Reputational Due Diligence - The key to strategic risk management
1. BERLIN RISK INSTITUTE
E i s e r m a n n & G i e r s c h
w w w. b e r l i n - r i s k - i n s t i t u t e . d e
Jennifer
Hanley-‐Giersch,
Business
Risk
Research
Dr.
Carsten
Giersch,
Berlin
Risk
Institute
Reputational Due Diligence –
The key to strategic risk management*
Reputational Due Diligence supports the strategic risk management of business ventures in
international markets. As introduced in the following article, the combination of Integrity Due
Diligence with Political Due Diligence enables an investor to gain a comprehensive assess-
ment of possible reputational risks attached to a business partner. This concerns compliance
and corporate governance issues in relation to individuals and target companies as well as
the reliability of the political environment in a specific country.
The focus on ‘human’ risks assigns Reputational Due Diligence a truly strategic attribute in
the risk management process. The article discusses the relevance of reputational risk evalu-
ation in the due diligence process. In addition, it expands on the numerous hidden sources
of reputational risks than can be unveiled in the course of the Integrity and Political Due
Diligence process. Examples and a case study serve to illustrate reputational risks as a
serious business security matter.
The benefit of Reputational Due Diligence consists of improving an investor’s chances to
finding integer and reliable business partners and to enable him or her to protect his ven-
tures from harmful political entanglements. Reputational Due Diligence ensures being in line
with ‘best practice’ regarding compliance and corporate governance rules. Moreover, it in-
creases the transparency of surrounding business and political networks. Providing critical
information for identifying hidden and connected reputational risks at an early stage contri-
butes to an extended decision making basis with respect to foreign investment. As a conse-
quence, management resources can be used effectively and transaction costs optimized.
*
First published in German in BERLIN RISK BRIEF No. 6, October 2010
2. Reputational Due Diligence –
The key to strategic risk management
Carsten Giersch / Jennifer Hanley-Giersch
The careful analysis of reputational risks is as equally important as the assessment of
market, legal and financial risks. When engaging in business ventures such as mer-
gers and acquisitions, foreign direct investments and joint ventures, it is fundamental
to assess the integrity of the target firm as well as the reliability of the political envi-
ronment. In order to evaluate the feasibility and estimated success of a project, and to
ascertain whether there is a risk that the endeavour might be impeded due to the am-
bivalent standing of a business partner or due to the resistance of political actors,
Reputational Due Diligence should be undertaken. Reputational Due Diligence im-
proves strategic risk management in the lead up to business transactions by assisting
decision makers to identify the ‘soft risks’ attached to an investment by focusing on
the ‘human factor’.
Choosing a reliable business partner is analysis of the immediate environment
one of the main challenges facing com- surrounding a transaction with a view to
panies seeking to expand into new mar- identifying the direct and indirect reputa-
kets. The annual survey ‘Going Interna- tional risks. The strategic orientation is a
tional’ conducted by the German Chamber key attribute of the Reputational Due
of Industry and Commerce (“DIHK”), regu- Diligence Process (see Diagram 1).
larly confirms that the integrity and relia-
bility of cooperation partners is the key to Definition
successful engagements in foreign mar- Reputational Due Diligence concerns the
kets. In addition, as a result of compliance careful evaluation of reputational risks
and corporate governance standards, attached to a business partner or target
companies encounter increased require- company including issues of integrity and
ments, in particular due to anti-corruption reliability of the individuals involved, as
and anti-money laundering legislation, to well as the trustworthiness and predicta-
establish the integrity, standing and repu- bility of the political environment.
tation of their business partners.
Integrity and compliance touch a particu- A recent example, which highlights the
larly sensitive area regarding the evalu- relevance of Reputational Due Diligence,
ation of a planned investment. Issues can be seen in the difficulties facing the
regarding reputation can have a significant WAZ-Group, one of Germany’s leading
influence on foreign investments, particu- publishing houses, as a result of its ex-
larly the informal political risks which often pansion activities in the Serbian market.
exist. Reputational Due Diligence, which Questionable businessmen, shady middle-
includes the assessment of reputational men and so-called oligarchs, i.e. influential
risks, is based on two pillars: Integrity Due businessmen who are closely connected
Diligence and Political Due Diligence. to the state, jeopardised the WAZ group’s
This approach involves research and investment in Serbia so severely that the
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3. Diagram 1: The Due Diligence Process
media company is now considering re- Integrity Due Diligence
treating from the Serbian market place.1 It
is particularly important to take necessary With regard to the business partner or
precautions regarding integrity issues target company, the ownership structure
when selecting a business partner in needs to be assessed. In the lead-up to
countries which lack a democratic tradi- an investment, a transaction or a business
tion. corporation agreement, one would like to
understand whether hidden risks are
However, democratic countries, even lingering in the immediate or surrounding
within the European Union, also have had environment of the respective business,
some noteworthy cases where planned which could negatively impact the evalu-
transactions have become entangled in an ation of the target’s reputation.
impenetrable net of business and politics.
