How to Mitigate Against PE GP “Sharp Practice”

Fait ou fiction?

Ahmed Badreldin, Former Head of MENA for The Abraaj Group, has written an interesting article on the above topic for Private Equity International.  

He emphasizes enhanced controls over the GP by LPs and proper due diligence.  

A lot of good common sense suggestions. 

Some quotes that particularly resonated with AA:  

1. “A key element of diligence is maintaining skepticism until the very end.”  
2. “Furthermore, funds shouldn’t have large positive cash balances and alarms should go off if there are drawdown requests from funds that already have large cash balances.“ 

What I found particularly interesting was his focus on a three specific examples of GP “sharp practices”.   

Do you wonder if he witnessed these “sharp practices” first-hand during his career at one of his previous employers? Or is he just applying his theoretical knowledge to identify key risks?  

AA has his own opinion, but what’s yours? 

In his own words:

“A recent case involved a fund that had externalized fund administration, but where drawdowns were made despite the fund having large cash balances.  Monies ultimately went to a bidco SPV where the bank accounts and the SPV were controlled by the GP without external oversight by independent directors or fund administration (despite the actual fund having fully externalized its fund administration).”

“Funds should not have large cash balances for multiple quarters, especially given the risk of fund bank account balances with “quarter end window dressing”, where the cash balances of the fund can be temporarily shored up from external funding sources, which can be difficult to detect, resulting in reported cash in the GP reports not actually existing for the reporting period.”  

He also focused in on valuation of portfolio companies.  Suggesting that these be audited by independent third parties with perhaps the inclusion “simple” metrics such as EV/EBITDA versus comparables as a way of providing a check on the GP's valuation.  

AA would note that selection of “comparables” can allow the GP a great deal of discretion to achieve a desired result.  And there is always the possibility of manipulation.  

Bahrain International Bank valued its investment in Burger King franchises it owned in the Carolinas using a multiple based on an unconsummated offer to buy the Burger King company. Note that is comparing the value of a franchise (part of the chain) to the main company (ex the franchised outlets).  

That’s not to say the DCF produces a more accurate result.  Small changes to assumptions (discount rate, growth rate) can result in big changes to valuation.  

As he notes, valuation is an art not a science.  When the intended result is known, the artist can employ all of his talents to achieve that result.  Or just enough.  One hopes though that the arts employed are not the "black" arts.

Dubai and L'Affaire Abraaj - Realism Amid Emotion and Financial Fairy Tales

Perhaps Better to Wait Till the Dust Settles to Get a Clearer Picture?

As you might expect, in the wake of the Abraaj scandal, financial journalists are examining the impact on GCC markets and in particular Dubai. 

Nicholas Parasie at the WSJ took a look at Dubai earlier this week.  “Once Billed as a Financial Haven in the Middle East, Dubai Turns Investors Wary”   

As usual, I have a slightly contrarian view which I’d like to convey by responding to quotes from his article. The point of this exercise is not to cast doubt on the article, but use several of the points mentioned to highlight areas of difference. 

“Investors are questioning whether Dubai’s young financial center can police itself as the meltdown of its marquee private-equity firm highlights broader concerns about placing money in the region.”

That’s a perfectly natural human reaction.  I’ve got a problem so first let’s identify all the people who let me down and are responsible for my misfortune.  Perhaps, but perhaps not, I’ll eventually get around to examining my own behaviour. 

There’s another element.  Realistically, where is that well-policed market that Dubai should measure up to? That sought after “haven”? 

The Bernie Madoff scandal, the dot.com bust, the almost a Second Great Depression, Lehman, Libor all occurred in what are generally described as the “mature” “well regulated” markets in the OECD.  These scandals are widely attributed to regulatory and corporate governance failures which is the central “charge” against Dubai in L' Affaire Abraaj. 

Given the dollar magnitude and number of these scandals relative to those in Dubai, shouldn’t investors be questioning the ability of these “Western” markets to police themselves much more than questioning Dubai? If not, why not?  

Should Dubai be held to a higher standard?  If so, why?  

“Dubai was supposed to be a rules-based haven in the Middle East’s opaque financial world, but fears about corporate governance and conflicts of interest are rising."

I suppose if one didn’t look too closely but rather relied on the promotional advertising alone one might have imagined that Dubai was a “rules-based haven”.  But one would have had to be pretty oblivious.  It's like reading "The Art of the Deal" and thinking that the chap on the cover is America's #1 DealMeister.  In both cases your credulity would have gotten the better of the facts. 

I know that for some—usually bankers and investors--ten or fifteen years in the past is an age unknown probably before recorded time.  

