Going Private

At Least They Were Warm

Armin spends a lot of time entertaining on the Estate.  I suppose I would too if I owned such a place.  I don't know exactly what it cost but getting curious one night and looking at similar acreage and nearby zip codes on some online high-end realtors websites, well, let's just say he better be focused on getting a return when that much capital is in play.  Not to mention that getting a return on an asset like that is about more than what you expect to sell it for later in life, or what rent you are collecting from tenants (and so far as I could tell the only Tenant Armin had was me).

At first I was a little creeped out.  I had a whole room to myself.  Well, almost a wing really.  I didn't even see the Manhattan office for three weeks.  Eventually, however, I woke up and realized that I was actually lamenting the fact that I wasn't sitting in an office 90 hours a week.  That wasn't normal.

As this had all gone before, I was quite happy to be present for the various dinners Armin hosted.

This particular evening we were hosting the CEO and majority owner of a middle market company, a fast-talking mid-40something guy you just knew worked his way up from nearly a lifetime in sales.  The CTO of the firm, who was so thin and frail looking that I was afraid the breeze in the outer hall might blow him gingerly away and out into the cold night.  I think he said 20 words in the entire evening.  His 15 year old daughter, a black-eyeliner, black dyed, bob haircut goth, who somehow had been talked into bringing her violin to play for everyone.  The CTO's wife, a nervous looking fret of a mother who constantly worried after her daughter's every move and tried to engage anyone who would listen into a barely contained, frantic sounding conversation about child development.  With her for a mother, I'd be a goth too.  And their lawyer, a corpulent, bearded pig who spent the majority of the evening name dropping names I didn't recognize (neither did Armin).  I never discovered if he was their personal lawyer or the general counsel.  I doubt he was particularly effective in either role.

After dinner we retired to the front room and sat around the fireplace to listen to the goth girl play violin.  I sank into one of the deep armchairs in the far corner.  She began to play- she was quite good, and coaxed out some very difficult classical pieces.  I closed my eyes, tilted my head gingerly back as the three glasses of red wine were beginning to take deeper effect.

In the middle of what must have been a Mozart piece I opened my eyes for some reason and saw the CEO, CTO and the lawyer all sitting against the far wall and suddenly realized they were all wearing slightly different colors of the same knit Mr. Rogers sweater.  I immediately began to sink into a spasm of uncontrollable laughter which I had to suppress by imitating sneezing.  It was entirely unrealistic sneezing, so I tried to play it off as if I had aspirated wine, converting my crude snarfing into coughing.  This wine thing was hard to substantiate, as my wine glass was sitting, empty, in the other room on the dining room table.  Everyone looked at me, including the goth girl, who, to her credit, kept playing.

I shook my head as if to indicate I was alright and finally stifled the laughter.  I could barely contain myself.  I was in the middle of a gothic violin recital for a fucking Mr. Rogers convention.

We didn't buy the company.

Swords at Dawn

If in the course of a discussion, during which the rules of politeness have not been transgressed, but in consequence of which expressions have been used which induce one of the party to consider himself offended, the man who demands satisfaction cannot be considered the aggressor, or the person who gives it the offended; the case must be submitted to the trial of chance.

But if a man sends a message without a sufficient cause, he becomes the aggressor; and the seconds, before they allow a meeting to take place, must insist upon a sufficient reason being manifestly shown.

All these are insisted on because the selection of the weapons and the kind of duel rests with the offended party.

The swords are measured to ascertain that they are of equal length, and in no case must a sword with a sharp edge or a notch be allowed.

The combatants are requested to throw off their coats and to lay bare their breasts, to show that they do not wear any defence or cuirass that could ward off a thrust.

A refusal to submit to this proposal is to be considered a refusal to fight. If, on comparing weapons, the swords are found to differ, the choice must be decided by chance, unless the disproportion is of a material nature.

At the word ALLEZ, "commence," they set to, the seconds holding a sword or a cane, with the point downwards, and standing close to each combatant, and prepared to stop the fight the moment the rules agreed upon are transgressed.

Unless previously stipulated, neither of the combatants is allowed to turn off the sword of his opponent with the left hand; should a combatant persist in thus using his left hand, the seconds of his adversary may insist that the hand shall be tied behind his back.

When one of the parties exclaims that he is wounded, or a wound is perceived by his second, the combat is stopped; but with the consent of the wounded man it may be renewed.

If the wounded man, although the combat is ordered to be stopped, continues to press upon his opponent, this act is equivalent to his express desire to continue the conflict; but he must be stopped and reprimanded. If, in the same circumstances, the combatant that is not wounded continues to press on his antagonist, although ordered to stop by the seconds, he must be immediately checked by them, and considered to have infringed the rules.

- Andrew Steinmetz, "The Romance of Duelling in all Times & Countries" (1868)

As with much written by Steinmetz about dueling and gambling, there are direct parallels to Steinmetz everywhere in Private Equity.  We could easily be discussing the process of putting a company in play, and going to due diligence in the passages above. In Private Equity the weapon of choice is usually the discounted cash flow analysis.  (DCF).

The concept is simple.  What would you have to pay me today to forgo $1,000,000 per year paid for 10 years?  It should be obvious to most that the chance of seeing $1,000,000 next year is worth less than having $1,000,000 this year.  This is the time value of money.  How much less?  That depends on how risky you think things are.

Clearly, we think that a loan by a bankrupt company is riskier than a loan from GE.  We quantify how risky we think these obligations are with something called the "discount rate."  It's the return we need to see on the capital at risk in order to be compensated for that risk.

That said, when we guess what a company will spill out to us in "free cash" each year and apply the discount rate back against it, we then decide how much those cash flows are worth paying for today.  The higher the risk we perceive, the higher the discount rate, and the less we are willing to pay today.

It should be clear that sellers have several interests here: First, to boost revenues.  This will, holding all else equal, boost free cash and thus boost the value of the firm. Second, to minimize costs.  This will, holding all else equal, boost free cash and thus boost the value of the firm. Third, to keep the "discount rate" low.

These, dear readers, are the protocols for the DCF duel.

The duel can begin anywhere.  In discussions fostered by the LOI.  Before the LOI.  In the management meeting.  After the management meeting.  Anywhere.  But it typically starts in the same way.

Last month I was engaged in a fencing match along these lines.  I recount it to you now set to the background of the mortal duel fought in 1613 between Lord Sackville, 4th Earl of Dorset and Edward Bruce, 2nd Lord of Kinloss, over Venetia Stanley, the grand-daughter of Edward Stanley, 3rd Earl of Derby, and who was 13 at the time.

The part of Lord Edward Sackville is played by me.
The part of Lord Edward Sackville's Second is played by our attorney, Michael.
The part of Lord Edward Sackville's Third is played by our banker, Thomas.
The part of Lord Edward Bruce is played by the company's CFO, Ike.
The part of Lord Edward Bruce's Second is played by the sell-side investment banker representing the company we are considering purchasing.
The part of Lord Edward Bruce's Third is played by the company's general counsel.
The part of Venetia Stanley is played by the company.  (It's a non-speaking part).

Act I

Scene, Manhattan, an elegant boardroom encompassing an obscenely expensive conference table, leather chairs and a wide range of expensive looking (but probably cheap) art on the walls.  Present are Lord Edward Bruce, and the Friends of Lord Bruce, his Second and Third.

Enter Lord Edward Sackvlle with Second and Third, armed with swords and bucklers (pens and laptops).

Sackville's Second: "Gentlemen.  I think everyone knows everyone else, so let's just get started, shall we?"

Handshakes all around.  The newcomers sit.

Bruce's Third: "Alright.  We have reviewed the provisions in your LOI and I have to say we don't feel we are very close on the purchase price."

Sackville: "What exactly do you base that on?"

Bruce: "I don't know who put together the valuation, but it needs to be reviewed.  It's quite low."

Sackville (offended, icily): "I did the valuation."

