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Due diligence and Corporate Governance

by Arthur Kendall

…And the different attitudes of institutional vs private equity investors

A recent case of due diligence scuppering a major acquisition highlights for me one of the core issues of corporate governance (and why corporate governance is important): the separation of ownership and control. But this time I put the spotlight on the investor companies not the businesses being acquired.


The amount and depth of due diligence performed will vary depending on whether the company is using other people’s money or its own. While that may seem logical, it should be of concern to investors, just as it should be to shareholders in public companies. Directors are under legal obligation to look after the money entrusted to them, whether via a fund or directly in the company. They have a moral and fiduciary duty to minimise risk, which in the case of institutional investors seems to be perennially flawed. Fiduciary duties include:

  • a duty to act in good faith
  • a duty not to act for improper purposes
  • a duty not to engage in ‘corporate opportunities’
  • a duty not to fetter future discretion

It is clearly necessary for institutional investors to complete a minimum number of deals in a year, which combined with the lower charges of institutional funds vis-à-vis private equity funds puts time and cost pressure on due diligence activity. Institutions would also argue that it mitigates risk by balancing portfolios with a range of different investments. But the collapse of Lehman Brothers and the wider fall-out from the bank-led financial crisis shows that this risk balancing did not work and that not enough due diligence was being performed.

That is clearly not the recent example I referred to at the beginning, with the financial crisis kicking off in August 2007 with the bursting of the sub-prime mortgage bubble. This week (beginning 13 February 2012) it has emerged that US private equity firm TPG pulled out of acquiring Chinese insurance agent CNinsure [note: paywall] last year not due to price issues, as CNinsure stated at the time, but because of accounting discrepancies uncovered by investment investigators as part of the more rigorous due diligence performed by TPG. Much more connected to the source of the funds than institutional investors, private equity firms clearly take a longer view and unlike the markets, will not automatically view negative information as a deal killer. But they clearly want to ensure information is accurate. The use of investment investigators is becoming increasingly common, especially in China, where it is the norm for business owners to have more than one business and where therefore the instances of diverted income and artificial cash flows originating in related businesses are numerous.

The increasingly sophisticated ways in which companies go about vetting potential investments also emphasises the importance of good corporate governance and a political and business environment that encourages it. More deals will fall through unless China and other countries improve their governance to better ensure that when vigorous due diligence is performed, the partner companies receive a genuinely clean bill of health.

This is not just warm fuzzy talk, the domain of the Corporate Social Responsibility statement (itself a missed opportunity in most cases, I would argue). There is compelling evidence that improving corporate governance leads to better performance, not just in company terms but in market terms. Indonesia is a case in point. Since the Asian financial crisis of 1997/8, the country has made great strides in introducing and complying with corporate governance codes and this has led to the reinstatement of investment-grade status by the rating agency Fitches and enviable economic growth and stability. An excellent article in the Jakarta Post details how good corporate governance is paying off for Indonesia; the article includes statistics and charts which show, for example, a link between the introduction of corporate governance codes and the beginning of a sustained period of outperforming of the Indonesian stock market against the Asia-Pacific Index.

Interestingly, Jakarta has taken an ethical business approach, or self-regulation, rather than a heavy-handed legislative approach as in Sarbox in the US – and it seems to be working. If companies are genuinely taking this seriously (by 2009 83% of the JSE had introduced a corporate governance code), this clearly bodes well for inward investment and related due diligence investigations.

Certainly this and other evidence support our conviction that good corporate governance yields tangible business benefits (at a macro/country level as well as individual organisation level). As we say in our First Golden Rule of Good Corporate Governance, a highly ethical operation is likely to spend much less on protecting itself against fraud and the organisation will therefore have much less to fear from investment investigators going under cover in their quest for thorough due diligence.


Further proof, if it were needed, of the existence of a “governance discount” on valuations comes as shareholders of Bumi [note: this link is a further update, written in 2016, an account of the whole 3+ year saga], the London-listed Indonesian mining company, finally settle a feud with its founder and co-chairman, Nat Rothschild. Rothschild set up the venture with James Campbell, formerly with Anglo-American, to bring together some of the world’s most profitable mining operations while improving corproate governance – a seemingly winning combination that attracted a lot of interest and investment a year ago.

However, Rothschild received an unexpected and extreme reaction to a letter in November 2011 (made public via the FT) to PT Bumi Resources in which he criticised corporate governance at the Bumi subsidiary, quoting the existence of non-mining-related investments in connected parties as “one of the principal reasons why…shares trade at a significant ‘corporate governance’ discount”. Two major shareholders, the Bakrie family and Samin Tan tried to have the billionaire investor thrown off the board, though the final deal, reached on 18th February 2012 at talks in London, will see him staying on as non-executive director.

The case highlights similar issues referred to in the main article above, namely:

  • due diligence: Nat Rothschild, as a principal in the deal, and keenly interested in corporate governance improvements, took the cross-shareholdings uncovered in the due diligence more seriously than the institutions from which he raised the listing capital
  • corporate governance: shares are trading at a 25% discount on the price offered at listing in 2010 and dropped 15% in less than two weeks after Mr Tan and the Bakries started their action against Mr Rothschild. As Oliver Ralph of the FT points out: “the market’s verdict is clear – rather tahn offering the desired combination of UK governance and attractive overseas assets, Bumi is a company that deserves a governance discount.”

Influence of major foreign shareholders in a locally listed company is clearly of major concern to investors, but little seems to be done by institutions managing indexed funds to avoid the risks associated with a deal such as Bumi, where they cannot sell nor influence through votes. As lead FT writer Jonathan Ford argues, without “sanitised” indices, such companies should be excluded from the index. Even publicly available due diligence would highlight major risks such as those inherent in the Bumi case. I would also agree with Jonathan in his proclamation that corporate governance reforms should be completed before listing, not after.

While the subject for a whole series of articles in its own right, the issue of major shareholders and cross-shareholdings is probably still the major corporate governance and due diligence issue in Asia today, and reminiscent of the early debate in Western economies of the dominance of founding families in increasingly large corporations.

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