Not one to mince words, KPS Capital's Michael Psaros offers a ...

20-35_Roundup.qxd 4/6/09 5:39 PM Page 22Round UpDoes the M&A Space Have aMadoff in its Midst?With capital drying up, it is only a matter of time beforefraud starts showing up in the merger marketKen MacFadyen“In good timespeople steal;in bad timespeople reallysteal.”As the desiccation of liquidity exposes businessesand financial firms, instances of fraud, both ona grand scale and relatively minor offenses, seemto be emerging on a daily basis. Bernard Madoff’s ponzischeme is obviously the most talked about transgressionin recent months, though similar cases involving lawyerMarc Dreier, venture capitalist William “Boots” Del Biaggio,and Illinois Governor Rod Blagojevich has giventhe CSI set more scams than they can handle in a givennews cycle. The M&A market, while spared of anymajor hoaxes so far in 2009, is by no means immune.“In good times people steal; in bad times peoplereally steal,” Joseph Spinelli, co-founder and chiefoperating officer at Daylight Forensic & Advisory, tellsMergers & Acquisitions.Yogesh Bahl, a partner at Deloitte Financial AdvisoryServices LLP, notes that financial duress serves to“ferret out fraud,” as most schemes require a continuinginflux of cash. “As soon as the funding stops, that’s whenpeople start asking questions,” he says.At the same time, Bahl notes that downturns canoften present “a more fertile landscape” for fraud or collusion,as incentive schemes aren’t readjusted to dealwith the new environment. At the same time, companiesare cutting back on the infrastructure and compliancedesigned to root out fraud and employees will assumenew responsibilities that make collusion easier.In M&A, fraud can take on a number of forms. Perhapsmost common is the instance in which a targetcompany has manipulated the books and views a saleas an easy out. Marketwatchers will likely remember itwas The Blackstone Group, through its due diligence,that reportedly uncovered the fraud at Parmalat. Thedisclosure ultimately led to the dairy producer’s bankruptcyfiling.Another high-profile case, again involving a privateequity firm, occurred when former Refco CEO PhillipBennett was caught hiding $430 million of bad debt. Thiscase highlights how much damage instances of fraudcan create for the ancillary players. Bennett received 16years in prison, but in the aftermath shareholders alsowent after Thomas H. Lee Partners, which acquired Refcoand profited on its IPO; Grant Thornton, the company’sauditor; and a slew of investment banks, whichunderwrote and financed the company.Malfeasance in M&A is not confined to target companieseither. Deloitte’s Bahl notes, “You also see it happenfrom the acquirer’s perspective. Once these companiesstart mixing up the financials it clouds the level oftransparency that once existed.”Most recently, this cropped up at National Lampoon,whose CEO orchestrated a scheme providingkickbacks for stock purchases. The aim, which fell flat,was to artificially inflate the company’s stock price toimprove its capital position for all-stock deals and potentiallypump up the company’s valuation for a sale to astrategic.In other cases of fraud, companies will use M&Ato create enough noise that the din distracts regulatorsfrom seeing through to the swindle. In 1999, the Securitiesand Exchange Commission had investigated Tycoto determine whether or not the company was using itsmerger-related accounting to overstate its performance.That was three years before it was finally uncovered thatTyco’s CEO Dennis Kozlowski had looted $96 millionfrom the company. In a bigger scam, WorldComtallied an almost $80 billion overstatement, using M&Aas part of, and to camouflage, the manipulation.Because of this, it’s on the shoulders of both buyersand sellers to be aware of the potential for fraud. Prospectivered flags can be easy to spot. As the Madoff casedemonstrates, the first tip off might be performance thatis too good to be true. “Anything that looks like ananomaly deserves further attention,” according to Bahl.Another area that warrants investigation, Bahl says,is the incentive structure. If an opening for fraud exists,there’s a chance people will look to exploit it.FRAUD continued on page 8622 MERGERS & ACQUISITIONS February 2009