A good example are the numerous ma- Of interest are any uncommon or excep-
noeuvres undertaken by the Zapatero tional links in the business network, which
government in Spain in 2006/2007 which may raise questions surrounding the relia-
assisted Endesa in blocking the takeover bility and stability of the subject. Reputa-
by the German competitor E.ON.2 A more tional risks might lie in the shady past of
detailed case study of a complex Reputa- an individual or a company such as previ-
tional Due Diligence assignment is pre- ous mismanagement or in a worst-case
sented in a sanitised format at the end of scenario, links to organised crime net-
this article (see Annex). works. Such a tainted track record can be
drawn into the public limelight at any time
Reputational Due Diligence explicitly and exert negative pressures on business
includes the following two areas, namely relationships and thus jeopardise the
Integrity Due Diligence and Political Due success of cooperation when the basis of
Diligence which may entail human risks for trust is destroyed.
business transactions (see Diagram 2).
As a result of existing compliance re-
quirements, Integrity Due Diligence in-
cludes research which aims to indentify
critical ‘red flags’ attached to an individual
1
Frankfurter Allgemeine Zeitung, 9. September or a company in relation to their reputa-
2010. tion, whereby the aim is to identify any
2
Economist, 21. August 2006, 1. March 2007, deal breakers.
4. April 2007.
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4. Diagram 2: Reputational Due Diligence structure
‘Red flags’ include, for example, economic company have an untainted reputation and
crimes such as fraud, money laundering, can be expected to be sufficiently reliable.
corruption or embezzlement. The identifi-
cation of such critical integrity risks can In order to comprehensively ascertain the
protect a company from becoming em- reputational risks attached to an invest-
broiled in criminal investigations and also ment, the Integrity Due Diligence process
from investing in businesses whose capital should be combined with a Political Due
derived from the proceeds of crime. Diligence process.
Most importantly, Integrity Due Diligence Political Due Diligence
always creates the necessary level of The economic recovery process following
transparency. Through the identification of the financial crisis opens new investment
integrity risks, which are of a ‘certain con- opportunities internationally. At the same
cern’, management can put measures in time, events in recent years have high-
place, which can assist in controlling and lighted how important the political envi-
acceptably reducing risk. If no integrity ronment of a target country can be. Of
risks can be identified as a result of a particular concern are political interests,
comprehensive ‘background check’, the which can jeopardise or block an invest-
investor can, with a certain amount of ment decision.
comfort, conclude that the business part-
ner and/or the management of a target
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5. A comprehensive analysis of reputational works, not only when the power relations
risks in transnational transactions should shift.
therefore also include an assessment of
the reliability of the political conditions for Political patronage and clientelism in
an investment, meeting the requirements international markets increase the risk of
of Political Due Diligence. Political Due unfair practices and discriminatory deci-
Diligence focuses on the political and sion-making processes. This kind of
strategic risks attached to a planned busi- obstruction can emerge due to the inter-
ness relationship and its qualitative ap- vention of political circles as well as vari-
proach makes it different from that under- ous interest groups, which exert influence
lying various political risks indices. on ministries, regulatory bodies or the
justice system. Political Due Diligence
In order to assess whether the political includes an evaluation of the risk of be-
environment is favourable for an invest- coming a pawn of political events, due to
ment, the following rule should apply: The the changing interests of political actors,
extent to which political issues will influ- and the manipulation of decision-making
ence the reliability of a local partner is processes within state authorities.
defined by the strength of the democratic
structures in a country and by the close- Methodology of Reputational
ness of a business partner or middleman Due Diligence
to the state and government bodies. Integrity risks and political conflict risks are
Political Due Diligence therefore analyses hidden risks and can most effectively be
reputational risks based on scenarios identified and evaluated by undertaking an
attached to changing political power struc- independent Reputational Due Diligence.
tures. This includes a change of gov- Reputational Due Diligence protects inves-
ernment, arbitrary regulation, political tors from unpleasant surprises in the
control of the judiciary, or populist meas- ‘human’ environment of an investment. If
ures undertaken at the expense of the free integrity and trustworthiness are critical to
market. Such strategic changes in the the long-term success of an investment
political landscape can also strongly influ- project, then the information concerning
ence the acceptance of an investor in the such issues should be obtained in ad-
concerned markets and potentially result vance in order to improve the basis upon
in him or her being embroiled in social which decisions are make in the lead up to
conflict. the transaction (see Diagram 3).