A brief silence.

Bruce: "Management's projections are realistic and conservative."

Sackville: "Which are they.  Realistic or conservative?"

Bruce (annoyed): "Look, anything less than 7 times [this means 7x EBITDA] isn't worth talking about."

Sackville: "Where are you getting that figure from?  We aren’t going to pay 7 times just because that's management's favorite number."

Bruce's Second: "Ok, ok.  Let's bring this back to reality.  Do you have specific issues with management's projections."

Sackville: "Well, yes, we do.  Shall we go over them?"

Bruce's Second: "I think that would be a good place to start.  How did you do the valuation."

Sackville: "We did a discounted cash flow after making adjustments to management's projections, of course."

Bruce's Third: "I'm certain that if we go over those you will see our perspective on the company and why we are optimistic."

Sackville's Third (aside to Sackville): "First realistic, then conservative, now optimistic."

Sackville (drawing sword/laptop): "Ok, let's start with the projections management made for revenue growth."

Bruce (drawing sword/management spreadsheet): "Alright."

The two salute each other.

Sackville: "You show revenues of about $156 million in 2005."

Bruce: "Yes." Sackville (a gentle thrust): "Those are audited?"

Bruce (a weak parry): "Yes.  Well, no.  Not yet.  We are expecting the auditor's to finish up soon."

Sackville: "Soon?"

Bruce: "Soon."

A long pause.

Sackville (steps forward): "Ok.  Now for 2006 you are forecasting $185 million."

Bruce: "Yes." Sackville (a quick lunge): "Growth of 18.5%?"

Bruce (another weak parry): "Yes."

Sackville (a second thrust): "In an industry with an average of 8.5% growth over the last 5 years?"

Bruce (stumbling back): "We have several new initiatives which we feel..."

Sackville (sensing weakness, presses the attack): "In the same industry?  Or are you moving away from your core competency?"

Bruce (wavering): "We're not unfocused if that's what you mean."

Sackville: "So in the same industry.  You're not going to start making plastic bookends, right?"

Bruce: "Same industry, but we feel..."

Sackville (a quick slash drawing blood from Bruce): "See, this is the problem I have with your projections.  You are forecasting 18.5% growth in the year after a transaction when your company, by your own figures, has never seen more than 9% growth in the last 7 years.  I might add that the number one player in the industry averaged 11% growth over the last 3 years and their record growth year was 12.4%  How are you going to get..." (Looks at the figures) "18.5% in 2006, 22.0% in 2007, 16.0% in 2008, 13% in 2009, 12% in 2010... The list goes on.  It looks to me like someone just picked a bunch of even percentages and figured revenue forward that way."

Bruce (wounded): "We are quite confident in the numbers."

Sackville: "Did you do a revenue build-up?  Or did you just pick percentages?"

Bruce (wounded twice): "We didn't 'just pick' anything."

Sackville: "Did you do a revenue build up?  Is there some way I can see where these huge growth figures are coming from?  Which products are contributing what?"

Bruce (pushed to the ground): "I'll get back to you on that.  I am sure we have something."

Sackville (backing off to let Bruce get back on his feet): "Alright, that would be helpful.  Let's do this.  For the moment let's just give you 11.5% growth.  Better than industry average, yes?"

Bruce: "I don't think that's right."

Sackville: "Well, we certainly don't think 18% is the number.  Even 12% is generous here, I think, but let's use that for the moment, at least until I get those buildup figures, ok?"

Bruce: "Alright, alright."

Sackville (cleaning the first blood from the sword/typing into excel): "12% across.  Ok.  Now, why is your cost of goods sold steadily decreasing every year?  You're at 64% of revenue in 2005 but by 2008 you're down to 61%.  How does that come about."

Bruce: "We've instituted improvements in our processes."

Sackville (renewing the attack): "Well, this would put you at the top of the industry for cost of goods sold too.  The industry average is 63.6% and the only player I could find with lower is a Chinese firm that doesn't even sell to the U.S.  They were 60.5%  How are you going to be at 61% in 2 years?"

Bruce: "Part of that is through outsourcing arrangements."

Sackville: "You're already outsourcing 65% of your production costs, how much more savings can you get?  Look, let's flat line that at 63%.  Top quartile in the industry.  We can live with that for the moment, can't we?"

Bruce (weak counter-attack): "Well I really don't think that's a good figure.  We can do better than that."

Sackville: "Do you have pilots you've done?  Have you gotten vendors to do studies?  Where do these figures come from?  It looks to me again just like someone picked a nice even number.  It's not even 61.02% it's exactly 61%.  Look, let's flat line it at 63%.  We can come back to it."

Bruce (wounded again): "Alright."

Sackville (a brutal stab now): "Typically, I'd go into add-backs next, but let's just see where we are, ok?  Just changing the revenue figures and the cost of goods sold figures to be in line with the industry, no at the HEAD of the industry, my DCF shows $196 million."

Bruce's Second (crying out): "That's WAY out of line."

Sackville: "Ok, well, where did this $350 million figure you have come from? I assume that was a discounted cash flow?  Something of the sort?"

Bruce: "That's right." Sackville: "Well, what did you use for your discount rate?"

Bruce: "11%."

Sackville (lunging again): "11%?  I could get 12% out of the S&P 500 in 5 years.  Are you trying to tell me this middle market company here is no riskier than a strong index fund?"

A long silence.

Sackville: "Ok, you did the discounted cash flow at 11%.  Did you apply a liquidity discount?  It's not like the buyer of this company has a ton of liquidity here folks.  20% even 30% of discount on the final DCF figure is not out of line in a case like this."

Bruce lays on the ground, bleeding from multiple wounds.

Sackville: "Alright, maybe we should take a break."

Exeunt all but Bruce and his Second and Third.

In this case we fought another 30 minutes, they seemed to even acquiesce to our points.

In the duel between Sackville and Bruce, Sackville killed Bruce, but then found that Venetia Stanley had decided to marry Sir Kenelm Digby instead.

You can win the duel over a DCF and still lose the company.  This company sold for $365 million to someone else (thank god) dim enough to buy management's assumptions without fighting a duel. 

They've gone through 3 layers of layoffs already, even though the company was already having problems meeting demand, and it's hard to imagine how they will survive given all the debt they took on.

As you may have noticed, this week is Andrew Steinmetz week.  What can I say?  I'm feeling romantic. 

The graphic is from Jean-Léon Gérôme's "Duel After a Masked Ball" (1857). -ep

Project Sinister

Being at the upper end of middle management (or the lower end of senior management?) in an buyout firm means you spend a lot of time dealing with portfolio companies.  In theory I don't mind that.  In fact, I always thought it would be a plus and add some variety to the job.  It was even part of my "early employment theory."  You know, the lofty aspirations you have for how cool your finance related job is actually going to be.  I did, after all, want to use my strategic and marketing casebooks.  Those are fixed assets.  They were expensive.  I need a positive Return on Assets figure for them.

"Sinister, LLC" is a portfolio company on the left coast.  Sinister has issues.  Armin would tell you that the problems started after a bad month in November.  Personally, I think the problem was that we bought the company.

Sinister was snapped up just before I joined the firm.  Good thing too because I would have put all my waking hours into sinking the acquisition.  It is not that the firm doesn't have potential.  It is not that there are a bunch of Stanford grads running it.  It is not that it isn't in an interesting industry (financial services, basically).  It is not that the firm's name starts with the wrong letter.  (You know, I've given it time and effort but I still can't get over what a yahoo Kawasaki is).  It is that the firm's management and sales team have zero concept of what it means to work for a living.

Part of the role of being a parent to the firm is nurturing and helping the firm along.  Of course, we don't do this because we are the Red Cross.  We do it because that big debt payment needs to get serviced with regularity.  We do it because we paid for the damn thing and we want our money back.  Yesterday.

