Good due diligence is defined by the deals you walk away from

As regular readers of this blog know - I don't much like buying stocks where I am competing with potential private equity (PE) buyers.

PE buyers have two advantages over me. Firstly they are able to borrow large amounts of money often at mid single digit rates. I don't think a mid single digit rate of return is worth getting out of bed for - certainly I will not invest my client money on those returns because the mistakes I make (and there are plenty) would wipe out any profits.

The second advantage is more important. That is private equity firms get to do a proper-due-diligence before they close any transaction. They can talk to staff throughout the organization. They can open the books up on any part of the business. They can talk with suppliers and customers. They can sit in on business meetings. They can even talk to critics and investigate the claims of those critics. In fact competence requires that they understand (and hence can investigate and dismiss) the claims of critics.

That is a pretty big competitive advantage. If I sought that advantage it would be called insider-trading and I would be sent to prison for it.

For a PE firm - its called good business practice.

Due diligence (or legal insider trading) is the main thing that makes it attractive to be a PE investor.

However if a PE firm always closes the deal then - almost by definition it is forgoing the main advantage of being a PE firm. A PE firm that eschews that advantage is - in my view - not a worthy investment.

This is especially true in China. Private equity investors have been involved in some egregious frauds in China.

Probably the most prominent example is how Richard Heckmann, a normally a very competent deal maker, was utterly defrauded when he invested in a Chinese water company. He now tells the world he was swindled. But other examples abound - such as Carlyle investing in China Forestry - a company which can now verify less than 1 percent of its previously reported sales.

I have a test for the competence of a private equity firm. A private equity firm is to be judged by the deals they walk away from.

What you really don't want as a PE investor is for them to announce a deal subject to due diligence and then close a bad deal because they get "deal fever".

Competence is the ability to walk away. It is what defines a really good PE firm.

I collect examples.

One recent example of a PE firm dropping a deal (though we will never know why) was Texas Pacific which bid for CNInsure (CISG:NASDAQ). They dropped out. Whilst we never know why they dropped it shows a willingness to drop out - and hence demonstrates a culture of competence.

Texas Pacific have also walked away from other deals.

Closing a deal on a fraud in China where the closure was subject to due diligence is the very definition of incompetence. I have a few examples at least as nasty as the Heckmann case. However there is no need for name calling here.

Just saying to potential PE firm investors: if a PE firm is known for always closing a deal you probably should not invest in them.




John