CMS Cameron McKenna’s Conlon: Investors needs to understand what they are buying
CMS Cameron McKenna partner Graham Conlon.
In this Kyiv Post interview, CMS Cameron McKenna partner Graham Conlon said that in practice, proper due diligence involves a lot more than following a few specified steps.
Kyiv Post: When an investor is pondering whether to buy an asset in Ukraine or enter into a partnership, what are the five essential concrete steps in terms of Due Diligence that should be taken to minimize risk and protect the investment?
Graham Conlon: As with any country, an incoming investor needs to understand what he or she is buying so as to ensure that he gets the valuation right, and to ensure that he is not going to face a myriad of surprises if/when he takes control. In practice due diligence therefore involves a lot more than just 5 steps. However from a high-level perspective, the key areas to investigate are as follows:
· Do the accounts of the company provide a true and accurate picture of the company’s state of affairs? For example, the profit (often measured in terms of ‘EBITDA’) of the company may look impressive at first glance, but if that has been achieved as a consequence of the company carrying out one-off exceptional items (such as a disposal of superfluous real-estate), or as a result of ‘channel stuffing’ (i.e. artificially increasing sales by distributing more products than the market actually needs), then this may not give a fair picture of the actual underlying operating success of the company. Conversely the profit may be understated as a result of the company using one official set of books for the tax authorities, and another set of books to reflect reality – such a practice being illegal, of course, and a potential deal-breaker;
· Are future sales and EBITDA growth forecasts realistic? It is only natural that a seller would want to give as rosy a picture as is possible, and in most cases actual sales and EBITDA growth will be lower than that first suggested by the seller;
· Does the seller have good title to his shares, and does the company have good title to all of its key assets? This is especially important for a country like Ukraine where even a seemingly minor defect may be used as a ground by third parties (e.g. raiders) as a means to cause trouble in the future;
· Ukraine operates strict currency control rules. As a consequence the transaction needs to be structured in a way that ensures that the buyer will be able to repatriate proceeds out of the country in the future. This should involve more than just a review of the laws – the parties need to ensure that repatriation will be possible in practice, not just in theory; and
· Having good management is key. Those managers may have built up a raft of local connections and goodwill which, in practice, is key to the company’s ability to operate efficiently and smoothly without facing undue amounts of red tape. An incoming investor may want to ensure therefore that such managers remain in the picture post-acquisition, and that they are duly incentivized to operate to the best of their ability;
KP: There are various forms of due diligence: legal, financial, reputation, etc. To whom should an investor turn to get all the potential red flags checked out? How does the process work?
GC: Having good advisers is key, especially if this is the first time that the investor is looking to invest in Ukraine. Advisers can make or break a deal. For example advisers which are overly cautious or not commercially-minded enough may inadvertently kill a deal, whereas advisers which don’t have the fine eye for detail may miss an issue which subsequently comes back to bite the investor later down the line.
The point is that things don’t always work in the same manner in Ukraine as they do in other countries. A good adviser should be adept therefore at bridging the gap between the investor’s expectations, and the reality of how things work on the ground in Ukraine. It is the adviser’s job to not just find the problems, but to find sensible solutions that can be implemented in a pragmatic and cost effective manner.
KP: What are the Top Five most common red flags or problems uncovered by due diligence work involving Ukrainian assets or potential partnerships between investors and local groups? Which are serious risks to a potential investment or partnership? Which are minor and can be handled?
GC: It is not possible to generalize, as the issues vary depending on a number of factors, such as how well run the company has been, how old it is, the industry it operates in, the types of assets that it owns, etc.
Generally speaking however the key issues which seem to arise deal-after-deal is that documents necessary to prove due ownership of key assets are missing, the company has a history of tax disputes with the tax authorities, or the company is in breach of the applicable permitting requirements (e.g. it might not have all the necessary permits that it requires, or it may be in breach of existing permits – given the extent of permits and red-tape in Ukraine, this is perhaps not surprising). In 9 times out of 10 these issues can all be addressed, either as a ‘condition precedent’ to closing of the deal, or simply through providing the buyer with adequate protection (in the form of warranties, indemnities, a reduction or holdback of purchase price or through other means) in the share purchase agreement.
KP: From a standpoint of due diligence, what are the Top Five "hardest to uncover risks" for investments and partnerships in Ukraine, and what can be done by the government and other interested parties to bring more transparency?
GC: Again, it is not possible to generalize. However key risks which are sometimes difficult to uncover include the following:
· Tax liability. Disputes with the tax authorities are almost par-for-the-course these days, as the tax authorities seek to maximize revenue receipts on behalf of a cash-strapped Government. However it is widely known that many companies in Ukraine operate a portion of their business in the black-market (i.e. they do not duly declare everything that they should do to the tax authorities). Uncovering the latter can therefore be difficult; and
· Corruption. Given the applicability of laws such as the US’s Foreign and Corrupt Practices Act, the UK’s Bribery Act, and indeed Ukraine’s own anti-corruption laws, most incoming investors will be keen to ensure that the company has been (and will continue to be) operating lawfully. This can sometimes be difficult to determine from the outside however. A company which practices good corporate governance therefore and which has appropriate anti-bribery policies in place (and which has audited accounts going back a number of years) may therefore be looked upon more favorably by a potential investor than a company which does not – indeed the seller will likely even be able to charge a premium in such circumstances.