Building value in a daughter firm means that, at least if you want to be credible, you need to have some kind of operational expertise.  It has grown quite fashionable among LBOs to claim a high level of operational expertise.  It shows your limited partners that you can extract value out of a firm by doing more than just restructuring the balance sheet.  You can build revenue.  You can help the firm excel. Well, most firms.

Right after we bought Sinister we pushed them to put together an entirely new product line.  Armin thought it up and cracked the whip until something presentable was crafted.  I had mostly been able to avoid entanglement in Sinister's affairs until late last month when I was asked to help review some materials for the product line.  They were mostly ok. Perhaps a little techno-babble filled, but that was to be expected as the development team was composed of 6 Ph.D. holders and one graphic designer.  A little tailoring and it was a solid B+ presentation.

This month, through no small amount of effort and the leveraging of a series of personal contacts, Armin managed to secure for Sinister a Wednesday meeting with one of the members of the "Hedge 100" list, the top 100 hedge funds in the world ranked by size of assets under management.  It should go without saying that adoption by this firm of Sinister's product would, by itself, make the firm.  It should also go would out saying that this would, therefore, be the biggest and most important sales call Sinister's sales team would make. Should go without saying.

Armin, quite cleverly in my opinion, generally has visiting luminaries, be they from clients, limited partners, daughter firms or even competitors, stay at the estate if their visit is to be short, so when 3 of the Sinister team were put on the list to make the sales call in Manhattan their efforts to book rooms at the Peninsula ran into a hard stop (against a brick wall).  Instead, they have been booked at "Chateau Armin."

You would think this presented no problem.  Chateau Armin is, in fact, much nicer than the Peninsula.  Particularly, as it happens, with respect to scenery.  You would think.  You would think wrong.  In fact, the whining was so intense it prompted a detailed review of the last 18 months of expenses and, though he won't know it until Friday, one of the team has already lost his job on this account.

Two days ago, because I made the tactical error of agreeing to review the materials last month, I was asked to review the sales presentation and provide some direction.  Herein lay the abyss.

Yesterday, I arranged a conference call with two Ph.D. Vice Presidents and the sales guru assigned to the project.  Of course, the first thing I asked for on the call was the PowerPoint presentation.  It took me 20 minutes to finally extract from them that there was no PowerPoint presentation whatsoever.  None.  This is now two days before the meeting with the hedge fund.  Well, there was really no reason for us to be talking then, was there?  They should immediately put one together and we would reconvene in three hours.  I set up a conference line and went off to other things.

As is my habit, I called in 10 minutes before the appointed time and left the speakerphone on mute, listening to the hold music and trying to pretend it wasn't bad.  The meeting time came.  And went.  And so did 10 minutes.  Then 20.  I called into Sinister's offices and asked for each one of the scheduled participants.  Their morose voicemails greeted me with taunting malaise.  I had them paged.  That only returned 15 minutes of holding, 5 for each of the AWOL participants. Finally, tracking down the head of marketing, I managed to determine that all three of them had been out of the office for the last 90 minutes.

"Where in the world are they?"  I was so foolish to ask.

"Well, I expect given the hour that they are at lunch."

"For 90 minutes?"

"This isn't New York, you know."  Oh, that's quite clear, I think.

Cell phones rang the full 6 rings (telling me they weren't turned off, I was just being ignored) after which even more morose voicemail recordings were the only reward for my efforts.

By this time I was tempted to pass the issue up to Armin.  Mind you, I don't like to be a tattletale, but I, to some extent, was on the hook for this presentation and I knew the lengths Armin had gone to in securing this meeting.

When I finally got the three stooges on the phone again (don't worry, they had been at a "working lunch") I was told to take it easy.  They had matters in hand.

"How many slides is the presentation."

"Twelve."

"How long have you scheduled the meeting for."

-silence-

"You have given them a timeframe right?"

-silence-

"Ok, who is presenting?"

-silence-

"Is anyone presenting?"  I could feel the anger, swelling in me.

"Hey, Dave, why don't you do it?"

"Yeah, ok, cool.  I'll do it."

"Ok, are you bringing a projector?"  Personally, I think this is critical.  Why depend on someone else's machine which you have never used before at someone else's facility?  I can't tell you how many times I've been witness to the embarrassing desktop icons on some young presenter's laptop revealed to a laughing audience of twenty because the wrong button was pushed on the projector.

"Well, don't they have one?"

"I have no idea," I replied.  "Hasn't anyone called them?"

-silence-

"Ok, so have you talked to their IT department?  You do plan to do an online demonstration right?  You will need an internet connection, right?"

-silence-

"Guys, you are the sales team.  Who is it you think is going to do this for you?"

"Well, we thought that since it was your contact that all that stuff would be arranged," whined one of them.

"Yeah," chimed in the fat one, Dave.  "Will there be food?  And diet soda.  I can't drink non-diet soda."  Given his bulk, how he was even going to remain standing for 12 slides was beyond me.  Then it occurred to me that the real problem was the food.  Maybe he could remain standing all that time, but he was never going to make it 12 slides without eating.

I have this problem.  I think in Technicolor.  Even about bland things.  Blue skies when I make airline reservations.  I see the Google logo whenever I think of bubbles.  Suddenly, the vision of a fat, slobbering Dave, talking about statistical values with his mouth full while desperately trying to cram down his throat yet another one of the wet, squishy, yellowish muffins that always seem to haunt lunch plates at financial services firms struck me.  Crumbs on his chin.  Moving as he spoke.  One of them just about to fall off, hanging on for dear life to avoid the fate of his comrades, squished ignominiously into the $200 per yard carpeting in the executive conference room.

Oh my god.

I counted to ten in my head.  "Breathe," I thought.  "There's no need to vomit.  Really.  That mouth watering you are feeling is just a trick of the brain.  Breathe.  Breathe."

It pains me to even continue to relate the rest of the conversation. Suffice it to say I spent the better part of today doing their presentation for them.  That's the rub when you are the parent firm. You own them.  Even if they are a bunch of fuckups you have to carry them.  Much as you might want to, you can't fire the entire sales and marketing team.  As a result, they are almost rewarded for underperforming, particularly if you've already cut staff to the bone, because you parachute in at the last minute and pull the slack in when they trip (or are caught sleeping) on the job.  Why work?  Our wonderful parents will save the day!  Hey, does the Peninsula have in-room massages?

So here I was.  We were flying three sales boobs over just so I could do their entire presentation for them and they could blithely handle the subsequent Q&A session.  (I am due to go to Europe for a transaction today but know this is how it will turn out instead). Subsidizing mediocrity.  There is nothing closer to anti-matter to me. It is the bane of my existence.  It is time I should spend on the next deal wasted on the pits of the last one.  I know that will sound arrogant to the non-industry readers.  You industry people know exactly what I mean though.

Don't you?

Invisible Executives

No one knows where the Sinister, LLC people are.  Apparently, they left early in the morning from the left coast to get to the Estate, but no one has their itinerary.  There's a rumor that flights are delayed because of an outage in New York's ATC radar, but no one knows what flights they took.  No one knows how they expect to get to the Estate from the airport.  No one knows if they even know where the Estate is.  No one has seen the presentation they are due to give.  No one knows if they took a projector.  Efforts to get someone else at Sinister to see if a projector was missing resulted in the answer: "Three projectors are missing."  Now there is a witch-hunt for projector thieves raging in the Sinister hallways.  To find the missing projectors, the head of IT for Sinister has been calling every employee into his office one by one and pretending he's a main character in the TV Drama Law and Order.

Unconcerned with the projectors, Armin has instead devolved into calling everyone he can get to answer the phone to grill them about the location of the missing executives.  It is Armin's habit, in circumstances such as these, to vent to me and poll me repeatedly for my opinion.  My challenge, in this circumstance, is to totally avoid rendering an opinion.  It is all downside for me, this rendering an opinion business.

