Constraints breed creativity. Investors with the determination (or mandate) to keep capital flowing through the COVID crisis are turning physical constraints into opportunities to address long-standing inefficiencies and biases in due diligence processes.
Emerging tools and strategies give us a glimpse of what a better investment process might look like. We spoke to the pioneers about their challenges, advice and new approaches.
Development finance institutions have a mandate to keep investing in the current climate, Unsurprising these institutions are piloting new approaches with virtual due diligence.
The U.S. International Development Finance Corp. is adapting to the new operating environment in order to keep moving highly developmental transactions through its pipeline, says Loren Rodwin of the DFC’s Social Enterprise Finance Team. Rodwin’s team has held several video conferences with a fund manager deploying capital to social enterprises in Africa and Latin America, as well as the manager’s staff and investment committee.
“Once travel resumes, we look forward to meeting these teams in person,” Rodwin told us.
Finnfund ran the first (of two) virtual due diligence processes soon after lockdown began. It was a five day process involving around 20 people in various video calls.
“I must say I was pretty surprised by how well we were actually able to dig deeper into the case at hand, into the investee company, and the substance,” says Hanna Kauppinen, a financial analyst who has become the organization’s go-to person for practical guidance on the topic (see “Finnfund’s practical advice for virtual due diligence,” below). As a relatively small organization, Finnfund is able to be agile and to consider the possibilities for virtual due diligence on a case-by-case basis. “Many investors are indicating that they’re not looking at new commitments,” says Jennifer Buckley at Small Enterprise Assistance Funds.
SEAF secured an anchor investor for the SEAF Women’s Economic Empowerment Fund three months before COVID hit. Planned travel to Southeast Asia as part of the due diligence process was subsequently postponed. One of the investors, a European pension fund decided to take “an extraordinary organizational step” and conduct due diligence virtually throughout June, via a series of team calls, use of remote collaboration platforms and online management meetings.
One piece of the puzzle still to be cracked is video-recording company facilities and operations as a stand-in for the usual onsite visits. “Ordinarily we would have preferred the investors get a firsthand experience of the stories of the women entrepreneurs in the region,” says Buckley. “Site visits remain one area where we need to be innovative in finding alternatives.”
In the flow of capital from investor to fund to company, there are different perceived challenges and risks. Actors across the spectrum have some doubts about whether virtual calls can replace in-person meetings.
“Zoom meetings are not enough to conduct the full due diligence in our target countries where mobility is reduced,” says Roeland Donckers at Iungo Capital. “We ask potential investees to help us to find a way that we can move around and go to their factory and effectively see what’s happening, and how much stock they have, for us to be able to continue moving forward.”
Those who invest into emerging markets also face the more basic challenge of broadband connectivity. “Being able to go to that last mile, that’s tough to do virtually,” another investor said. “We’re limited to what you can do in areas of good broadband, and bandwidth, and most of our companies are at the bottom of the pyramid, rural. It’s very difficult in the illiquid markets.”
Leveraging networks of trust and using a local proxy could support with last mile diligence, which will become easier as restrictions lift. “We need a trusted and respected central body to take ownership, says Goddard. “An accreditation body with people on the ground and appointed reps who go and perform diligence activities.” During recent GenderSmart online sessions, we’ve witnessed several informal offers of this help, between investors, fund managers, and intermediaries, but there is no reliable central repository or database of actors.
Some investor communities were already collaborating on diligence before COVID hit, but the need for transparency and knowledge sharing has accelerated. “Using local, external consultants has been in discussion,’ says Finnfund’s Kauppinen. “Also, in many cases, we are a part of a syndication with other development finance institutions; [they] might have already been to the site, met the people, seen the operations, so then we can also trust their work. This could be enough for us to conduct a remote due diligence process. But it’s a case by case evaluation.”
Emerging tech solutions are stepping in to help facilitate this knowledge sharing and collaboration. Cathy Goddard of FyreFem Fund Managers is repurposing a business rescue software suite for the COVID era. Fyre5 streamlines the early stages of due diligence and enables remote post-investment management between fund managers and investees – with gender impact criteria built in. It’s not yet a full diligence suite, though – it doesn’t get around the site visit. “Investors that have reliable networks in the countries they want to invest in will have an advantage’, says Finnfund’s Ulla Huotari.
The need to do remote due diligence presents an opportunity for first time and emerging markets fund managers, allowing them to build up fledgling relationships and demonstrate local knowledge to prospective investors.
“If the investors have been talking to those emerging markets managers for a while, they might not have invested in this fund so far, but they know they’re out there,” says SEAF’s Buckley. “I think they could use some of them as a proxy, which may lead to them getting money in the future.”
FyreFem’s Goddard says relying on existing networks could replicate existing cliques and biases. AllRaise’s Pam Kostka has cautioned that warm introductions in VC can shut women out.
Emerging artificial intelligence-driven solutions might help to address this bias. Crowdsmart.io, an investment prediction platform powered by AI and an intellectually diverse evaluation committee, claims 85% accuracy in reducing bias. It has so far disproportionately recommended companies with female founders and gender diverse teams. The chair and founder is entrepreneur Kim Polese.
“I don’t want to be completely radical and suggest limited partners use AI to invest in general partners – I’m not saying that,” says Goddard. “But if that’s a possibility, imagine how far we can move from where we are by using collaborative systems, by using electronic systems, by using referral networks and trust networks.”
Everyone’s entering a new normal, says Sudha Bharadia at Advance Global Capital. “[Before COVID] our process would be to do an on-site audit right at the end of our diligence to fully sign off on a deal. If that becomes untenable then we’ll have to figure a better way of keeping on top of the potential risk, but feeling comfortable enough to write new deals.”
An industry standard or consensus around what good looks like for virtual due diligence could help keep capital flowing through the travel ban, “so that at least we have our industry trade association saying this is a best practice,” says one investor. “I can’t construct a virtual DD in isolation.”
Virtual due diligence won’t be for everyone – or not for a while. “It really depends on what kind of portfolio construction you’re doing, where you’re based, what your thesis is, if it’s an urban environment or rural,” said another investor. “Then ultimately, what’s the risk profile of the family endowment or institution that you’re stewarding? And how adept are they at tech-enabled diligence?”