Eyes wide shut
As a result of increases in liquidity, GPs now have an abundance of dry powder that needs to be deployed within a short period of time. There appears to be a rush to do deals, especially, when a fund has just done a first close from LPs and needs to amass Term Sheets to attract more LP commitments for subsequent closes to hit their desired fund corpus.
The tendency to skip third party financial due diligence (“FDD”) is slowly becoming the norm, especially for round sizes below $20 million because the costs of FDD cannot be "justified" and most of the transaction expenses budget (reimbursed by the fundraising company) is allocated to lawyers to ensure the deal closes - I call it "rubber stamping".
Don’t get me wrong, the legal elements are an important and necessary part of deal making but all the downside protections, indemnities and warranties in the world cannot fully guard against a flawed business model and/ or fraud.
The implications of skipping financial due diligence with a robust scope of work will usually rear its ugly head when the company is about to enter a trade sale or IPO and the costs of third party due diligence should be perceived as purchasing insurance against companies that defraud and/ or fudge their numbers.
Chanos describes the current environment as “a really fertile field for people to play fast and loose with the truth, and for corporate wrongdoers to get away with it for a long time”. He reels off why: a 10-year bull market driven by central bank intervention; a level of retail participation in the markets reminiscent of the end of the dotcom boom; Trumpian “post-truth in politics, where my facts are your fake news”; and Silicon Valley’s “fake it until you make it” culture, which is compounded by Fomo — the fear of missing out. All of this is exacerbated by lax oversight.
Financial regulators and law enforcement, he says, “are the financial archaeologists — they will tell you after the company has collapsed what the problem was.” All in all, it’s “a heady witch’s brew for trouble”.
Source: Financial Times “Jim Chanos: ‘We are in the golden age of fraud"
How a typical deal process looks like
The above illustrates a typical deal process for growth and late stage fund raises. Depending on the company’s readiness around the availability of data and robustness of financial reporting, the end to end process can take anywhere from 3 months to 6 months.
Now you might think that accounting firms and consultants are inadept at detecting these irregularities but I think it goes back to how the deal is run post Term Sheet, whether the scope of work is adequate and whether the FDD team is given sufficient time and access.
This podcast episode focuses on the importance of third party due diligence that usually takes place after a Term Sheet is signed.
Podcast guests and discussion areas
For this podcast episode, we have the benefit of a multi-faceted view from growth and late stage investors and also a renowned Transaction Advisory Services provider.
Special thanks to Yong Cheng from Qiming Venture Partners, Evelyn from General Atlantic, Dawn from Alvarez and Marsal who kindly agreed to be part of this episode and shared many interesting insights.
Some of the interesting areas that we discussed are:
What is the value add of performing another round of due diligence through third party advisors?
How extensive should the FDD scope be for various fundraising stages, Series A vs Series B vs Series C and beyond?
What is a "standard" scope of work for FDD for a Series A+ companies which should already have some basic BI infrastructure and must have a sound financial reporting process?
What are the red flags to look out for before FDD starts, during a FDD and while performing the FDD?
What can we learn from the recent headlines around board supervision failures at some well known and publicly listed companies? Can we mitigate these risks earlier on through a well scoped third party FDD? How can we spot early indicators of financial irregularities?
What are some of the methodologies and/ or techniques commonly deployed by FDD advisors that can provide investors with more certainty over a deal and their investment thesis?
What is a ballpark fee range for engaging third party FDD advisors?
Is Tech and product due diligence important? How can we separate the traditional businesses dressed up as tech businesses to command a tech multiple vs “true” tech companies?
Tune in to the podcast if you are keen to learn the answers to the above questions! Also keen to get some feedback on this podcast episode, where you think it can be improved and suggestions for future topics.
Share this post