If I echo his present disdain, it is just as likely as not that he will reverse his position and seem apologetic on the subject for a solid week.  (It won't stop him from just as apologetically firing someone's ass, but it makes me feel like a callous old heel).  If I counter it, then the firing he does anyhow becomes the physical manifestation of my error.  Not to mention that if I render a strong enough opinion I actually have the quite dangerous potential to spur drastic action on Armin's part.  I think two executives were the unwitting collateral damage related to my learning curve on how much power I had, inadvertently, been wielding. Of course, I could also be roped into "solving" the problem, if I gave any sign that I agree there is one.  No, it is better that I try to remain neutral.

"This is very rude, you know," he starts, standing at the doorway of the library, which is one of my sometime-unofficial workplaces at the Estate.  Uh oh.  I keep my nose buried in a stack of financials.  I resist the temptation to murmur.  It is hard to make a murmur neutral sounding.  (Try it.  No really.  No one's watching.  Try to murmur without conveying a value judgment.  Anything that sounds neutral gets mistaken for agreement with the speaker, I think you will notice).  So, I sit silently.  Trying not to even turn a page for fear it will keep his attention.

"They are guests in my home and I have no idea when or in what number to expect them," he delivers this as if he is talking about a flock of sheep, or the Wehrmacht or something.

"There are three of them."  Fuck.  I couldn’t help it.  I should have kept my mouth shut.  He sucked me right in.  Armin - 1.  EP - 0.

"What?  How do you know this?  You spoke with them?"

"Well, yes.  Yesterday.  I..."

"Do you have their schedules?  Why didn't you tell me?"

"I do not have their schedules."

"Then how do you know there are three of them," he demands, suspicious that I am hiding critical information from him.  I can hardly blame him.  He was a CEO of a Fortune 500 company in the 1980s.  I bet all his subordinates feared to give him bad news.  And since you couldn't really determine in advance what the CEO would think was bad news, it was safer to just keep your mouth shut.  Sort of like I am right now. I would be ashamed if I wasn't prone to be really vocal with respect to pending deals, negotiations and valuations.  It is just these petty daughter firms, particularly the ones that predated me, that just don't hold my interest.  It is not that I do not want them to do well, it is just that I don't have any real emotional stake in them.  I'm such a snob.

"Well, there were three of them on the conference call."

"So does that mean there are three of them coming?"

"No," I admit.  "I guess not."  For a minute I think I've escaped.  There's a long silence.

"This is outrageous."  That's it.  Now I know someone is losing their job.  "You do not behave like this.  It's entirely unprofessional." He's moved off of "angry" and into "resolved."  Someone's head is already on the floor.  The body is still twitching around.  Blood everwhere. Whoever it is, they don't even know they are dead yet.  At this very moment they are probably happily sipping wine in a leather covered business class seat trying to determine if the flight attendant will sleep with them and if so how they can swing meeting her later after the pesky meeting they have to attend in the morning.  "I want you to speak with them.  I want you to find out what the hell they think they are doing.  And then, I want you to call me."

Fuck.

Swim Team

The "fall party" was in September of 2005.  Typically, we host around 200-300 people on the estate for a day of food, wine, socializing, industry gossip, and whatever other trouble people can get in. Before the main party there is always a little party "ex ante."  Since all the outdoor tents, the tables, the liquor, and a good bit of the food are already present, Armin takes advantage of the infrastructure to entertain 30-40 people the night before.  Armin is all about extracting value.

Armin's wife had been making some changes to the landscaping around the Estate's driveway all that week.  Apparently, one has to make these particular changes before frost sets in so there is a huge demand for landscapers just before the winter months.  I have no idea if this is true, but one of the associates, who seems to regard himself as an authority on every subject that might potentially enter into a conversation, mostly I think by liberal use of bullshit, made this claim when I asked why a huge part of the hedges bordering the driveway had been removed and covered with gravel.

I wanted to catch him on his bullshit (I've been wanting to do that for a long time) but as with any of his claims, this one was impossible to verify without obtaining an advanced degree in landscape design and by the time two hours had passed I'd forgotten all about the little promise I made to myself (probably when I was a bit more sober) to look up the latest little stinking tidbit he had offered up.

As it was, I was walking into the main house for a glass of wine right around 5:00 or so.  I had just found the bottle and was starting to pour my first glass of the day when I heard the most alarming scraping sound from outside and then a loud splash.

The teenage daughter of the head of one of the largest hedge funds in the country had driven her brand new Saab straight through the gap in the hedges and right into the swimming pool.

Haemoglobin

It is true that I only grudgingly accept assignments involving the care and feeding of daughter firms, particularly when I had no part in the acquisition, but be this as it may I do take the assignments I am given quite seriously.  It is in this way that I discover the location of the Sinister team.

Quite a clever bit of detective work on my part, if I don't say so myself.  I happen to know that one of the Sinister sales team members, let's call him "Tom," is almost certainly sleeping with another Sinister employee, let's call her "Linda."  Linda has no idea I know this so I figured calling Linda at Sinister's headquarters and insisting that there was a medical lab calling with something about "test results" was a good way to find out where Tom was.

"Hi, Linda, it's Equity Private from your benevolent parent company."

"Oh. -pause- Hi, Equity."  (Linda doesn't like me very much because I delivered the news that three people in her department were getting laid off right after we bought Sinister).

"Look, this guy from Hemotest Labs, California keeps calling here asking for Tom."

"Hemotest?"

"Yeah, some kind of medical test results or something?  Anyhow, I need to reach him and I know he is traveling in New York but no one has his itinerary."

There is a long pause.  Linda doesn't even think to ask why I am calling her about Tom or why the lab would be calling me, the panic has already set in on several levels:  1.  What is this medical test result thing about?  2. Whenever the parent company calls, it's trouble.  3. I wonder if Tom will be mad if I tell Equity where he is.  4.  Does Equity know I'm bumping uglies with Tom?  5.  Does Tom's wife know I'm bumping uglies with Tom?  6.  I wonder if Tom is sleeping around.  7. Wait a minute.  He's cheating on his wife with me... why would I think he's not cheating... that bastard... I'll...

"Linda?"

"Oh.  Sorry.  Uh, why don't you give me the number for Hemotest and I'll give Tom the message."

"Oh, Linda, I wouldn't have bothered you with that sort of thing.  The Hemostat guy insists that he has to talk to Tom personally.  He won't tell me anything at all.  Apparently, it's some kind of confidential test result or something.  Heee-moe-test.  What do you think they test for?  Anyhow, I really have to reach him.  These people keep calling here and the partners are starting to ask questions."

"Uh.  Well.  I think Tom is at the Peninsula Hotel."

Duh.  Should have figured that.

"Ok, I'll try that.  Thanks Linda!"

Tom isn't the only one.  All three of them are at the hotel.  Calling their rooms is a useless endeavor.  I am sick of the hotel's scratchy, and somewhat bitchy, generic voicemail message by the third time I hear it.  I commandeer Armin's driver and head into the city.

Maybe I'm the only one, but I have to think that it would be obvious to anyone that if a VP of your parent company has to come hunting for you because no one can find you the day before a critical presentation, you might have made a career limiting move.  Apparently, it wasn't obvious to the Sinister sales team.

I tell the driver to wait nearby, copy down his cell phone number and walk up to reception.  Of course, none of the team are in, or if they are they aren't particularly disposed to answer their phone.  Getting room numbers from the suspicious and savvy staff at the Peninsula's front desk is going to effectively be an impossibility.  (I remind myself that should I ever want to have a discrete affair with someone the Peninsula is a good bet to keep the matter quiet).  Instead, I leave notes ("Medical Emergency.  Call Equity Immediately: [cell phone number]") for each of the team members and after taking a quick peek in the almost totally empty Bar at Fives I camp out in the lobby.

I should have brought a book.

