Three reasons why PE firms care about compliance (and why you should too)

March 2019
By Pete Viksnins, Director and Core Forensic Services & Anti-Corruption Leader, PwC Malaysia and Chris Harrison, Consulting Manager, PwC Malaysia

The traditional perception of private equity (PE) firms is that they are the business world’s version of house flippers – they buy an asset and unlock its value, then sell it for a higher price in a relatively short time frame. While that is clearly an oversimplification of many PE firms’ strategies, it does contain a grain of truth. PE firms are in the business of seeking favourable economic returns for their investors, be it through asset disposals, future growth in revenue streams, or dividend payments, for example.

So why, then, would they care at all about whether their portfolio companies are adhering to compliance standards?  Why would an asset manager invest scarce resources in a function that is rarely perceived as a key contributor to a company’s bottom line?

1) A company with a robust compliance programme reflects the PE firm’s own standards

A company that exhibits strong potential for growth is likely to attract the attention of PE firms. But as trust becomes harder to earn amidst demands for greater transparency, PE firms will be more inclined to do business with companies that have robust compliance programmes in place. Why? For one, this may be the PE firm’s requirement for all their business partners and investees, as a decision to purchase an asset will not only have an impact on their financial returns, but their reputation too. Cost is another factor. PE firms recognise that they would need to inject more capital into companies that don’t invest in such programmes, to bring them up to acceptable standards.

PE firms also regularly dispose of their assets – hoping to turn a profit in doing so – by taking the company public, i.e. selling to diverse investors via an initial public offering (IPO). This would, of course, have compliance implications. Stock exchanges and national regulators have stringent listing requirements, often with compliance obligations that must be fulfilled. So for PE firms to back an IPO, they would first have to ensure that the company will not find it difficult to meet these requirements.

2) Compliance is critical for minimising risks

PE firms across the globe are facing increasing regulatory pressure and scrutiny. In fact, more often than not, they may be held responsible for the acts of their portfolio companies, depending on the level of control and acquisition due diligence exercised by the PE firm. For example, if an asset is wholly owned by a PE firm, who then controls the Board, there is a high chance the PE firm will be held accountable if a regulator determines there has been a compliance failure at the portfolio company.

An organisation that prioritises compliance also helps PE firms avoid ‘successor liability’. Simply put, if you were to buy an asset with a revenue stream that is tainted by corruption, you could end up owning the liability for the corrupt action. This is certainly not a risk a PE firm would want included in their deal. These are all signs pointing to the fact that PE firms need to exercise due diligence and monitor the actions of their business partners.

3) Protection against the questionable actions of other parties

To reiterate the earlier point on minimising risks, PE firms want – or more accurately, need – to know who they’re doing business with. This is a prerequisite for providing them with the assurance needed for their investment decisions. To satisfy this need, another necessary precaution PE firms may lean towards is to include adequate protection in legal documents. It is encouraging that most global organisations today require their business partners to outline clearly how they plan to adhere to compliance standards – in line with the relevant laws and regulations – in their legal agreements. This is, in part, a result of regulators (such as the US Department of Justice [DoJ]) holding companies accountable for the actions of third parties who act on their behalf. In fact, studies have shown that well over 70% of ‘Foreign Corrupt Practices Act’ cases prosecuted by the US DoJ are related to the acts of third parties, such as the use of sales agents, consultants or other vendors to act as conduits for bribes to government officials.

Compliance: It starts and ends with trust

If your goal is to expand your business with the financial backing of PE firms, a key point to take away is this: PE firms today are attuned to the fact that compliance creates value. They will be paying close attention to compliance and its place in the company’s culture when considering whether the company should be added to their portfolio. Evidently, companies who are strong in this area will be:

• More attractive to potential buyers and business partners who may have compliance expectations of their own
• Be in a better position to withstand regulatory scrutiny

After all, compliance builds trust. And trust should always be part of the deal.