough pre-investment checks is up from 88 per cent to 99 per cent, and the proportion of satisfactory investments has risen to 78 per cent.

Emerging markets remain lucrative, but risks still prevail. There is a way to minimise exposure to these risks - a comprehensive Integrity Due Diligence process followed by the necessary response to findings.

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