Detrimental Reliance

The Peninsula is a beautiful hotel.  It does, however, feel a bit cramped.  The lobby seating foyer feels more like a little alcove.  A couch and two chairs.  The chairs are terribly uncomfortable.  The couch is the only realistic seating option if you are going to be there for a while.  I was going to be there for a while.  Then there is the little girl, probably 5 years old, running around and up and down the stairs in the throws of what can only be a major sugar high.  I am sorely tempted to hurl one of the throw pillows on the couch at her.  Instead, I try to entertain myself by doing as much business on the phone as I can. 

I toy with the idea of getting up and buying a book to read, but I know that the moment I do the entire team will walk in.  I have no idea how long it took but they eventually walked in, bright as day, pleased as punch with themselves.

Tom, the VP of sales, is their unofficial ringleader.  I've only met him once before.  Dave and Hal, on the other hand, both know me.  I walk right up to them before they even have a chance to gauge my approach.

"Gentlemen."

They freeze.

Step back for a moment and consider the scene.  There is something highly backwards about private equity when it comes to hierarchy.  Here I am, not even 30 yet, and I have more clout than the CEO of their firm.  The perception, right or wrong, is that heads roll, divisions are diminished and products eliminated at the whims of young, MBA'd upstarts like me.  If we are prone to get big heads quickly in private equity, this is why.  Here is an "experienced" sales team, terrified by the likes of me.  Or, perhaps more accurately, the power of the entity standing behind me.  I, of course, play it up whenever I can.

"We have a serious problem and the Senior Partner has asked me to come down here and speak with you."  I always say "Senior Partner," with capital letters on it when I am on a "force projection" mission for the firm.

Tom managed to collect himself, barely.

"Equity.  What a surprise!  What are you doing down here?"

"I just told you that.  The Senior Partner has sent me here to collect you and put things back on track for the meeting tomorrow."  I love the phrase "put things back on track."  There is no opportunity to argue that things never got off track.  There is only the discussion about how to put them back on track.

"Well, I think we have that in hand already," Tom begins.  I cut him off.

"The Senior Partner does not share your optimism."  I am convinced that slightly modified Darth Vader quotes are a badly under leveraged asset. I have been using them, and I think with good effect.  "This is what we are going to do.  We are going to sit down, go over the schedule and the presentation tomorrow and then I am going to decide if we need someone else to manage this process in your stead. What we are not going to do is discuss why you three are checked in at the Peninsula, or the anger of the Senior Partner's wife, who has been slaving in the kitchen all day to prepare the dinner that any moment will be slowly getting cold on the large table in the Senior Partner's dining room on 3 plates placed carefully in front of three empty seats in which your respective asses should be sitting at this very moment."

Surprisingly, and to their credit, the three of them obediently took a seat in the cramped lobby alcove and began pitching me their presentation.

It sucked.

Two hours later, it sucked less, but it still sucked.  I despaired of the debacle that would be tomorrow's presentation.  Whatever, it wasn't going to be my problem anymore.

I called Armin and gave him the long summary.  He was very quiet for a very long time after I finished speaking.  After a ten second pause that seemed an eternity I broke the silence.

"Armin, they are going to need some adult supervision tomorrow.  Left to their own devices I shudder to think what might happen."

"Good idea.  Go with them and take charge of the presentation.  I am relying on you."  -click-

Fuck.

Never Hire a Latte Drinker

I was wrong about Sinister's sales team.  They aren't hopeless.  It is the Vice President of Sales, Tom.  He's hopeless.  The thing about some "techie" or "engineer" professionals is that there are so focused on their own fields that they are often socially maladjusted.  Social ineptitude is often, I am told, a sign of great genius.  Sinister's sales team seems to be a data point right on this regression line.

After being tasked with managing this entire sales call, as if I were a sales guru, I snagged the last hotel room at the Peninsula and hand-held the team through at least a passable presentation.  This was no easy task given the fact that I knew exactly nothing substantive about the product.  I learn quick, or at least that's what my resume says, so at the very least I could talk the talk by the next morning.

The day started off with a 20 minute panic as we waited in the hotel lobby for Tom.  I got tired of saying "Where the hell is he" after the third time and, instead, sat brooding and thinking to myself that I would rather be just about anyplace else at all.

20 minutes after our appointed departure time Tom waltzed in with a Starbucks Latte in his hand.  Not a care in the world.  "Hey guys."  I could have killed him.  Later, when I described the incident to another Sinister employee the reply was, "That guy moves like old people fuck, and if you put a latte in his hand, you have to half that speed."

We all piled into a taxi (I took the front seat) and lumbered through the city to our destination.  On the way I handed a massive bag of danish, bagels, banana bread and granola bars I had snagged from the local upscale coffee shop to the back seat.  I thought Dave's eyes were going to bug out.  He set upon the bag like a big cat on the Serengeti.  There was nothing left by the time we had traveled 2 miles.

As we got closer, I shot a cross look at Tom.  "I will do the talking today.  You need to just be a fly on the wall."  I turned around and gave him the back of my head before he could reply.  All the while, I imagined him making obscene gestures behind me and almost spilling his latte.

You know a hedge fund is bursting at the seams with money when the refrigerator that holds the soft drinks for the late working employees is a Sub Zero(tm) with digital temperature controls.  This hedge fund was clearly bursting at the seams with money because I found four such refrigerators in the short span of our visit.

The presentation was a bravado performance.  I had completely despaired of it being even mildly successful.  The presentation slides were weak.  I feared Dave would be eating the entire time.  I feared Tom would break in and offer to reduce the price of the product to half of our cost.  I feared our techies would veer off into the never-never land of tangential trajectories.  I feared the audience would see through our thin veneer of competence and confidence.  In reality, I had nothing to fear.

I am still convinced that it was the breakfast bag I had handed Dave that saved the day.  Once I made the introductions I had been prepared to lead the entire discussion, referring to Dave and Hal only when necessary and completely shutting out Tom.  Totally unnecessary.

Dave took the floor and threw himself into the presentation with full force.  He delivered succinct and effective points, highlighted the exact features of the product that the quant guys in the room wanted to have and spun any barbed questions into a triumphant outline of why the product was the best thing since the discovery of portfolio management theory.  The passion he had for the product, heretofore concealed beneath a silent and brooding exterior, hemorrhaged from him and filled the room with the sweet, oxygenated plasma of enthusiasm.

By the end the quant guys were begging for more details, looking up into their eyebrows and imagining all the time and effort they were bound to save and all the money they were going to make for the firm.

It dawned on me.  Tom was the problem.  Hal and Dave weren't sales guys.  They were the technical, Q&A and presentation guys.  Give them just a little direction, put them in front of the right people and keep them fed and fireworks would follow.  Tom, who was supposed to be the grand leader, the sales guru, was in fact useless.

I dreaded the debrief with Armin.

Testify

Having endured the Project Sinister presentation I hoped dearly to avoid Armin until a day or so passed.  Maybe he would neglect to quiz me on the team.  I feel guilty giving poor reports, a characteristic that could, in a more severe form, make me quite unsuited for this line of work.  I have no problem whatsoever doing it in the ethereal confines of my own thoughts or to someone's face.  Reporting back to the partnership, however, feels an awful lot like telling the teacher in Kindergarten that the kid who picks his nose in the back of the classroom peed in his pants when she wasn't looking.  If I just left it long enough the teacher would see the soaked pants on her own.  Why should I intervene?  Involve myself in the nastiness that followed?  Be a direct party to it?  Why get involved?

Because I wasn't given a choice.

And so, back on the estate the next morning, an elegant note written on engraved stationary laying atop my desk in the library.

"Lunch? - A."

Such a simple note in the midst of all that white space always throws me.

One didn't really reply to these notes.  It was a given that you would accept and anyhow there wasn't any clear mechanism to indicate your approval.  Like getting a card with "prière de répondre - regrets only" except there's no phone number.  Eventually, the butler would announce something like: "Mr. Armin has asked you to join him in the reception," and I would finish what I was doing and find him there, dressed for a formal business lunch.

