PE And VC Funds: Managing Potential Pre-investment Existential And Reputational Risks

At the stage prior to investment, managing dynamics of risks in their various avatars becomes crucial to ensure that the value of the potential portfolio company is not impacted

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The world’s business landscape is not only changing rapidly, but also becoming increasingly cohesive. Inflation, followed by the pandemic and lockdowns, has made the economic situation unpredictable, leading to changing trends in investments, procurement and other business transactions.

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There is an emergence of a new set of unicorns worldwide. Estimates are of at least 650, with cumulative valuations exceeding $2 trillion.  India has more than 50 unicorns, and more are anticipated by 2030. For the PE and VC sector, there will be more transactions, business deals, consolidations and M&A.

In these circumstances, the race to invest in promising startups continues to rise. PE and VC firms feel pressured to add to their existing portfolio. Risks are plenty: be it new, stricter regulatory requirements, new forms of cyber threats or red flags in the past of the promoters. At the stage prior to investment, managing dynamics of risks in their various avatars becomes crucial to ensure that the value of the potential portfolio company is not impacted.

What can VC/PE firms do to manage potential pre-investment reputational risks?

To start with, the best way to tackle reputational risks during the pre-investment phase is to have a strategic alignment that leads to good board oversight, risk management integration within a business model of the startup or company which is of interest.

To manage risks better, compliance issues need to be proactively solved, and the startup entities in question need to have a defined cultural positioning within the structure. Having a strong incentive program with shareholders, clients, and employees if of benefit during potential pre-investment analysis, which in return keeps a check on layoffs, lawsuits, scandals and regulatory penalties.

Additionally, for portfolio companies, it is imperative for VC and PE firms to put in place and follow a progressive and approachable escalation protocol, strong company values, compliance with rules and regulations, a detailed discussion with primary stakeholders, furnished company status reporting and robust environment control pact. These should be the tenets of a pre-investment reputational management.

Understanding pre-transactional due diligence

The fast-paced startup arena needs robust operational contracts and processes, and PE/VC firms should be in a position to understand and manage risks with confidence, using pre-transactional due diligence as a critical tool in the process. Ahead of business transaction, there needs to be a focus on both the compliance and reputational track record of the firm in question. Due diligence reviews and assessments are of many types, such as commercial, customer, IP, administrative, tax, ESG, HR, integrity/forensic, financial and legal.  These vary based on the type of business deal in question.

Partner with professional firms to drive due diligence

When a professional company undertakes due diligence before investment, the entire modus operandi becomes structured. The process involves a rigorous examination and evaluation of a target company’s critical documentation and data. 

It is recommended that each due diligence be conducted by experts from various business fields to ensure that the whole process is unbiased, and without conflict. These procedures within various due diligence assessments bring a holistic approach toward problem detection, followed by problem correction.

Laying the foundation

It is pivotal to Lay the foundation for due diligence before any investment covering critical processes and documentation like Term Sheets, NDAs/Confidentiality Agreements, Share Purchase Agreements, Employment Contracts, and Intercompany contracts which need to be complied with, before next steps can be conducted. 

Regulatory compliance requires all parties to be transparent with legal documentation and history.  Board rights, veto powers, and quorum rights need to be well defined and should typically cover fundamental warranties related to operation matters, potential disputes, financial history, taxes, and tangible and intangible assets. Changes in practice or structure should be expressed as part of the report. Future predictions must be calibrated with great importance, and any impending obstacles should be reported. 

Handling the flags

During the pre-investment assessment, red flags such as unverifiable addresses, recent company changes or relocation, attrition at senior levels, whether the business sector seems inconsistent with the transaction (for example, a textile manufacturer dealing with software), unusual payment terms or undisclosed related party transactions, and subdued company information or records, cannot be ignored. Most entities are bound to have certain Yellow Flags - family-owned management, lack of diversity, high attrition, frequent changes of auditors, ESG or IP issues, or an entity that rents properties owned personally by the promoters or their family.

PEs/VCs, fund managers, banks, due diligence companies, even though instrumentally meant to avoid risks, also function in their best capacity to solve flagged matters, which can be done by modifying the process or including appropriate legal clauses.

The very essence of the due diligence process is to make sure there is value addition, unification of the ventures is done smoothly, and profits are optimized. All tools employed ensure that risk is mitigated pre-investment.