Finlight - The black box – why fraud risks make some private investments so dangerous
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The black box – why fraud risks make some private investments so dangerous

JB Tanqueray

22 July, 2019

By Dr. Ricardo Gomez Alcazar & Madhura Sawant, Forensics & Integrity Services, EY.

While expanding investment portfolios and selecting investment opportunities,knowledgeable investors, be it private or institutional, usually trust their advisors.More often than not, this circle of advisors is rather limited and regularly does notinclude more than a handful of trusted private bankers, consultants or subjectmatter experts, like for example when the investment field is the world of art.

Every once in a while, though, in spite all the knowledgeable consultation and diligence provided, something will go wrong: horribly wrong in fact. The company you invested into in Europe, may wind up in the press because its subsidiary in Belize bribed public officials to obtain a certain permit; or you may fall victim to aproperty condition scam due to false documentation provided or you simply may have immensely overpaid when purchasing a piece of art from one of the great Spanish maestros.

And when that happens, it is not even the fault of the advisors, because they –most of the times – did everything right. Some of the fraudulent schemes or scams which may surface are simply not visible if you perform perfectly solid,financials-only, pre-investment diligence.

A.Private Equity (PE) investments

PE has long been a mainstay of institutional portfolios. But in recent years, as the effects of the financial crisis have receded, there has been a surge in demand forthis asset class. According to the EY 2019 Global Private Equity Survey, investments in new assets rose to $681 billion. Private investors are increasingly looking to add PE exposure in their own portfolios, as low interest rates hit returns available on cash and bonds and fears grow that equities are over valued.

Many investors are aware of the key risks in PE, i.e. operational risk, funding risk,liquidity risk, market risk, and capital risk – and therefore carry out a due diligence on targets for each of the above areas. These financial due diligences generally provide answers to the following questions:

  • Do historical reported results accurately reflect run-rate profitability of thetarget company? Does the target have accurate data to support its forecast?
  • Which factors, if any, will affect the purchase price?

The important aspect to remember here however, is that financial due diligence typically will only cover the relationship between the target and the buyer; it will exclusively focus on the financial data of the target entity.

Sometimes the ugly secrets lie only in the relationship of the target entity with third parties

In the urgency of decision-making, what in some cases gets overlooked, is that the anti-corruption (forensic) due diligence does not – differing from the financial due diligence – cover mainly the financial performance data of the target. It especially focusses on the relationships of the target which could create reputational or legal challenges or which could be the basis for fraud or corruption. These cases are especially common when investing in subsidiaries inremote regions. According to the list of SEC enforcement actions published by theU.S. Securities and Stock Exchange Commission, in 2018, 41% of the actionslisted were related to subsidiaries of internationally acting corporates.

So, what does a forensic due diligence entail?

  • Performance of background research on the target, the target’s key management and major third-party vendors or partners for negative media,government actions, and government connections. This point is important,since it covers the relationships of the target entity and its executives to(local) government officials and authorities. Only through these forensic procedures you could identify, for example, how a specific business unit in aremote region, was able to obtain certain permits or licenses.
  • Assessment of target’s sales channels to detect higher opportunities for corrupt activity. Typically, sales through third-party sales intermediaries, suchas distributors and agents present a higher corruption risk than sales througha direct employee sales force.
  • Assessment of target’s internal controls for high-risk activities specifically related to the client’s industry, known industry risks and the target’s key operating locations.
  • Analysis of the target’s financial information to identify trend outliers and potential corruption red flags. This could include analysis of third-party payments, distributor margins, expenses involving gifts and entertainment,and promotional spend. Such an analysis could isolate specific target locationsand customers that could represent a higher corruption risk based on the geography or industry they operate in (see heat map below).


Transparency International(TI) is an international NGO with a purpose to act against global corruption and to prevent criminal activitiesarising from corruption. It publishes, for example, the Corruption Perceptions Index – the map above represents the Index for 2018.

B.Fraud risks in real estate acquisitions

The variety of fraud patterns in the real estate business is vast. While many successfully invest in real estate, there are others who are not so fortunate andend up losing substantially due to real estate investment scams.

They assured a 16th century chateau in the Loire valley”

In terms of real estate, globalization has made it easier for affluent buyers to invest in real estate overseas. Since the buyer may live far away from the area and may barely visit the property, unethical sellers and real estate agents could falsely claim to have property for sale that is in a good or promised condition. Asubsequent scam cover tactic may involve the sellers insisting on using their inspectors or contractors to give the buyer an impression or assurance that the real estate investment is in good shape.

Investors who are interested in buying properties regularly nowadays first turn to the internet for their property search. Consequently, nowadays, scam artists may also turn to the internet. Scam artists could select listings which do not belong to them and post them on their own website. Scammers may even hack the site of the original listing and replacethe written information with their information. Potential investors are then asked to wire the payment to a third party.

Many real estate investors turn to lending resources to seek investment property financing. Many of these alternative lenders may not have the same standards for property condition as a conventional mortgage lender would, for example. Because of this, these types of lenders often offer loans that come with higherinterest rates and shorter payback periods or offer discounted rates for an upfront fee.

C.Art / Rare items

My Goodness, they are good Sotheby’s New York recently purchased the research company Orion Analytical,whose forensic knowledge is now part of its own brand. When a leading auction house sets up its own forensic department, so it can offer art collectors the additional reassurance of a battery of scientific tests to estimate whether apainting may be a masterpiece or a fake – that tells you how difficult it has become to identify forgery. The forged pieces out there in the market must begood if Sotheby ́s acquire specialized help to identify the forgery. In a controversially discussed report dated 2014, an update by Switzerland’s Fine Art Expert Institute (FAEI) stated that at least half of the artwork circulated in themarket was fake.


Not so limited editions

Similarly, potential investors are tricked into buying rare items which are, inreality, produced by the thousands, thinking they are purchasing “limitededitions”. Any anxieties the buyers may develop are calmed by promising 30-day, no-obligation trials and with “certificates of authenticity”. Participants in auctionsare tricked into bidding high prices for items as auction prices are commonly driven artificially high due to false bids by the scheme’s co-conspirators.

Limit the risk

Most investors do not have the luxury of being able to contact a forensicdepartment specialized on scientific testing of art pieces. So, what can they do? When purchasing art, either directly from the artist or from the art gallery, it isessential to thoroughly assess the accompanying documentation and obtain asmuch information as possible on the piece. The more information there is on thework, the lower the risk. Let’s not forget that the certificates of authenticity andthe accompanying documentation might also be counterfeited, so the supporting documentation should be checked thoroughly when buying art.

Lastly, to avoid falling into these scams, careful research and gaining the right knowledge before making any decisions is always necessary. Remember the litmus test: What seems too good to be true, probably isn’t!

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