Sometimes these kinds of invitations meant Armin took me out to eat, studiously ignoring the subject that would eventually be the focus of our lunch until we were seated and well into the main course.  Other times they meant a glass of wine while I watched him cook, he refused all offers of help, and emergence of the point in the Estate's cavernous and otherwise empty main dining room.

Each time it was a bit agonizing.  You knew it was coming.  Almost like the traditional Christmas family fight during dinner.  What would spark it this time?  Who would be the trigger this year?  My mother's soft, wistful sigh taken by my grandfather as a subtle slight to his childrearing abilities?  (So subtle, in fact, that no one else noticed it until he stiffened and grew silent).  Mention of the family dog that my mother had put down before my father returned home?  ("Everyone knows you always hated that dog!")  Discussion of the economy, leading without fail to the subject of my decision to go to business school? (My parents had wanted me to pursue a more "intellectual" career, whatever that meant).  I could only entertain myself by speculating in the hours before the line was crossed.

This time it was out to eat.  We flirted around a dozen discussions in the back of the car, over salads and bisque until he finally broached the issue in the midst of my lobster risotto.

"I understand you had an eventful meeting with Sinister's sales team." I have no idea how he would know that.  Surely, none of them would have told him.

"Well, yes."

"I suspect this was among the most important meetings Sinister will have this year.  Don't you agree?"  I was uncomfortable immediately and the tension had been bothering me.  I could almost feel the sweat on my back.

"Actually, I do."

"Tell me, Equity, do you think we put our best foot forward?"  I could see already where we were headed.  Armin was calm.  Resolved. Pensive.  Deeply calm.  He was using the sedate Britishlike accent. The one that reminds me of the Harvey Birdman, Attorney at Law Character, "Vulturo."  Tom was history.

"I am afraid not."  With this Armin acted surprised.  The briefest of eyebrow elevations.

"Oh?"  I was, unfortunately, expected to elaborate.  And so, as Armin gestured for the waiter to fill my glass with more red wine, I did.  I described the hotel fiasco, my suspicions about Linda, my ruse to find the team, the state of the presentation before and after my work at the hotel, the latte in the morning, the bag of food, Dave's performance, everything.  Several times along the way I was tempted to downplay the comedy of errors that was the Sinister sales effort, but I found that Armin's polite attention made even this kind of deception impossible for me.  He did not nod in agreement, or shake his head in bewildered horror.  He just listened.  Almost, but not quite, passively.  He always seems to receive such reports this way.  It is unnerving.  There was also the sneaking but totally irrational suspicion that he had somehow gotten the story already and the fear of the consequences that might follow my giving anything other than a faithful rendition.  So I was brutally honest instead.  It was painful.  When I finished Armin was silent only for a brief, thoughtful moment before speaking.

"I am glad I sent you, Equity."  I still don't know how he meant this, but I heard it as "I am glad I sent you, and not someone else, Equity."  I was still pondering this during the long pause that followed when he, suddenly as unconcerned as if he had not even heard the tale of woe I had just woven, caught the eye of the waiter again.

"I would like an espresso, please."

Paddles Prohibited Beyond This Point

The hedge fund people suddenly have issues with the product we showed them.  Things had gone spinningly in the presentation, but now they seem to have some kind of strange set of technical issues.  There is a lot of back and forth between Armin's highly placed friend, me, Dave and the technical team at the hedge fund.

Now things don't look particularly good.

This would be a bad strike for Sinister and, if the early concerns of the hedge fund's technical team pan out, it would imply that the primary product Sinister, and therefore we, had hung its hopes on could be worthless.

It never ceases to amaze me how Ph.Ds can disagree about technical details.  These are supposed to be statistical conclusions.  We can argue forever about the conclusions themselves but being unable to agree fundamentally on the data and the calculations used to get there is like taking contrary positions on whether 2 + 2 actually equals four.  Or so it seems to me.

If the two teams cannot come to some common ground quickly it probably means one of two things:

1.  The hedge fund team is calculating something wrong, there is actual value in Sinister's product but they are looking in the wrong place for it.
2.  Our team is calculating something wrong, there is zero value in Sinister's flagship product.

Of course, option #2 would be a dire consequence for Sinister.  It also, based on my experience in these matters, is probably the more likely of the two.

This is why buyouts of tech, service and other firms whose primary value is based on intangibles are more risky and undesirable than buyouts of boring manufacturing firms.  The due diligence is just harder.  How can one possibly know if the product is real?  With manufacturing you can touch it, see the machines, watch them work, hear the click of the 900,000th washer falling into a bin of 899,999 other finished washers.  A slick technical product that was "in the final touches of development" can evaporate right in front of you like so much Windex on clear glass, taking with it any hint of the grease of your already accounted for profits and leaving you staring right through to the now clearly visible abyss beyond.  Unfortunately, however, debt payments are not soluble in Windex.

"There Might Be an Issue"

Sinister melted down last week.  A lot was riding on the flagship product and now it seems clear that it either needs another 3-6 months of development, or it is entirely worthless.  In a way it doesn't make much difference.  Sinister was counting on the revenue from that product to deal with debt payments.  Orders were already in.  Now things look bad.  Very bad.

As it turns out, almost no real due diligence was performed on the technical side.  Typically, these things are handled by outside experts Sub Rosa retains.  This time it seems some corners were cut.  The party responsible?  Sinister's CEO, Jeff.

This presents a real problem as Jeff was friendly with some of Sub Rosa's partners and this was his path into his own partnership with Sub Rosa.  Want to be a partner in a private equity firm?  Bring a deal.  Close it.  Run the firm.  Make money.  On top of this, he was also responsible for doing a good piece of the due diligence.  Permitting this was an error.

It seems clear now that Sinister is in for a big lay-off, Jeff's head is on the block and there are rumblings that the entire company may be headed for an "orderly wind-down."

That I know about this at all is a bit of a shock to me.  It seems only to be the fact that I am constantly working so closely with Armin that I hear so much.  I walked into his office on Saturday to show him some analysis I had done.  He was on the phone and I motioned to him that I would come back later but he waved me in and motioned for me to close the door, which I did before sitting on the little couch in his office.

I am not sure why exactly, but I always feel like I'm visiting my father at work when I sit in Armin's office.  I catch myself sitting up straight, worried about posture, hands in my lap.  It is comic when I notice it, but I can't seem to stop.

It soon became clear that Armin was on a conference call with the partnership.  Not half a minute after I walked in, Armin hits the mute button and turns on the speaker phone.  He sits back, watching me blankly as we listen together.

What emerges is a long string of profanities from one of Sub Rosa's partners, Sean.  Armin has to turn the speakerphone down.  Sean is calling for Jeff's head "on a fucking platter." This is a little amusing since apparently it was Sean who originally recommended Jeff as the man for the job.  It is then suddenly less amusing because Sean is also the "industry partner" who was supposed to be watch-guarding the due diligence process for Sinister.  If he is yelling now, I thought to myself, it is to try and distract the group from his complacency in the matter.  Armin catches on without me saying anything.  Hit hits the mute button and chimes in.

"Now just a minute.  The partnership shares some of the blame here. Typically, we would have done technical due diligence like this ourselves.  But in this case, we were confident that it could be handled by our incoming CEO and our own senior members here."  Here, of course, everyone understands that Armin means Sean.

"Of course, none of us thought hard enough about the incentive structure we were setting up for our CEO-elect, did we?  How motivated was he to find and expose problems that might have killed the deal, considering without this position his chances to be elevated to the partnership were, shall we say, limited?  And now it will cost us a hand and a foot, and we may have to close the unit down entirely." Armin meant "an arm and a leg," but sometimes he has problems with English idioms.

The call went on for what seemed a long time.  The bank has already warned Sinister that they are close to breaking some revenue covenants.  News of this could cause them to seek "additional assurances" or even call a portion of the loan.  I haven't seen the loan terms so I don't know, but given the tone of the call, it sounds bad.  The call ends indecisively.

