Top Six Risks for Private Equity Firms
Market conditions are challenging, interest rates are rising, valuations are slipping, and private equity (PE) deals are booming, spurred on by firms using their vast capital to acquire investments at bargain prices. But, strategic, operational, and external risks represent potentially disruptive forces that can wipe out your investment.
Whether the company is a family business, backed by venture capital, or funded by private equity investors, internal controls are essential as you evolve. Internal controls can be integral to processes that can help mitigate risks and add bottom-line value.
Internal controls and risk management in private equity firms
Public and private companies are subject to different regulatory requirements about financial and operational disclosures, including who receives the disclosures and the level of detail they contain. All businesses can benefit from transparent operations when reporting to stakeholders.
It may be tempting to throw out many of your governance and risk management precautions, but managing risk is essential for PE firms. Private equity firms encounter risk everywhere, from disruptive technology and cyber threats to fraud and regulatory compliance. And new threats are emerging every day.
Top six risks in private equity
Financial Misstatement Risk: While no law mandates you to release your financial statements to the market, investors will still require you to disclose your financial reporting. The most effective way to avoid financial reporting errors is to prevent them with robust controls. Controls are policies, procedures, and technical precautions safeguarding an organization's resources by preventing mistakes and inappropriate actions. Controls, such as the segregation of duties, access controls, automated process controls, and internal audits, can help you prevent errors and increase the ability to detect mistakes and fraud.
Technology Risk: Managing technology risk is a considerable challenge and requires more than information security. Technology risk management must mitigate your firm's risk exposure and all entities to be effective. Risk in your investment entities also poses a threat to your firm. Technology risk management solutions need to grow and change as your technology evolves.
Third-Party Risk: As your investments grow, employing third-party vendors to perform services is common. But increasingly, this exposes you to outside actors, who can easily damage your reputation and investments. Third-party vendors are essential to support operations, but regulators will ultimately hold your firm responsible.
Fraud Risk: Increasingly, organizations are concerned about insider threats. One malicious employee with elevated privileges can manipulate data in your ERP and perpetrate fraud against your organization. Identifying an employee engaged in fraud can take years to detect because they are adept at covering their tracks, know what manual controls are in place, and understand how to circumvent them. Automated controls can reduce this risk by limiting staff members' access to data and systems that can be manipulated.
Cyber Risk: Private equity firms are not immune from cyber security threats, whether from employees, vendors, or other bad actors. Attacks have become common, and spending has increased, but better security doesn't necessarily protect you. According to Gartner, organizations will spend $188.3 billion on information security and risk management products and services in 2023. PE firms evaluating a company of interest's cyber hygiene is as important as assessing its financial health and market potential. Cyber security and reporting supply necessary insights for decisions making pre-acquisition as well as ongoing insights into the cyber posture of a company post-acquisition.
Compliance Risk: Performance is not the only factor in the private equity business models – you must balance costs with compliance. And PE firms face increasing regulatory pressure and scrutiny. You may even be held responsible for the acts of your portfolio companies, depending on the level of control and due diligence exercised. For example, suppose an asset is wholly owned by a PE firm, which controls the Board. In that case, there is a high chance the PE firm will be held accountable if a regulator determines a compliance failure at the portfolio company. An organization prioritizing compliance also helps you avoid successor liability.
How to control these risks
The most effective way to control the risks identified above is to prevent them with strong automated internal controls and access governance. Internal controls are policies, procedures, and technical precautions that safeguard resources by avoiding mistakes and inappropriate actions. Controls, such as the segregation of duties, access controls, automated process controls, and internal audits, can help prevent errors and increase the ability to detect mistakes and fraud.
Access governance solutions can help you prevent risks and help you keep your data accurate and restricted. Restricting your data and systems decreases the risk of that data becoming unreliable. To lock down your data and system access, you need robust access control processes for the automated detection, mitigation, remediation, and prevention of access risk and segregation of duties to mitigate risk. Implementing automated controls and access governance processes is critical to efficiently managing and mitigating risk in private equity firms.
Financial Misstatement Risk
Automated access controls, like Segregation of Duties, are the primary methods used to ensure the accuracy of financial reporting. While private equity entities are not required to comply with Internal Control over Financial Reporting (ICFR), PE entities should adhere to the intent of those regulations, which is to increase trust in financial reporting by establishing reliable systems and controls.
Increasingly, organizations are concerned about insider threats. One malicious employee with elevated privileges can manipulate data in your business application and perpetrate fraud against your organization. Identifying an employee engaged in fraud can take years to detect because they are adept at covering their tracks, know what manual controls are in place, and understand how to circumvent them. Automated access controls can reduce this risk by limiting user access to data and systems that can be manipulated.
Provisioning and de-provisioning access can feel like a guessing game. You can't allow too much access, permitting vendors to entrance to resources or data they don't need, or too little access, where vendors create workarounds to essential resources. The vendor access level must be perfectly balanced. Provisioning and de-provisioning access are often cited as the biggest roadblocks to achieving this, with a lack of fine-grained visibility also a repeated problem.
Most businesses rely on VPNs to secure third-party access. But VPNs weren't designed to manage dynamic privileged access requirements, like policy-based access and session recording. Businesses also lack visibility of third-party vendors' actions once they authenticate, which is a huge concern. A best practice is to record, log, and monitor privileged activities, a common requirement for audit and compliance.
Most data breaches have something in common: poorly secured privileged user accounts. Privileged accounts are cybercriminals' favored means of stealing sensitive data, planting malware, deploying ransomware, or executing other acts against the organization. Bad actors exploit the heightened permissions of these accounts to gain access to the network and infiltrate systems and data. Access policies for privileged accounts and access management enforce the security of privileged accounts, authorizations, data encryptions, and direct integrations to the security platform.
Reducing manual controls significantly impacts the compliance costs of a business. Manual processes requiring the involvement of employees are not sustainable. In the long run, automated compliance controls are more stable because they enable a repeatable, reliable, and predictable framework while lowering the cost of compliance.
SafePaaS can help you prepare for private equity oversight and remove the pain and pressure from pulling together your supporting documentation and evidence. SafePaaS provides the data and security needed for private equity compliance by securing risk across all your business entities and applications, automating manual tasks, and enforcing internal controls.
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