An uncomfortable truth

What do a private equity house, an agri-foods commodities business and a diversified healthcare group have in common? For those who work in and around the Middle East region, the answer is an uncomfortable truth.

The Middle East region has seen a number of high-profile cases of alleged widespread fraudulent activity, which has resulted in large companies—often viewed as the rising stars of the region’s expanding private sector—entering a formal insolvency process owing billions of dollars to lenders and financiers, who are unlikely to ever be fully repaid.

As the global and regional economy starts to recover from the Covid-19 pandemic, large corporates will arguably need access to credit as never before. There will be market opportunities to seize, in addition to balance sheet rebuilding and working capital funding required to launch a new phase of growth. Lenders will naturally be cautious about a repeat of the last economic cycle. While typical financial, legal and commercial due diligence serves a purpose and is a well-established process in any lending decision or transaction, we explore how it could be further enhanced to ensure it is fit-for-purpose and tailored to mitigate the specific risks present today.

Phoenix Commodities, Abraaj Group and NMC Healthcare entered into formal insolvency processes during 2019 and 2020, primarily as a result of alleged fraudulent activity. Once the fraud was discovered, an insolvency process was inevitable. To the horror of many market participants, these three businesses had approximately US$10 billion of bank and other debt – which is unlikely to ever be fully repaid.¹

There was understandable outrage. How could this happen? Should it have been identified earlier?

The answer is simple. Typically, large-scale corporate fraud does not occur in businesses that suffer from covert actions by a minority of employees, which slip through the net of well-established internal governance and controls. It is generally more widespread, and many elements of the corporate structure and culture can be configured to enable and disguise the wrongdoing. Identifying fraud when it’s committed on a widespread basis within an organization is inherently challenging. Clearly, more needs to be done – by those charged with governance, but also other key stakeholders within the company’s ecosystem.

Lenders and financiers need to carefully consider how to ‘top-up’ the current level of due diligence they perform on the borrower/target before parting with their cash. Of course, there are already significant requirements on financiers to perform customer due diligence for anti-money laundering and corruption. During 2018 to 2020, the UAE introduced a number of new anti-money laundering (AML) and anti-corruption laws, in line with Financial Action Task Force (FATF) recommendations. Clearly, this is not a Middle East-specific issue: globally, fraud losses have been increasing consistently since 2009, both in nominal terms and as a percentage of GDP.

The question for lenders and financiers should be: does the status quo regarding pre-lending due diligence provide sufficient comfort? This is even more pertinent when the amounts are significant and the borrower high-risk. A survey of participants from the Association of Fraud Examiners (ACFE) suggests the outlook is worsening:

A three-pronged approach

1- Perform financial analysis – the NMC issues were first identified by a U.S.-based hedge fund, Muddy Waters, which predominantly highlighted potential issues from financial analysis. This could comprise:

a- Performance review – analyzing the financial statements to identify irregularities and inconsistencies. This could comprise:

i. comparison of different business units and geographies to understand variances in profitability and to ensure the rationale is legitimate;

ii. high-level balance sheet review – understanding aged working capital balances to form a view on provisioning and the ability to convert into cash, ensuring no hidden accounts which can be used to inflate Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) earnings; and

iii. EBITDA to cash conversion – ensuring this can be fully reconciled and any non-cash adjustments to make commercial sense.

b- Understanding the financial reporting process – understanding the component parts of the group, how the financial records are consolidated and deep-diving into the consolidation. From our experience, many accounting irregularities are processed through various head-office/centralized consolidation adjustments.

c- Benchmarking key KPIs – analyzing key ratios to identify material deviations to competitors i.e.:

i. Net debt – net debt / EBITDA, interest / net debt, interest income / cash; and

ii. Performance KPIs – gross margin, EBITDA margin, working capital days and cash conversion cycle, EBITDA / cash flow (operating and net).

Benchmarking analysis can identify potential areas to investigate further, albeit rarely will a financial metric lead directly to a smoking gun. It needs to be considered in context but can highlight potential red flags.

2- Understand the governance and controls framework – large-scale corporate frauds typically have one thing in common, poor governance and a weak control framework – which ultimately needs to be attributed to those charged with governance. It is this fabric and culture of an organization which allows fraud to go undetected. The lack of such framework is a red flag, that either the business is poorly structured and run, or worse.

This workstream could comprise gaining a more detailed understanding
of the following:

• Internal audit and compliance function, including role of the board and signing authority;
• Treasury department which include debt and cash management;
• Monitoring of related party transactions;
• Procurement and payment approvals, including delegation of authority approvals; and
• Litigation i.e. how are legal cases managed, monitored and reported.

3. Substantive transactional analysis – there are times when heavy lifting is required to form a view on a specific area or balance, through a review of individual transactions. This could comprise reviewing specific cash balances, total debt liabilities and any unusual one-off transactions. Data analytical tools allow us to review huge amounts of transactional data in a relatively short amount of time. Certain parameters can be set to focus on transactions which may be unusual and require further investigation.

It is important to understand the perimeter of the target organization and to gain confidence that there are no joint-ventures, affiliates and associates which are outside of the ring-fence and where wrongdoings or certain transactions could be hidden.

Conclusion

Enhanced due diligence may provide lenders and financiers with an extra degree of comfort over the target company and support making informed lending decisions. In turn, this could allow for more competitive pricing and terms which, importantly for the financier, has been appropriately risk weighted. Given this process can add value for the borrower/target, the cost of this additional work can usually be passed onto them and incorporated into the overall deal as part of the transaction costs.

by Rana Shashaa, Partner, Waqas Ahmed, Principal Director, Tom Howitt, Director and Paul Huck, Director, Financial Advisory, Deloitte Middle East

Endnotes

1. https://www.thenationalnews.com/business/economy/abraaj-former-ceo-stole-385m-from-the-firm-liquidators-say-1.1032722
   https://www.khaleejtimes.com/business/corporate/nmc-case-probe-identifies-financers-involved-in-fraud-