The entire thing is very embarrassing.  It's highly unprofessional on the part of Sub Rosa's partnership to permit this kind of oversight.  There are a variety of explanations, but it seems pretty clear that the partnership is poised to blame Sean.  With good reason, in my view.  I wasn't present for the Sinister transaction, but I heard that Sean pushed it though with something like vitriol.  It was quite a rushed thing, and attention to management and the transformation of the firm into a real operating unit was never really undertaken properly.  Enough little things, added up, can ruin a deal.  Can destroy a company.  There is little margin for error post-transaction in an LBO.  Now the losses are looming.  Someone will have to pay.

If I was shocked to be included in what was supposed to be a "partnership only" call, I was totally stunned when Armin sat me down and asked my opinion.

"What would you do?"  He asked simply.

Fire the CEO?  Try to buy out Sean, clearly he lacks the confidence of the partnership, and he potentially cost them a lot of money. Really, I had no idea.  Nor was I keen, exactly, to be asked to chime in on partner level decisions as a Vice President.

"These people can't even fucking keep track of projectors," he grumbles.  I stifle a laugh as best as I can.

Reconnaissance, Incentives, Failure

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.

Speed Bump

Closing Project Velocity has taken a turn for the worse.  Or, I should say, the larger issues that have always been contained within Project Velocity have begun to emerge.

From the beginning we suspected that the involvement of other private equity firms would either price Velocity beyond the scope of reason, or make the process too prolonged and difficult to manage.  Both are now true.

Velocity's management has responded to our letter of interest, and more particularly to the pricing range we offered, with the mergers and acquisitions equivalent of a Walther Mathaeuesque grumpy frown, a long whiny letter.  It is three pages but boils down to "We think it's worth more," and is highlighted by this absolute gem of business literature:

"In our conservative estimation the cash portion of remuneration contemplated by your letter of [Date] may be in need of some adjustment."

No wonder this company pissed away so much money.  They must a committee of seven attorneys writing letters by committee or something.  What I wouldn't give one day to get a letter more like this:

April 3, 2006

Equity Private
Vice President
Sub Rosa, LLC

Re: Valuation of Velocity, Inc.


Dear Equity Private,

Too low.

Best Regards,

Velocity, Inc.

Of course, I know exactly which firm it is that's pushed Velocity's expectations into high Earth orbit.  I suspect it is pointless to pen a letter back pointing out that the cash in our offer is unlikely to shift downward much, while others are.  I'm not even really supposed to know who else is interested, but I do.  Since it's been a bit slow, I am going to write the letter anyhow.

Kierkegaard, Scientologists, Private Equity

An interesting thing happens when a sudden realization of impending doom hits a firm.  Suddenly, all those people who were "selflessly burning the candle at both ends to keep the company afloat," somehow find the capacity to "burn the candle at all three ends."  Project Sinister has managed to really boost sales of their secondary products after the dramatic crash and burn of their flagship product, on which the hopes and dreams of the firm (and the servicing of its required debt payments) were laid.

Suddenly, after a frank "all hands" disclosure by the CEO that the firm was headed for imminent ruin, along with the positions of all gathered in the room, (and that included the phrase "well and truly fucked") the sales force which was "working as hard as humanly possible" to sell "products that can never support the revenue needs of the company" has managed to "work harder than humanly possible" and return a cash-flow positive, record revenue week selling "products that can never support the revenue needs of the company."  As compelling a lecture as he gave you'd think he didn't know that he is only weeks away from being fired.  This is because he doesn't know he is weeks away from being fired.

Perhaps one of the many the lesson here is "don't provide a magic bullet if you want people to learn marksmanship."

When you see something like this it is hard not to think that some of the universal tenants about mankind forwarded by notable philosophers over the centuries have been, well, slightly off.

I've put together this convenient table to explain my new (and horribly disillusioned) position.

Group/Individual: Belief

Confucius: Man basically good.  (Significant evidence during the brutal warlord infighting of the Chou Dynasty to the contrary notwithstanding).
Rousseau: Man basically good ("Noble Savage").  Society makes man evil.  Widespread peasantry is the ideal state.
Scientologists: Man basically good, but the machinations of certain evil aliens long ago complicate matters.
Kierkegaard: Man is impossible to classify.
Puritans: Man is basically evil.  Fire purifies.  (Though this is hard to compute given how deeply carbon stains).
Baptists: Man is plagued by total, hereditary depravity.
Equity Private: Man is basically lazy.  Innovative and complex incentive and disincentive structures must be continually created and refined to compel any desirable behavior (including the absence self-destructive behavior).  Excessive gaming of the system will be employed at every opportunity to avoid doing anything resembling work.

Much as I enjoy the work (and really, it may not sound it, but I do) I dislike the disillusionment that it breeds in me.

I suppose I might have one dirt encrusted root, sticking precariously out from the side of a sheer cliff face yet to hang onto:  If we bought the company it's partly because the personnel were in the bottom quartile and, accordingly, I'm getting a poorly representative sample of the workforce at large.  Please, oh please, let that be true.

(Artwork: William Blake, "The Good and Evil Angels" c. 1805, c/o The Tate Collection)

Philosophical Private Equity

Sometimes a post I write sticks with me for awhile and grows (festers? ferments?).  This has been the case with my post yesterday on, well, motivational inertia.  Efficient markets depend on more than just perfect information.  They require actors able to actually process that information.  The assumption that actors are rational (i.e. that they understand the information and price it accurately) is a rather huge leap to be making, in some circumstances.  Like this one:

Urgently in need of cash, Sinister moved to shift some short term compensation (bonuses) towards longer term non-cash sensitive compensation (deferred bonuses, stock and/or phantom options).  The upside was out of all proportion to the short term compensation that would be sacrificed.  For example, in exchange for voluntarily forgoing a half-year bonus on June 30th this year, employees would be contractually guaranteed 120% of that bonus at calander year-end plus 100% of any year-end bonus they were due plus some amount of stock and/or phantom options.  Coupled with this plan was the caution that if not enough people adopted the plan there might not be any year-end bonus at all (as more layoffs would likely be in the works).   Maybe I'm dense, but that looks to me like a 20% IRR over the 6 month period just on the bonus piece, and with a reduction in risk to future cashflows. 

Not one employee took the option.

This entire analysis begs the question, "What the hell is Sinister paying bonuses for given the flagging performance of the firm," which I can only answer with a shrug of my shoulders and the glib comment "I wasn't here for the transaction."  Others I ask seem to generally answer with long, run-on sentences which invariably include the phrase: "contractually assured non-discretionary bonus plan."  I've given up asking why that wasn't axed on day one after the purchase or the seller wasn't obliged to cash it out.

As if all this this wasn't enough, several employees circulated actively after the plan's unveiling attempting to dissuade anyone at all from taking the option.  Why?  What possible explanation could there be for that kind of behavior?  It's not a unionized labor force.  What could possibly cause anyone to think this a zero sum game between employees?  The only zero sum aspect is the obvious loss to the firm of 20% of the bonus pool for people who opt in.

Is there some subtle externality that I am not aware of that is pushing up the risk component of a 6 month, interest bearing bonus deferral?  Is a contractual credibility of the company so low that the beta on a 6 month loan is 3500 basis points over LIBOR?  Maybe there's a bigger bankruptcy risk than I know about.  Or, as I have come to believe, are Sinister's employees just totally unable to price these things?  Is it a corporate culture thing?  Did the previous owners just inspire such ire that any action by the firm was met with immediate and organized resistance just for the sake of "sticking it to the man?"  If so, perhaps a complete churn of the workforce is warranted.  (Or we should milk all we can out of Sinister and leave the charred, smoking wreckage to wither and die).

See, I hate that I have started to think this way, but I'm running out of charitable explanations (and charitable thoughts).

