Private equity firms are finding themselves in the crosshairs of the SEC since the Dodd-Frank Act was introduced in 2010. New registration requirements and a renewed focus by the SEC means private equity firms have to be more vigilant about risks.
Portfolio companies represent some of the bigger risks for investors. Private equity firms may have implemented compliance programs for the firm itself but not have paid as much attention to their portfolio assets. PE firms should have effective compliance programs in place throughout their organization, including their portfolio companies. For private equity firms with international operations or investments, the organization’s compliance program should cover anti-corruption, an area that has been high on the SEC’s agenda for a number of years.
Firms should be aware that they could be held liable for corrupt activity taking place within the portfolio company prior to the investment as well as during the period of investment.
To help mitigate the risk of corrupt activity occurring within a private equity firm’s portfolio companies, and the corresponding impact that could have on the firm and its return on investment, there are a number of leading practices that private equity firms can implement which are explored in detail, below.
I. Due diligence: Private equity firms may be held directly liable for actions undertaken by its employees as well as employees of the portfolio company. Furthermore, private equity firms may be held liable for violations committed by the portfolio company before the investment occurred. As such, firms should ensure that their investment strategies include both pre-investment due diligence and post-investment compliance activities.
Effective pre-investment due diligence generally includes an assessment of the portfolio company’s corruption risks by analyzing the following factors:
• Industry risks and business practices,
• Jurisdiction of operations,
• Joint venture relationships,
• Interactions with governmental entities,
• Background of key management of the portfolio company,
• Use of third parties, and
• Existing anti-corruption policies and current control activities in place.
Generally, if an issue is identified during this phase of the investment cycle, it can be proactively managed and remediated to prevent similar issues occurring in the future. However, if due diligence is not conducted, or not conducted at a sufficient level of detail, prior or ongoing corruption issues may not be identified and resolved. This could magnify the potential impact if the corrupt activities come to light.
Conducting effective risk-based due diligence prior to investing in portfolio companies is one key to mitigating the risk of successor liability under the Foreign Corrupt Practices Act (FCPA). An effective method of assessing relevant risks is by conducting a detailed and individual risk assessment at each portfolio company. Private equity firms should caution against using a standard risk assessment without tailoring it to each company, as each portfolio company is likely to have a unique set of risks that will need to be evaluated.
Each portfolio company should also have a set of internal controls that are designed to reduce the risk of corrupt activity occurring, and to encourage a culture of compliance within the company, including reporting concerns or potential violations internally without fear or risk of retaliation. Private equity firms should conduct an assessment of existing controls as part of a risk assessment and take action to address any issues or gaps that are identified. Because all private equity firms are structured differently—as are their portfolio companies—internal controls for risk management could sit within compliance or legal or a combination of the two. Typically, internal audit serves as a monitor of internal control performance.
In addition to performing risk-based due diligence, a private equity firm can also suggest implementation of a robust FCPA compliance program following the investment, and conduct a post-investment assessment to identify and mitigate, in a timely manner, other potential FCPA concerns.
II. Compliance Program: A private equity firm should take steps to implement or enhance the portfolio company’s anti-corruption policies and procedures after its investment. Anti-corruption compliance procedures can assist in mitigating the risk of potential misconduct and help private equity firms gain comfort in the integrity of the portfolio company.
An effective anti-corruption compliance program may include the following components:
• A robust code of conduct,
• A detailed corruption risk assessment throughout all operations,
• Periodic anti-corruption training,
• Monitoring of political donations or private investments,
• Independent Chief Compliance Officer,
• Annual compliance certifications from relevant personnel and third parties, and
• Regular monitoring of the portfolio company’s overall compliance program to identify gaps and areas for improvement.
In addition to the compliance program being tailored to the business, an overall culture of compliance should be enforced and promoted by directors and senior executives of the portfolio company to its employees. An enforced compliance program that discourages employees from engaging in misconduct to achieve business objectives is considered an effective program. Private equity firms should also evaluate the culture at the portfolio company to determine whether there is a risk of a whistleblower contacting the SEC directly, given the financial incentives brought forth by the Dodd-Frank Act.
Greater regulatory and compliance demands have been challenging and costly for firms struggling to complete their compliance program. However, this should not be a reason for deciding not to implement an effective compliance program.
A strong compliance culture and program throughout the private equity firm and its portfolio companies can have a significant benefit to the firm, from both a financial and reputational perspective. Specifically, performing pre and post-investment anti-corruption due diligence and ensuring that the portfolio company implements an effective anti-corruption compliance program and maintains a record of compliance adds value that will likely be recognized over the life of the investment.
About the authors: Mike Brodsky is a Deloitte Advisory director while Rachel Berk and Dawn Neisen are Deloitte Advisory senior managers for Deloitte Financial Advisory Services LLP. The authors offer anti-corruption compliance consulting services to private equity investors and their portfolio companies in industries from financial services to consumer and industrial products, technology and life sciences.
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