By: Anup Kulkarni

Edited by: Raymond Helayel


Through the effective use of internal audit, private equity firms can grow portfolio returns

As the MENA Private Equity (PE) industry returns to normalcy from the burdens of the worst global financial crisis, followed by the political uncertainties arising from Arab Spring events, newer challenges await PE investors and auditors evaluating these investments. Investors are starting to place more importance on the Governance, Risk & Controls (GRC) aspect of business, which has become a relevant consideration in pre-acquisition evaluation of the PE opportunity and its post-acquisition management.

The purpose of this article is to share some experiences of interactions between Internal Auditors and PE investment teams and highlight how the audit function could add value to the decision making, and portfolio management of PE investments.

I. Pre-Acquisition Phase

In the pre-acquisition phase, it is necessary to spend the first few days understanding the business of the target company. Mapping of the shareholding structure, organizational matrix and processes of the business lines would be a valued contribution by Internal Audit to the investment team. In a number of PE investments, process mapping has helped the investment teams to understand the business process, identify key risks and fix critical control gaps prior to commencing the deal negotiations.

One of the main characteristics of mid-market PE and venture capital investments in the MENA region is that the investment space is dominated by family owned small and medium enterprise (SME) businesses. Most of these businesses have a tendency to maintain key business affairs within the family and decision making may be less formalized. Closely held shareholding, absence of independent board members, lack of separation between directors and management, lack of proper delegation of authority, and inadequate policies and procedures are some of the commonly experienced issues. Since the objective of the PE investor is to exit the investment after a reasonable holding period, preferably through the IPO route, they would ideally want these governance requirements to be fixed before the investment is made. In the due diligence phase of pre-acquisition, Internal Audit could assist in recommending a suitable corporate governance framework and policies, in line with accepted practices and regulatory requirements relevant for a listed company.

Another possible challenge with MENA family owned businesses is with regards to investment portfolios. Family offices tend to have investments on their balance sheet which may be unrelated to the principal business activity. Internal Audit’s review of the investment portfolios and its valuation, particularly for investments in related companies, real estate and junk bonds could be beneficial to separate unrelated investments and defining appropriate deal structures.

Provision for doubtful receivables is an important area for valuation as well as investment negotiations. In some cases there may not be established policies for providing doubtful receivables. In another instance of a PE investment transaction in a healthcare company in MENA, during the deal negotiation phase, a large receivable which was claimed to be recoverable by the management was found to be small receivables from thousands of cash customers (with no medical insurance) which were 12 to 36 months old. This also included certain insurance claims which were rejected or disputed by the insurance companies. Internal Audit’s review of receivables and recommendation of appropriate provisioning policies, as part of the due diligence process could have helped identify such issues and contributed to the negotiation process. Certain ratchets included in PE term sheets/agreements are based on future recovery of receivables which tend to influence valuation. Based on the Internal Audit’s inputs appropriate ratchets could be added to the deal terms.

Judging the adequacy of controls in the light of deteriorating economic conditions could be challenging. An example of a recent PE transaction involved investment in a company engaged in factoring business in the MENA region. A factoring company lends money by discounting multiple receivables of the same client to the extent of 70-75% of the invoice value, so that risk of delinquency is spread. The institution largely relied on this spread mechanism in conjunction with personal guarantees and postdated cheques securities from the clients as well as their debtors. However during the economic crisis certain clients, in collusion with several of their debtors, did not honor their commitments closed their businesses and left the country. Internal Audit’s review of the business in the pre-acquisition phase could have helped the PE investor to identify weaknesses in the credit process and introduce risk mitigation measures, such as the establishing more robust credit assessment procedures and risk transfer measures, like credit insurance.

II. Post-Acquisition Phase

Internal Audit plays another vital role during the post-acquisition management of the investee companies. Adequacy of management reporting could be a shortcoming in some of the MENA family owned businesses. Management reporting may be on request by the senior management or may be produced only for regulatory compliance. In some of the investments, enhancing the reporting systems may be required as a first step to prepare a post investment business plan. Enhancing and streamlining the management reporting systems is another area where Internal Audit can step in.

PE investors usually set ambitious targets for their investee companies. Early stage companies might take longer to start earning revenues due to structural difficulties and regulatory approval processes. Review of capital expenditures, cash flow projections and financing plans become critical in the early stages of the post-acquisition phase, for managing debt commitments. Cash flow breakeven point tends to get postponed typically by 12 to 24 months from the initial business plan, depending upon the stage and nature of the business. If external financing is used, debt restructuring may be required in some cases. Internal Audit’s review of the projected cash flow and its achievability may prove to be a vital input for restructuring negotiations. In case corporate guarantees are given for the debt issued to the investment vehicle, it needs to be considered in the risk assessment of the PE investment company.

Moreover, investor relationship management has emerged as an important audit area in the post crisis era. As investment performances are deteriorating, fund investors are questioning the management expenses and fees. Internal Audit’s periodic review of fund expenses and management fees, to check whether they are within the limits specified in the Private Placement Memorandum (PPM) is crucial. Ongoing issues revolve around the valuation and Net Asset Value (NAV) reporting. Fund houses usually conduct in-house annual valuation through their investment teams. Independent valuation is usually conducted for investments involving real estate, telecom or specialized technologies. Internal Audit can play a vital role in conducting independent analytical review of the approach and assumptions used in these valuations.

As such, Internal Audit’s scope for PE firms is ever expanding and needs to be regularly refreshed to respond to changing business dynamics. An important note in this regard is the need for the Internal Audit to come out of traditional perception of performing post fact audits which restricts focus on operational and compliance issues. It is also important for Internal Audit teams to develop and enhance their skills, particularly in the areas of due diligence, project management and valuation. With investors and regulators demanding more from fund managers, Internal Auditor’s role of providing independent assurance to the board and senior management will continue to deliver competitive advantage to PE firms.


ANUP KULKARNI, ACA, CFA is an investment professional at an investment company in Abu Dhabi.