Our Intelligence and Investigations Partner, Juliet Young explores the importance of Investigative Due Diligence in the context of deal making.
Over the years I’ve had some weird and wonderful investigative questions thrown my way, but none so strange as those from clients looking to close a deal. For example: ‘is it true that [insert name of relevant business owner or director] spied for the Russians/was a member of the National Front/was the target of a hitman/was connected to a Colombian drug cartel?’ None of these are made up.
You may be thinking: how on earth did these individuals find themselves on the radar of serious investors? The answer is that they were all extremely successful businesspeople. They had founded and grown companies which had performed exceptionally well, had developed a niche in the market or were driven by innovative technology. Their founders had taken calculated risks and made bold decisions underpinned by almost boundless reserves of passion and energy. But it was precisely this risk-taking that had led to “red flags” being thrown up, and the clients needed to evaluate the credibility of these rumours. Was there a reasonable explanation? Or was there some truth to it?
What is investigative due diligence?
Investigative due diligence, which to borrow from the infamous Heineken advert, reaches the parts other due diligence does not. It is usually instructed early in the deal process to inform legal, financial and commercial due diligence, and potentially save abortive costs. The process should substantiate what information is available (do the facts stand up?), and then go beyond this, performing a thorough trawl of public records, open-source material, and potentially speak to people who know the business and executives.
Investigative due diligence is not “taking up references” provided by the executive team. An investigator will make their own list of sources to speak to. Whether or not they approach all of them (and how) will be a decision for the investigator and the client, but the aim is to understand the universe of people around a business or executive, both friend and foe.
Unlike financial and legal due diligence, where there are tried and tested methods of establishing working capital needs or future earnings, investigative due diligence needs to be rigorous and thorough – but rely on experience, intuition, and judgment to know where to look for information that might be valuable. The words of one ancient Greek philosopher hold just as true for 21st century deal-making as they did around 400 BC in Athens: “a good decision is based on knowledge, not numbers”. We once identified detailed accounts of lavish office parties from a company’s Glassdoor accounts. This was further corroborated with some interesting social media photos. Fortunately for the company, these hadn’t been picked up by any enterprising journalists, but it certainly raised some questions about the culture at the company.
In the cases I described above, the investigation was triggered by a “red flag” uncovered by other due diligence processes (legal, commercial, financial). In these cases, the job is to look for information which may show, on balance, whether the rumour is likely to be true, the likely source of the information, and any explanatory context. For example, had this stemmed from a disgruntled employee or competitor?
In one case, we discovered that one of the executives had inherited several businesses. His father had most likely transferred them because he was, as it turned out, likely to do time in jail for money laundering. A deal killer, right? However, as his parents’ only child, he had been put in an awkward position and taken custody of the businesses, a fact we verified, and was in the process of shutting it down. Had he been one of six siblings, and hand-picked by his father, the picture might have looked very different.
Analysing the stories; interrogating the findings
As investigators working closely with media lawyers, we have a privileged insight into the stories behind the headlines. What can seem like a laundry list of “red flags” – or deal breakers – are often more nuanced. Detractors, competitors, and adversaries know that the most effective way to damage the other side is by hitting them where it hurts – financing; seeding a rumour which will ultimately end up blocking a transaction with a bank or a deal with a counterparty.
Once you have the context and analysis, you can begin to formulate recommendations – ways to handle the issues that have cropped up.
An obvious next step might be putting a series of questions to the executive or target company to see how they react, particularly where you have ascertained the facts in advance. Does their version of events stack up? After all, it is as worthwhile to judge them not only by their past actions, but also how they handle the issue. Are they upfront and transparent? If they fall at this hurdle, it doesn’t bode well for future reputational crises.
Perhaps there are specific provisions or indemnities that you can include in the deal to protect the investment. In the worst-case scenario, you might have to agree a dignified exit for the troublesome executive to protect the interests of the business.
The surprising fact is that following some investigative due diligence, none of the clients walked away from the deals. Equipped with a strong assessment of the facts, they found ways to navigate the issues when a queasier competitor might have baulked. In a period when more money is chasing fewer good deals, this can give an investor the edge. Either way, whether you instruct it at the outset of the deal process, or when something doesn’t smell right, investigative due diligence is always money well spent.