Crisis Diligence: Considerations for investors in distressed companies during COVID-19

Before COVID-19 hit North America in earnest, the cannabis industry was already in the midst of a downturn, and investors were beginning to talk about focusing on identifying high-potential but distressed companies for investment. Now, we are seeing an entirely new level of distress across the global economy, and mixed signals from cannabis operators. Many retailers saw a sudden spike in sales as consumers stocked up before staying home; like the run on toilet paper, however, analysts don’t expect this jump to be sustained.

There are undeniably still opportunities for investors in cannabis companies, especially those willing to go in for the long haul on operators experiencing what we all hope will be a temporary crisis. But these challenging times call for a different angle on due diligence.

Here are the factors that we’re keeping in mind when vetting investments for clients during COVID-19. 

1. Understand: Fraud risk is up.

Investigators are familiar with the Fraud Triangle, a model developed by criminologists to explain how individuals become motivated to commit fraud, but it’s less well known to investors. To quote W. Steve Albrecht in Fraud Magazine,

“The triangle states that individuals are motivated to commit fraud when three elements come together: 1) some kind of perceived pressure 2) some perceived opportunity and 3) some way to rationalize the fraud as not being inconsistent with one's values.”

It won’t surprise anyone that “perceived pressure” is heightened during an economic crisis; the financial strain that businesses and individuals are experiencing at this time is historic.

 When pressure is elevated, it becomes easier for individuals who might not otherwise engage in criminal activities to rationalize their actions as necessary, perhaps for their own survival or that of their families.

 All that remains, then, is an opportunity to act. New cash flow from an investment or loan to a distressed business could represent just such an opportunity, especially for embezzlement (we’ve seen issues like this in cannabis companies before, even in better times, such as in the case of Canada Cannabis Corp.).

So how can an investor identify and mitigate this elevated fraud risk? You need to know how much pressure a specific business and its executives are under, and then minimize the opportunity to commit a crime.

2. Identify: Measure the pressure to measure the risk.

Begin by making sure you adequately understand the reason why a company is distressed, and the type of pressure it is experiencing: Is it in trouble primarily because of the external shock of COVID-19, or has the business been mismanaged for a while? How much personal financial pressure are the key executives experiencing?

To answer these questions, we look for signs of financial issues involving the company or its management, such as judgments, liens, lawsuits from unpaid vendors, complaints on social media, and bankruptcy filings. Then we contextualize it: Did the signs of distress start in early 2018, or did they just hit in Q1 2020? 

Keep in mind that with many courthouses closed or operating on limited staffing, lawsuits may be a lagging indicator of financial issues at this point; that’s why it’s important to review what suppliers are saying about the business online.

 When it comes to the company’s executives, does the public record show that they’ve spent their money on luxury goods (say, a much more expensive mortgage and two fancy cars), or have they linked their personal financial well-being with that of the business? A lifestyle that is out of proportion to the performance of the business is a common indicator of fraud risk.

Context matters here, too: We would evaluate debts related to, say, medical care differently from debts related to gambling.

3. Manage: Financial controls are more important than ever.

It’s possible that after identifying the underlying reasons for a company’s distress, an investor may decide to simply walk away. But even in the best case scenario, where a business has been well-managed and its current financial issues are primarily due to external factors, steps should be taken to minimize the opportunity for a fraud to occur. This comes down to implementing or reinforcing financial controls within the business.

In 2008, Boyd E. Foster, Jr. wrote in Fraud Magazine,

“In small businesses it's common for employees to have multiple responsibilities. It keeps overhead costs low and lets managers focus on operations and staying profitable. Employees say they enjoy their jobs because of the variety of functions they perform; owners like to think of it as ‘doing more with less.’ For auditors and fraud examiners it often indicates a lack of segregation of duties and raises concerns of internal control weaknesses.”

Companies in financial distress are very likely to ask employees to “do more with less,” especially in the back office. Add in the cash-heavy nature of many cannabis businesses’ operations and a remote, stressed back office, and you have greater risk for fraud.

To evaluate a company’s internal controls, I recommend working with an accounting firm with deep experience in the cannabis industry, and I’m happy to provide recommendations.