It is a poor organization that fails to learn from its mistakes. And don't be fooled. The press seems taken enough with private equity right now that it is hard to hear a story about a major (or minor) buyout failure. They happen. Often, in fact. But then that doesn't make for good ink right now, does it? Everyone knows that private equity firms are floating in cash. That the mistresses of private equity moguls bathe in the more expensive tiers of champagne nightly to cleanse themselves after their filthy dalliances with their lovers. Who would read a story about the woes of buyout firms. Well, ok, you would probably.
So Sinister looks poised for failure. And this is an interesting lesson.
First, the work you do with your lenders if something fails and after it fails is critical. Every dollar you salvage for lenders from a ruined deal is worth five dollars earned in a success, at least when it comes to credibility. Every dollar you salvage for equity holders in the same circumstance is worth ten dollars earned in a success. (They expect zero from a failure). As a private equity firm, the credibility you gain from slugging through the mud to protect value for your partners in the midst of chaos is critical. How you act in defeat is probably more important than how you act in victory. This is particularly true in highly competitive environments.
So how does one handle a Project Sinister like failure?
At the risk of sounding Sun Tzu (and hence Gekkoesque) deals are made or blown before the closing. A few simple things, and hence rookie mistakes, have put Project Sinister where it is.
First, check the products. Then check again. The mess Sinister is in would be fairly tame if someone had done more checking. We likely would have pulled the expected revenue from the product down to a less optimistic level, extended the time before the product came "on-line" or pulled this revenue line all together for our model. (In this case it probably would have killed the deal because supporting the debt service without this revenue line would have been a difficult bit of math to do).
Think carefully about the incentives and the motives of everyone who
touches a piece of due diligence. Do they have an interest in seeing
the transaction go through? In failing? If you can identify any
incentives that push them either way then you have a problem and you
need to get some more independent views involved. This is, it seems,
exactly what happened with Project Sinister and Jeff, who was counting
on closing this deal to get his cushy CEO position and then to work his
way into Sub Rosa's partnership. Sean, having suggested Jeff, wasn't
the partner to be overseeing Jeff's due diligence efforts. (If there
ever were any).
Unsure about the risk of a given product or service line? Seek assurances from the seller. What representations, for instance, did the seller make about the product that's now imploding? If the seller agreed to stronger assurances then the seller will have to stand behind those and make the buyer whole if something is missing. If not then we should have wondered aloud what it was the seller knew that we hadn't discovered yet. In the absence of a good set of representations and warranties a buyer will often have to sue "off the contract," and that typically puts you into a common law fraud argument. This quickly becomes a difficult (and expensive) process. Still unsure? Lower purchase price. Risk and reward go hand in hand.
Don't get so married to a deal you can't leave it on the table. I cannot say enough about how important this is. The urge to "just do the deal" is powerful. Often, when it is most powerful is when it is the most important to resist it. Let the next idiot pick it up for you. (Hopefully, bid the price up a little bit beforehand though).
In line with this, make sure the decision making structure one has in place for approving deals is independent enough without being overly burdensome. Though I wasn't in the discussions, it looks like Sub Rosa let a single partner (Sean) dominate the decision and "push the deal through." That was a failure in process at Sub Rosa, since there are fairly explicit procedures in place. I suspect they weren't followed. I also expect they won't be broken again.
So it is blowing up badly anyhow? Recognize the danger as early as possible so that if you do end up sitting down with a lender there aren't any surprises. Debt payments sometimes get missed. Covenants sometimes get broken. Waiting for it to happen and then apologizing is a bit more annoying for a lender than giving warning that there might be issues and working with the lender to resolve them or get a cushion for the company before the fact.
Don't throw good money after bad. In the LBO business it is highly
tempting to start supporting the ailing unit "just until it gets on
its feet." Doing this subverts one of the best incentives LBO's have
going: The pain associated with a failure to produce ready cash-flow to
service debt. You probably have your hands on this unit because some
big corporate spent half a decade doing exactly this, feeding every
need of the unit without a thought to cost control or profitability.
This reminds me of certain countries that never have to develop
sophisticated financial and social structures to support themselves
because they have billions of dollars of oil or diamonds in the ground
that foreign firms will be happy to come extract for them. If firms
get used to being bailed out by a moneybags rich parent there isn't
much attention or urgency about cash-flow. This is the kiss of death.
Sometimes firms will fail. The nature of finance must sometimes be
permitted to take its course.
As for Sinister? We'll see.
