Plenty to Investigate for Due Diligence Firms

Does That Car Fly? GPs Turning to Specialists to Help Substantiate a Company’s Worth
By Lauren Wiley, Pg. 56

A couple of years ago, a group of angel investors hired Intelex, Ltd., a Greenwich , Conn. based due diligence firm, to investigate a claim by an inventor that he ad developed a flying car.

Intelex discovered that the car – which turned out to resemble a vehicle straight out of the Jetsons – actually can fly, said Matthew J. Cherry, the firm’s president.

But Intelex also learned that the Federal Aviation Administration didn’t allow flying cars to cruise over public highways, so the investment never got off the ground.

For private equity firms that need help weeding out bad investment ideas, Intelex is just one of nearly a dozen we’ve identified that provide due diligence services. (For a guide to these firms, see pages 56-62.)

Such firms typically assemble teams of two to fifteen specialists, depending on a project’s complexity. They take from two to six weeks to complete their work, and charge anywhere from $3,000 to $100,000 per project.

The services they offer range from simple background checks on executives, to extensive research conducted on potential portfolio companies, their suppliers, their customers and their prospects for growth. Sometimes, investigators find enough troubling data to convince general partners to walk away from a deal – or at lest to negotiate better terms.

A Global Player
With more than 2,000 employees working in 55 offices, worldwide, 30-year-old Kroll Inc. is regarded as the leader in the filed. In the weeks leading up to an LBO, Kroll might scrutinize the company for hidden liabilities, learn the reputation of key managers, and even try to find out whether those managers would be likely to stay with the company post-LBO.

About 15 percent of the time, Kroll uncovers information that could lower an acquisition price, or even kill a deal altogether, said Daniel Karson, executive managing director and counsel.

Intelex investigators have uncovered a number of questionable offer, prompting would-be investors to walk away. For reasons of confidentiality, no names are used in the following cases.

In on recent assignment, a private equity firm called in Kroll to perform a background check on a doctor heading up a medical company. The doctor, it turned out, claimed he had earned an MBA from the Wharton School of Business when in fact he hadn’t, and the client walked away from the deal, Mr. Karson said.

In some cases, due diligence firms are called in after acquisitions to assist with lawsuits and bankruptcy filings, according to Joseph Jaffe, executive vice president and general counsel at Decision Strategies, which last fall acquired another well-known due diligence firm, Strang Hayes Consulting, Inc.

A private equity firm recently hired Decision Strategies to investigate a Hungarian portfolio company that the firm had grown suspicious of. Decision Strategies discovered that the company employed mobsters, paid large sales commissions to the alleged head of a Russian crime syndicate and hid money in secret bank accounts. The findings led to a class-action lawsuit by shareholders and to investigations by securities regulators in the United States and Canada. (The company had registered its stock in both countries.)

GPs Feeling the Scrutiny, too
Ironically, more and more general partners are themselves the target of investigations conducted by due diligence firms hired by potential limited partners. After investigating just two or three private equity firms from 1992 to 2001, Intelex has completed 12 projects for pension funds and funds of funds managers in the past six months alone. One of those investigations did turn up troubling information, and the investor has not decided yet whether to invest in the fund, said Mr. Cherry.

Intelex and other diligence firms expect business to get even better in the months ahead, as both GPs and LPs grow more suspicious of business claims in the wake of the Enron Corp. collapse. “You cannot afford to be put in a position of dealing with the wrong people,” Mr. Jaffe said.