Don’t Take Money from Strangers

Posted on January 24, 2006

Not all private equity investors are created equal. They all have their own agendas, ranging from long-term conservative company-building to flip it fast and get out quick. Make sure you know which kind you’re dealing with by getting to know your potential investors first.

I guess it’s not surprising when you graduate from Harvard that many of your classmates become private equity investors.  But my mind shifted from offense to defense when JR Matthews, CEO of Tregaron Capital said that some of his Harvard classmates were so aggressive that he wouldn’t even do business with them.  Not all Harvard MBA’s are alike.  Some are willing to work in a cooperative manner with management and others are more aggressive in pursuing profits and goals.  I resisted the urge to ask Mr. Matthews for his class roster, but wondered, “How many CEOs take money from ‘aggressive’ private equity sources without really knowing it up front?”

I did ask how many times during negotiations he’s had a seller fully research who he is and how he has treated past sellers.  He leaned back in his chair thinking, and replied, “None that I know of.” I felt embarrassed for my fellow CEOs.

Mr. Matthews has a track record of buying successful firms and helping their management grow the business.  In his most recent deal, only two months after close, he’s already found easy cost cutting opportunities and is bringing IT know-how into the business to create a strategic advantage.  But he’s loathe to share too much of his strategy with a seller before the close since it might raise the seller’s price, or create worry or fear – traditional enemies of the deal.

Do the Research

Investors look closely at a CEO’s past performance, carefully reviewing financial results and other decisions, so they can estimate future returns.  Turnabout is fair play, and is advised.  Get a list of deals they’ve closed in the past few years.  Call, then step on the plane and learn how they treated those that went before you.  Is anyone left from the seller’s team?  Were the earn-outs paid?  Was the seller surprised or upset at how things turned out?  Did the deal turn out well for all involved?  Dig hard to find people no longer associated with the company.  Ask penetrating questions, and if you feel you’ve hit a nerve, dig in and probe more.  No one wants to re-live a nightmare, but hearing the realities is what will save you from one.  If you find that they treated the four or five companies that went before you well, it’s a good sign that they’ll treat you fairly too.

There are lots of private equity investors, and many of them know each other.  Sometimes they are competitors for deals, and other times team up to invest.  Who better to ask about a particular private equity investor than other investors in the same region?  With a bit of networking, one can find several people who will talk about the reputation of the prospective investor.

Look for Expertise

Mr. Matthews pointed out it is ideal when his team has know-how that can be leveraged to help the acquired business grow faster.  It is a bonus for the business as well.  More money is good, but smart, well-connected money is great.  Spend time with the prospective investor to understand their background and experience, and the circles in which they travel.

Style counts too.  Not fashion style, but work style.  The way the CEO’s personality meshes with the investors is really critical to the CEO’s happiness and effectiveness.  Talking to all the references will help assess this, but interactions with investors during negotiations will provide clues as well.  Of course, before the close everyone is on their best behavior, so know that it only goes downhill after the honeymoon.

I don’t have to tell you that for an investor, it’s about the money.  So no matter how nice you think an investor is, they invest for a return on that money.  But there’s more.  Some want high returns fast, and don’t mind risking the business to try and get it.  Others look more to the long term, and take a patient, conservative approach.  Some buy businesses and flip them quickly to some buyer you can’t yet know. A CEO must actively try and flush out of the buyer what their objectives are.  The buyer just wants to keep the sellers calm and ready to sign the deal.  The selling CEO’s job is to drag out of the buyer an accurate picture of the future.  That picture should jive with the actions taken by the investor in prior deals.

Maybe your deal will be the rare one where you are fully cashed out the day of the deal.  More likely, you’ll still have some skin in the game, or an earn-out, or an employment contract.  The wrong buyer can be much worse than no buyer.  Follow the lead of seasoned investors:  Do your homework.

Takeaways: 

1. CEOs must study the potential sources of their funding before taking the cash.
2. Make sure the objectives of the financiers match your objectives.
3. Make sure that their working style meshes well with yours.