Furthermore, a threat of damaging political For this purpose, within the context of the
influence by informal networks, in which Reputational Due Diligence process,
local business partners or middlemen secondary sources including media sour-
might be involved, also exists. Investment ces, corporate registry entries, relevant
projects can run the risk of failing as a regulatory information, other databases
result of open or latent opposition in or- and online information sources are evalu-
ganised networks which operate between ated. In a further stage, discreet inter-
political and business circles, typically views can be undertaken by experts in
engaging in protectionism, patronage and order to ascertain the reputation of target
clientelism. There is always a significant individuals or companies. Based on the
reputational risk attached to such net- information retrieved, a risk profile can be
established.
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6. Diagram 3: Reputational Due Diligence Methodology
The authenticity of a business partner’s Reputational Due Diligence also adds
résumé will be evaluated and his or her value to the risk management process as
public profile and reputation portrayed it expands the decision-making basis and
based on media coverage. His commer- helps to identify hidden and connected
cial interests and comments on his busi- risks at an early stage. As a result, limited
ness and political network, as well as management resources will be optimised
potentially controversial relationships with and the transaction costs can be more
government bodies will also be re- effectively controlled.
searched. Other issues, which can be
addressed, include any litigation or credit The need for investment and the attrac-
issues which may emerge in relation to the tiveness of new markets on the one hand
subject based on research of publicly and increased business competition on the
available information. other, require more effective risk man-
agement. Reputational Due Diligence
Benefits plays a strategically fundamental role in
this regard.
The costs attached to undertaking Reputa-
tional Due Diligence within the context of
an entire due diligence process are com-
Dr. Carsten Giersch, Berlin Risk Institute
paratively low but nonetheless generate
Jennifer Hanley-Giersch, CAMS, Business
significant added value. Vis-à-vis the
Risk Research Limited
increasing complexity of compliance and
corporate governance rules, undertaking
Reputational Due Diligence ensures that
companies are in line with best practice
approaches in particular regarding rela-
tionships with third parties.
In addition, creating a maximum level of
transparency will improve the chances of
success of an investment endeavour by
fulfilling the requirement to effectively
evaluate the integrity of a partner and to
understand associated networks. This
ensures that a business relationship can
be built on a stable basis of trust.
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7. Annex: that the seller had previously been subject
Reputational Due Diligence – to investigations based on allegations of
a Case Study embezzlement. The investigations were
closed leaving the allegations unsubstan-
tiated.
A multinational firm plans to expand into Research of international press data-
one of Eastern Europe’s regulated mar- bases identifies an article published in an
kets by acquiring a majority stake in a Italian newspaper, which claimed that the
local company. The target firm holds the Italian state prosecutor had launched an
largest part of the market share in the investigation into the seller as he was
regulated market place. The seller wants suspected to have been involved in dubi-
to retain a minority stake in the business ous activities in Italy. Research of Italian
which in itself could present a risk for the corporate filings confirms that the seller
investor, who aims to float the target com- indirectly retained a stake in an Italian
pany on the local stock market within a company. The owner of the Italian com-
couple of years following the acquisition. pany is registered to be a Cyprus based
Based on this strategic background the entity, which in turn is owned by one of the
client wants to clarify some issues of seller’s subsidiary companies registered in
potential concern. the target country.
Furthermore, research in publicly avail-
Firstly, the client plans to develop a de- able sources reveals that the seller retains
tailed profile of the majority shareholder, a stake in a bank, which has been subject
including a map of his corporate interests, to controversial media coverage in relation
with the aim of assessing the seller’s to allegations of it having been involved in
integrity and reputation. Furthermore, the money laundering activities. The company
investor wants to assure himself that the which the investor plans to acquire a stake
seller does not have a hidden agenda in is indirectly, through a complex owner-
attached to the sale of his stake in the ship structure, linked to the bank.
business. The investor also wants to Research and enquiries also expose
establish a profile of the management that the target’s management team are
team of the target firm and their respective known to act as puppets of the seller and
reputations. that they are therefore not in a position to
Finally, the client asks for a political risk make independent decisions. This is of
analysis with regard to the role that vari- concern to the investor regarding potential
ous local interest groups might play. A future conflicts of interest, which might
network analysis of the relationships of the emerge following an acquisition. Further-
various interest groups amongst one more, the seller’s son-in-law is appointed
another and to the respective regulatory as CFO. Given that the seller exerts such
authorities is requested. The key focus of an influence on the management team
this exercise is to understand the strategic and that he would continue to retain a
aim of the regulatory authorities and to minority stake in the business following the
ascertain the independence of their deci- transaction, this emerges as a significant
sion-making. risk for the investor.
The political risk analysis highlights two
The in-depth research undertaken in local final issues of concern. Firstly, according
and international databases and through to the research undertaken, the state
expert interviews reveal the following key government prefers to see the market
risks: being held in the hand of national players,
and secondly, the key person responsible
The seller is not only one of the richest for the company at the regulatory authori-
and most influential businessmen in the ties, in a country, which is known to be
country, but also publicly a very controver- highly corrupt, is related to one of the
sial individual, which in itself presents a board directors of the target company’s
reputational risk. Media sources report key competitor.
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