But back in 2004 Ian Hay Davison, Chairman, and Philip Thorpe, CEO, both of the DFSA were summarily sacked. Ian by mobile phone.  Philip was "escorted" from the DFSA’s offices.  Both “lost” their jobs because they had the temerity to suggest that the real estate transaction for the Gate was freighted with conflicts of interest among certain high “personalities”.   Read it here.  If you read it in the Torygraph, you know it must be true. 

After the Dubacle--which in itself might have suggested causes more than just irrational real estate exuberance--, a number of high ranking officials were relieved of their positions.  One chap, the former head of the DIFC, was “encouraged” to return “bonuses” that were alleged to have been improperly obtained. There is of course more but those are two rather glaring examples.  A good rule of thumb is that if you suspect there are ethical issues at a regulator or in government departments or corporations, you should be wary of ascribing high standards to the jurisdiction.  Focus like this can simplify your due diligence greatly.  

“Unlike in the West, where corporate executives are often held accountable by supervisory boards, “there are no checks and balances in the Middle East in some companies,” she said.”  The “she” in this quote is Alissa Amico, a Paris-based former executive at the Organization for Economic Cooperation and Development.

Quite!  As to the “developed” Western markets, there are “checks and balances” indeed but mostly on paper. Rarely do independent board members take action to prevent corporate malfeasance.   In some cases, they appear to aid and abet it. See Hollinger. See Enron whose board composition on its face ticked every box in good corporate governance.  See Volkswagen and dieselgate.  For more on supervisory board failures in Germany read this article from Handelsblatt. 

The clear lesson here is that corporate structures and rules while a necessary condition are not sufficient to prevent malfeasance. People are the critical variable that make these structures and rules effective. If they are wanting, the entire structure fails.     

“The longer it waits, the more Dubai’s ability to attract foreign capital could be at risk, said Oliver Schutzmann, chief executive of Iridium Advisors, an investor-relations firm.” The “it” in this quote is the DFSA.

No doubt immediate action might satisfy investors who no doubt are looking for vengeance. 

But a proper investigation needs to be conducted to determine the extent of the malfeasance, if any, and the parties involved.  

MF Global collapsed in late 2011.  In 2013 the US CFTC filed charges against the former Chairman and CEO that involved allegations of “misuse” of client funds similar to allegations against officers of Abraaj.  

There are risks to too-quick action.  

1. Failure to punish all those, if any, who should be punished.  
2. Failure to punish for all offenses.  The DFSA would look rather incompetent if it later turned out that there were transgressions more serious than “borrowing” client funds at Abraaj and that it failed to punish these. 
3. Or if in the rush to take action, it inadequately prepared its case and wrongdoers, if any, were subsequently acquitted.  

As well, while vengeance may be  satisfying, it won’t result in investors being made whole.  Rather cold comfort for Mr. Jaffar: I’ll get a jail sentence against Brother Arif, but I still won’t get my US$300 million.  

It’s perfectly natural for investors who have suffered a loss or think they have to get quite emotional and thus irrational.  

Sadly, there’s often a tendency for others to get caught up in these emotions of the moment. Cooler heads are needed, but few are found. 

1. False comparisons are made.  Dubai compared with the mythical conflict-of-interest free well-policed Western markets.  
2. Double standards are applied. Dubai must be purer than Caesar’s wife.  
3. Dire end of the world or end of the market predictions are made. No one will invest here anymore.  But why didn’t that happen after Hay/Thorpe, Bin Sulaiman, et al.? Or after the Dubacle?  Or in Bahrain after TIBC, Awal, GFH?  Or in Kuwait after TID and Global?  Or in KSA, after the typical SAMA response to prefer local banks over foreign in the TIBC and Awal affair? Or in the USA after the Almost a Second Great Depression? 
4. Fundamental issues can be missed.  Nuances lost.  What really makes a market investable?  A fancy building, some imported be-wigged English-law judges, an impressive rule book? Or are other things more important?  
5. Remedies are prescribed before there's enough information for a thorough diagnosis.  We really don’t know exactly the extent and type of malfeasance in L'Affaire Abraaj.  Is it equivalent to MF Global or Bernie Madoff?  Who was involved?  Yet, hobby horses are trotted out from the stable and vigorously ridden.  Sometimes very specific prescriptions given.
6. Sometimes meaningless platitudes are given.  Meaningless because they are not specific.  “Regulators and boards need to step up their game.”  Or perhaps “work smarter not harder”.  Indeed, if only the UK had “stepped up its game” in the World Cup, they would have won.  If Abraaj had “stepped up its game”, no doubt it would have realized the sale of K-El and there wouldn’t have been a cashflow problem.  
7. Can we be that far away from a suggestion to use Blockchain to “disrupt” old patterns of corporate governance? In some places it promises the disruption of courts. Why not corporate governance?  Let's step boldly forward together to the “bleeding edge of leveraging the Blockchain space to disrupt the existing paradigm of corporate governance”.