Numbers tell a story, but is the story good enough to invest in?

Venture capitalists and general partners of private equity funds are constantly looking out for attractive investments in private companies that can give them the mega returns they want. Yet for every 10 investments, how many would be considered successful based on their timeline and exit via trade sale or IPO? The failure rate is high, but if even one out of 10 investments is a superstar that reaps huge returns, the investment can pay off. To take one local example, Singapore billionaire Peter Lim backed Wilmar International with US$10 million in the late nineties, a move that netted him a return on investment of close to S$1 billion Singapore dollars.

The investment success rate can be dramatically improved by performing due diligence once a target is identified. This due diligence would normally cover financial, legal and regulatory compliance, operations, commercial data, corporate governance, and taxation. It would also include site visits of the target’s operations, as well as exhaustive interviews with owners, management, employees, customers and suppliers, corroborated by background checks by private investigators or intelligence firms.

Financial due diligence is one of the many forms of due diligence to be carried out. In this respect, there are 10 crucial insights that every venture capitalist and general partner of private equity funds should be aware of to reap the returns they want. Failing to pay attention to these recommendations could be costly. These 10 takeaways are as follows:

1. Think cash first, profits second

Profit is important but cash is the reality. Focus on cash flows first and profits second. Ask for cash flows for the past five years and the projection for the next three to five years. For example, a company can pay commissions to its salesmen to sell the products aggressively, but without monitoring the quality of the sales, this oversight can result in significant credit risk.

In short, high profit may be initially recorded, only to come up against the poor results when it is time to collect cash from customers. In cases like these, numbers can tell a misleading story as significant doubtful debts are pushed back into subsequent reporting periods.

2. Numbers should be prepared using internationally accepted accounting rules

Numbers can be prepared in many ways based on accounting policies and principles selected by the company. Different accounting principles give rise to different numbers that can influence decision-making.

Focus on numbers prepared based on generally accepted accounting principles such as International Financial Reporting Standards (IFRS). For instance, profit can be improved simply by capitalising substantial repair and maintenance costs and then depreciating them over 10 years, or not eliminating a sales transaction by the investor entity with its joint venture partner for the share it controlled.

3. Sustain the future growth

One of the fundamental assumptions when reviewing financial information of the target entity is that its financial statements and information are prepared on a going concern basis. This means the entity has the financial capability either through its own profitable operations, or through borrowings from third parties or related parties, or even owners’ funding to continue in operational existence for the foreseeable future.

Thus, it is important to ask for financial forecasts or projections for the next five years and to examine the inputs and assumptions used for cash inflows and cash outflows, including capital expenditure and funding needs of the entity as it journeys through its life cycle. It is wise to scrutinise the past for indications of historical performance, but more important to focus on the present to form a realistic picture of the current reality and the future for sustainable growth.

4. Discover hidden gems in the company

There could be hidden gems not reflected on the balance sheet, example, a solid customer base, talent capital, brand name, exclusive distributorship rights for large MNCs, control of market share, proprietary technical know-how, and patents. The balance sheet normally records assets that are tangible, because accounting rules generally set strict criteria for the recognition of intangible assets and thus, such assets are not valued and not recorded on the balance sheet.

5. Look out for undervalued assets

Look out for undervalued assets on the balance sheet like properties, plant and equipment that are recorded at historical cost less accumulated depreciation but whose fair market values may have escalated two to three times their original cost. Conversely, also beware of overvalued or underperforming assets on the balance sheet such as receivables from third parties and related parties that are not collectible, inventories that cannot be sold above cost, as well as investments that are not performing and not impaired.

6. Watch out for unrecorded liabilities

Unrecorded liabilities are like a time bomb waiting to explode. You may notice them without being fully aware of their accounting implications. Examples of these dangers include goods shipped based on agreed incoterms but not recorded by the company as payable to supplier; provision for warranty costs; provision for reinstatement cost of the premises occupied if the landlord requires the tenant to reinstate the premises to its original state upon vacating the premises; provision for unutilised leave; cash settled stock compensation; oral or written guarantees given by owners and their related companies or assets and shares of the company pledged against borrowings; contingent liabilities that are probable such as claims in litigation that are in progress, and more.

7. Key employees are assets, but can be costly

Scrutinise employment contracts with key management personnel including directors (key employees), and the implications these have on costs, including any stock options granted to them by the founders of the company.

Stock options or shares granted to key employees as incentives would give rise to a charge to profit or loss like employee salaries, but this fact may not be recorded. Key employees that are on a fixed contract term of three or more years could require heavy financial payouts by the company if their contracts are terminated prematurely in the event that they are not the right people to take the company forward.

A non-competition clause should also be included in revised employment contracts, as this risk can cause damage to the company’s performance in the future should key employees leave the company and set up on their own to compete with the company.

8. Good management is not good enough, honest management counts more

Good management is critical to the success of the companies they own and manage, but honest management is even more important. If a company’s revenue and profit figures are too good compared to its peers in the industry, beware the possibility that these numbers may have been manipulated.

Numbers can be beautified, packaged, and presented to tell the story the way the owners intend it to be and not the way it should be. This effect can be achieved by way of management override of controls over financial reporting, such as adopting accounting practices that are not in line with generally accepted accounting principles, suppressing or amending journal entries, and making accounting estimates or fair value estimates that are aggressive.

Examples of these practices include depreciating assets over a longer period of time than its economic useful life, not providing for doubtful debts for trade receivables that are in dispute, recognising revenue when collection is not probable at the inception of sale, and not recording a claim by the creditor when it is probable that the lawsuit would materialise in the plaintiff’s favour. Such aggressive accounting practices can lead to fraudulent financial reporting.

Remember to ask for audited financial statements for the last five years, while also evaluating the reputation of the audit firm that performed the audit.

9. Business losses sound terrible, but tax losses can potentially offset them

Don’t ignore tax losses as these are normally not recorded as assets on the balance sheet on grounds of prudence. In fact, these tax losses have a value as they can be carried forward to offset against future years’ profits, subject to the tax rules of the country where the losses arose. For instance, in Singapore, tax losses including unclaimed tax incentives and unabsorbed capital allowances can be carried forward indefinitely to offset against future profits so long as there is no substantial change in ultimate shareholders.

10. Don’t buy on emotion and justify on reasons thereafter

Finally, be honest with yourself whether the return on capital invested which you desired can be achieved based on the due diligence exercises you have carried out. Be objective and impartial and don’t let your emotions dictate your rational thinking. Psychologists have long observed that human beings buy on emotion and justify the purchase decision with reasons thereafter.

For venture capitalists and general partners of private equity, investing huge sums of money in private companies, be they start-ups, growth or mature companies, requires careful financial due diligence. Bearing in mind the 10 rules would reduce investment risk in the target and help you reap the rewards you are aiming for.

For venture capitalists and general partners of private equity, investing huge sums of money in private companies, be they start-ups, growth or mature companies, requires careful financial due diligence. Bearing in mind the 10 rules would reduce investment risk in the target and help you reap the rewards you are aiming for.