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Tue 23 Jun 2020 04:13 PM

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Opinion: The new universe of virtual investment due diligence

In the coming year, the world will see principal investors moving towards virtual investment due diligence, writes Emissary Holdings founder Matthew McGrath

Opinion: The new universe of virtual investment due diligence

With the reopening of economies across the United States and Europe, investors will start searching for the “new normal”.  While national economies may be open for business domestically, international travel has already been substantially dampened.  Government-imposed quarantines and general fear of Covid-19 transmission may be forced to linger until a global vaccine is available.  Long distances between cross-border deal counterparties will only feel longer, perhaps worlds apart.

And yet for principal investors in cross-border private equity and real assets, business must go on.  In normal times, investment due diligence relies heavily on information that is acquired in the course of travel, visits and relationship building, ultimately to build confidence in financial projections and trust in individuals.   But these are not normal times, and so trust and confidence building will not involve sitting face to face. 

In the coming year, we will see principal investors moving towards virtual investment due diligence.  Working with family offices, infrastructure and private equity investors on long-term, cross-border projects, we at Emissary Holdings see three key trends emerging to support the virtual shift. 

These are: (i) use of trusted communities as a requirement for partner selection, (ii) corporate intelligence services as a pro forma to the investment review process, and (iii) dispute resolution scenario planning as a new best practice.

The “universe” for partners is wide, so it is best to look within your “solar system”

Trustworthiness in another investor or company is going to be based on how you feel about that party as well as how others in your network feel about that party.  We know from the world of network science that “closed networks” involving two parties build a higher degree of trust and greater incentives to not break the other’s trust. 

Because it will be harder to vet new counterparties in person, many principal investors will naturally look to pre-existing counterparties for follow-on deals together or expansion of current businesses.

Where this is your first time transacting with a new counterparty, you may also feel more comfortable with people who are part of a shared wider network.  This could be a private investor club, university or business school alumni group or any number of common affiliations. 

The point is to look for a limited, shared community in which there is a reputational disincentive for the other side to not break your trust.  While this is an approach as old as business itself, it will play an outsized role in the coming months as a greater proportion of deal-related diligence and negotiations go virtual.

According to Charuprya Chahal, a Dubai-based infrastructure mergers and acquisitions expert, “The universe of sellers and buyers is being governed increasingly by a common network and the success of a transaction is dependent on the trust in this very network. Despite protections sought under the various legal contracts, the maturity of the parties in dealing with virtual due diligence and the confidence they gain in each other during the process are pivotal in a transaction going through successfully.”

Use corporate intelligence services for a more “telescopic” view of prospective partners

Even once you have identified a trustworthy counterparty, you will want to obtain an independent view of the people, entities and transactions involved.  Even under normal conditions (i.e., full cross-border mobility), investors will want (and in many cases obliged) to test their biases and information gaps;  this becomes even more critical when sizing up opportunities more virtually.

Corporate intelligence firms offer a means to obtain an outside view and test assumptions and hypotheses about your deal partners, their relationships and underlying businesses.  When weighing such services against the impact of potential risks, these service providers are cost effective. 

The very mention of the corporate intelligence industry can evoke ideas of James Bond or Mission Impossible, but the truth is that the best ones add value in very simple ways.  They will have trained staff who conduct more fulsome reviews of open-source information that may exist within local registries and/ or local language sources.  They will also draw on local networks and contacts to gather views on counterparties’ reputation, integrity and consistency.

According to Dr. Simon King, the founder of GMTL Advisory Ltd, a leading corporate intelligence firm in London, “The best way to use corporate intelligence advisors is to (i) present your investment memorandum or deal rationale, (ii) highlight the specific questions or potential risk factors, and (iii) ask your advisor to independently test your assumptions. A good corporate intelligence report should corroborate existing assumptions as well as provide additional insights unobtainable using ‘standard’ due diligence procedures. It will have the strategic value to help shape and determine the terms of the deal.”

The best-planned missions can go awry, so ensure that you have contingency plans in place

It is a truism across space travel, military operations and, yes, investment, that the best laid plans can go terribly wrong.  Just as space travel and military operations require substantial contingency planning, it is becoming a best practice that investors (particularly in long-term, cross-border and fixed assets) adopt the same mentality.

In the cross-border investment context, the worst-case scenario most often means an impairment to the investment by way of a dispute with a local counterparty or government.  This can result in substantial losses whether because the financial disputes themselves are irreconcilable, the eventual legal awards are not enforceable, or any number of reasons along the way. 

As a consequence, the most prepared (and confident) investors are those who deal with dispute risks clearly and openly at the inception of an investment by having the right sort of contingency plans in place.  This starts with a cold evaluation of the value and likelihood of enforcement of a successful legal award (i.e., the “battle plan”).  It then mitigates the reasons why such a legal enforcement would not be successful, reverse engineering a better plan.  The resulting scenario plan looks at how to ensure the “peace” including through alignment of interests, the health of key stakeholder relationships, community and social impact, and financial risk transfer or hedging.  The effect of such planning and preemption is a more limited downside scenario and a more likely maintenance of a healthy investment.  In the long run, this can even help investors access a lower cost of borrowing and insurance for new projects.

Into infinity and beyond

Starting due diligence shares a lot in common with travelling into space – project names, war rooms or data rooms, and many tense moments.  For investors embarking on a virtual mission, it will matter more than ever that trusted advisors are by your side.  On this mission, you will need analysts, advocates and emissaries to get you there.  Choose wisely, because failure is not an option.

Matthew L. McGrath is the founder of Emissary Holdings Ltd, a London based global advisory firm. 

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