Private Equity Newsletter - Autumn 2013 Edition: Investing in Emerging Markets: Are You Managing Your Risks?

by Dechert LLP

In times of austerity in Europe and America, emerging markets such as Africa, China, India, Latin America, the Middle East and CIS are increasingly offering the key opportunities for growth and investment returns for private equity fund managers. However, with many of these same countries ranking highly on the established corruption perception indices (such as that compiled by Transparency International) managers must take care about what and how they make and manage investments in such jurisdictions. With the carrot of large returns comes the stick of large risk – legal, operational, financial and reputational.

A failure by PE funds to identify and properly manage anti-corruption and trade sanctions compliance risks brings real risk of investigation and prosecution of the target asset, the fund and individual managers and directors. This can result in imprisonment, director disqualifications, debarment from government contracts and fines and confiscation of assets for directors and individuals. This risk has increased in recent years due to the current political and economic times, with the financial services industry being a publicly attractive target for enforcement. However, it is not all doom and gloom. Funds which invest and manage their risks appropriately via a properly resourced compliance effort can add significant value to their investments: making maximum profits with minimum risk.

Risk Exposure

The key risks faced by private equity firms across their distinct business model are:

Legal risks

The UK Serious Fraud Office (“SFO”) has indicated that it will actively seek to investigate and prosecute entities in the private equity sector. As readers will no doubt be aware, the UK’s Bribery Act 2010 gives the SFO wide ranging powers and extensive jurisdictional reach to prosecute individuals, companies and partnerships in the UK, for bribery which takes place wholly overseas.

Of course if companies or individuals are aware of, and actively or passively complicit in bribery, this is to be expected. But what about where there is no knowledge of any wrongdoing?

Again, under the Bribery Act 2010, a company can be held liable for bribery committed by others acing on its behalf, even where it had no knowledge of the bribery. This could include actions by agents or subsidiaries (such as portfolio companies). The only defence available is to prove that the company had in place “adequate procedures” i.e. effective compliance measures specifically designed to detect and prevent corruption. 

Further, the UK’s proceeds of crime legislation permits recovery (on a civil basis) of revenue derived from unlawful conduct (including bribery) even where the individuals or entities concerned had no direct knowledge of the misconduct. The SFO has already used these powers to recover dividends paid to shareholders.1 In January 2012, using its civil recovery powers under Part V of the Proceeds of Crime Act 2002, the SFO recovered funds from the parent and sole shareholder of Mabey & Johnson Ltd, a UK company convicted in 2009 for various corruption related offences.

In the press release regarding the settlement, the former Director of the SFO set out its view:

“... shareholders and investors in companies are obliged to satisfy themselves with the business practices of the companies they invest in. This is very important and we cannot emphasise it enough. It is particularly so for institutional investors who have the knowledge and expertise to do it. The SFO intends to use the civil recovery process to pursue investors who have benefitted from illegal activity. Where issues arise, we will be much less sympathetic to institutional investors whose due diligence has clearly been lax in this respect."

It should be noted that the above settlement took place prior to the appointment of David Green QC as director of the SFO. Since taking over the position, Mr. Green has reemphasised the SFO’s role as a prosecutor. At the inaugural Fraud Lawyers' Association meeting on 26 March 2013 he publicly stated that “the SFO is an investigator and prosecutor of serious complex fraud, bribery and corruption ....we investigate and prosecute: civil settlement is still alive and well, in the right circumstances but we are not there to offer deals and a special easy path for white collar criminals.” It therefore remains to be seen if further civil actions against shareholders will be taken, or if criminal powers will be exercised.

PE funds must also be aware of risks associated with ongoing issues which they may inherit at the time of investment. This could lead to potential action against the target, the PE firm and its directors in the U.S. under the Foreign Corrupt Practices Act 1977 and/or in the UK.

Operational Risks

PE funds which do not manage these legal risks are likely to encounter inefficient working and significant leakage of funds. All too often, corruption even at the level of facilitation payments (small bribes intended to speed up governmental processes, such as customs clearance) will lead to a culture of dishonesty within the entity concerned. Those who participate in providing such bribes also want something for themselves – and often go to elaborate lengths to conceal misconduct from their employer.

This could in turn lead to problems with financial audits, and even from exiting or divesting from an investment. In a world of increased awareness and pre-acquisition due diligence - corruption issues are rarely hidden for long. This can cause delays and cancellation of closing transactions.

Financial risks

Without appropriate pre-acquisition due diligence, corruption risk cannot be accurately factored into pricing models for a transaction, this can lead to gross overpayment for relevant assets.

The uncovering of an ongoing problem can lead to loss of existing and new customer contracts. Funding from the government (such as the ECGD), the World Bank or multi-lateral development banks can be withdrawn and companies and directors debarred from participation in future projects. In the case of companies such debarment is in perpetuity.

Reputational risk

The saying that “It takes many good deeds to build a good reputation, and only one bad one to lose it2 is certainly true of building and maintaining effective anti-corruption compliance in emerging markets. A failure to identify and manage corruption can certainly comprise a bad deed, leading to adverse publicity, a compliance discount being applied to the target and difficulty for the PE fund in attracting future capital investment and clients.

Factoring Anti Corruption Risk into Pricing Models - Good for Business

Private equity firms should be pro-active in addressing compliance. A prudent fund manager should prioritise adopting a tailored, risk-specific approach to pre-and post acquisition anti corruption due diligence in any new investments whilst also taking steps to monitor, review and reduce the risks associated with existing portfolio companies.

Private equity fund managers are required to look beyond the inevitable time and monetary burden of increasing the sophistication of its compliance functions and instead regard the task as an opportunity to add value to the target thereby obtaining a compliance premium.


See “SFO Recovers Dividends from Innocent Shareholder,” DechertOnPoint (January 2012)

2 Benjamin Franklin


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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