Cartoonish Opinions

I think my favorite section of the old 2005 In Re The Walt Disney Company Derivative Litigation opinion (online as a 1.95MB .pdf thanks to the Wall Street Journal) is:  "...based on my personal observations of Ovitz, he possesses such an ego, and enjoyed such a towering reputation before his employment at the Company, that he is not the type of person that would intentionally perform poorly."

Followed in amusement potential closely by:

This dichotomy places the Court in a somewhat awkward position.  By virtue of his Machiavellian (and imperial) nature as CEO, and his control over Ovitz's hiring in particular, Eisner to a large extent is responsible for the failings in process that infected and handicapped the board's decision making abilities.  Eisner stacked his (and I intentionally write "his" as opposed to "the Company's") board of directors with friends and other acquaintances who, though not necessarily beholden to him in a legal sense, were certainly more willing to accede to his wishes and support him unconditionally than truly independent directors.

My favorite passage from the recent 2006 In Re The Walt Disney Company Derivative Litigation decision (online as a 208KB .pdf thanks to the tasty Conglomerate blog) links right in with:

We conclude, for the reasons that follow, that the Chancellor’s factual findings and legal rulings were correct and not erroneous in any respect. Accordingly, the judgment entered by the Court of Chancery will be affirmed.

Artwork: "1967 Disneyland Memorial Orgy," Paul Krassner (1967).  Definitely NOT safe for work.

Beware Dark Figures Bearing Fairness

The appeal of Mark Cuban's ShareSleuth, that he is making markets "fair" for the little guys (on the backs of which he extracts his short-selling profit), is in the wonderfully romantic but entirely absurd notion that markets can be made "fair."  If you actually give it any thought, in this context "fair" often implies a certain blindness to things like hard work, research, and superior knowledge or expertise gained therefrom.  Everyone, "fairness" proponents would argue, should share in the riches.  Everyone should share in prosperity.  Why should a lucky few enjoy disproportionate gains?  Sounds appealing from an asthetic point of view.  Really, very democratic, in the French sense, even.  Pas vrai?  No, not really.

This is the same logic, tied together with an insidious vein of political savvy, that causes people (mostly those facing an election year) to call for taxes on "windfall profits," as if record revenues for oil firms are somehow a gift from the Tooth Fairy rather than a good deal of strategic planning coupled to a sustained program of massive capital expenditure and exploration efforts.  Now we have a more dangerous strain of this fairness virus: shared pain.

Abnormal Returns gives me no peace, filing their daily link post in the afternoon hours after I thought I had my news hounding done for the day.  Today they point to two Wall Street Journal articles on an emerging trend (subscription required) (which has actually been around a long time) whereby slow to respond investors sue early exiters from a failed (fraudulent?) hedge fund arguing that the early exiters, and I'm not making this up, "should be sharing the pain."

The legal term of art is "restitution for unjust enrichment."  The rub, of course, lies in the definition of "unjust."

Some of the allegations include the suspicion that higher profile investors were "tipped off" and allowed to get out early.  Absent this, however, letting anyone recover on this kind of a legal theory you'd have to collect every Enron shareholder who sold before the plummet and chase down their assets.  So I ask, how far back do you go?  Surely, the original investors in Enron, the very first, are more deserving than the bandwagon jumpers.  Shouldn't they get a larger bit of the pool?  It's only fair, after all.  What about more "deserving" shareholders?  Widows and orphans!  They, certainly, are more deserving.  No?  Suddenly, "fair" becomes a political status question, not a concept of equality (if it ever was).  Are we really saying that we are going to punish the investor who, because she carefully monitors her investments, one day, smelling something sour, catching a nuance in the tone of a manager of the fund on a conference call, decides it's time to lock in gains.  We should, I suppose, transfer her gains to the passive investor who jumped on the next "big thing" and failed to pay any attention to the signs?  Sure, we sympathize with the second investor, but "fair" is in the eye of the beholder once you make it political.

Dangerous, this line of thinking.

Difficult to Ignore

It is beyond difficult to write a blog that purports to cover private equity and not mention (with some glee if you are in the middle market) the mounting woes that plague Carlyle in the face of daunting margin calls from lenders.  Oops.  Carlyle is, however, awfully lucky in that certain other Schadenfreude magnets have created a much larger media splash.  One would almost think Carlyle had no influential enemies with media connections for all the press silence on the issue.  Alea catches the quote of the year for private equity (and it's only March):

The last few days have created a market environment where the repo counterparties’ margin prices for our AAA-rated U.S. government agency floating-rate capped securities issued by Fannie Mae and Freddie Mac are not representative of the underlying recoverable value of these securities....

Wow.  What happened?  We couldn't have seen this sort of thing anywhere else, could we?

Only slightly less amusing is this quote from Carlyle last week:

Carlyle said it had hired Olivier Sarkozy, half-brother of French President Nicolas Sarkozy, from investment bank UBS as it looks to "capitalize on the dislocation in the financial services sector."

Buy buying their own distressed assets at a discount, perhaps?

Breaking Views has a good piece on the fiasco.  To wit:

Carlyle Capital's investment manager's report for January, shows its funds, amplified with heavy borrowing, were 99% invested in agency securities.

Where "agency securities" is Fannie Mae and Freddie Mac.  Says Reuters today:

Carlyle said it has defaulted on about $16.6 billion of its debt and said the only assets held in its portfolio as of Wednesday were U.S. government agency AAA-rated residential mortgage-backed securities.

Carlyle Capital said that during the last seven business days the company had received margin calls in excess of $400 million.

I think that's it for them.  Indeed, if their lawyers are worth their salt, a lot of these vehicles will be insulated, but this kind of damage goes deeper than pure legal liability.  Indeed, Bloomberg quotes a Carlyle spokeswoman, who points out that the buyout operations of the entity are (mostly) quite distinct, with:

The Carlyle Group's only material financial exposure to CCC is through a $150 million unsecured subordinated revolving credit agreement with CCC.

But their reputation capital must at this point be totally depleted.  Apparently they were leveraged in the neighborhood of 32:1.  Oops.  You can see that they knew this was a rather serious reputation issue in the tone of the death rattle they hissed forth towards the end:

The Dutch-listed company said U.S.-based buyout giant Carlyle Group participated actively in negotiations with lenders and was prepared to provide substantial additional capital if a successful refinancing could be achieved.

Carlyle Group managers have a 15 percent stake in the company.

It said negotiations deteriorated late on Wednesday when the pricing service used by certain lenders reported a drop in the value of the mortgage-backed securities collateral that is expected to result in additional margin calls on Thursday of approximately $97.5 million.       

Ouch.  Of course, astute Going Private readers will have taken my advice back in April, 2006:

Raising a distressed and special situations fund seems like a wise thing to do just now.

Art credit: "Tai," the painted elephant in the room in Banksy's September, 2006 exhibit, Los Angeles.

"That's Just Being Silly. Don't Be Silly."

AGREEMENT AND PLAN OF MERGER, dated as of March 16, 2008 (this “Agreement”), between The Bear Stearns Companies Inc., a Delaware corporation (“Company”), and JPMorgan Chase & Co., a Delaware corporation (“Parent”). (Mmmm, optimism in terms).  WHEREAS, the Boards of Directors of Company and Parent have determined that it is in the best interests of their respective companies and their stockholders to consummate the strategic business combination transaction provided for in this Agreement in which Merger Sub will, on the terms and subject to the conditions set forth in this Agreement, merge with and into, Company (the “Merger”), with Company as the surviving company in the Merger (sometimes referred to in such capacity as the “Surviving Company”)....

What other interesting terms can we find I wonder?

"Surviving Company"
"Exchange Ratio"
"Risk Factors"
"Voting Debt"
"Broker's Fees"
"Material Adverse Effect"
"Covered Employees"
"Indemnified Parties"
"Alternative Proposal"
"Superior Proposal"
"HQ Property"
"Stockerholder Approval"

Anyone know where I can get custom refrigerator magnets made?

Bank of Merrill American Lynching