Monday, August 20, 2012
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.
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Did the FMCN takeout prompt you to post this?You should blog about them
Your article is very interesting. For Carlyle Group’s deal in Chinese Forestry, I am not so sure if they were truly "swindled". As a prominent PE firm, Carlyle went into China by connecting with the sons and daughter of the Chinese President and Premier.
To do PE deals in China, being politically connected is much more important than the deal itself. In the China Forestry deal, I am not so sure if Carlyle lost money. The investors might have lost money, but the senior officers may have gained a lot (my speculation only). There is always an agency issue, especially in money management industry. Look at some “prominent” hedge funds (such as long term capital or Amaranth Advisors), we can clearly see that investors suffered yet managers prospered.
Obviously there is a huge difference here. One can argue that these prominent hedge fund managers lost money without “fraud” involved while the PE firms engaging deals in China have deep knowledge of deal frauds. But to investors, are they any difference, economically?
To close deals in China has political and marketing “edge” for PE firms. More deals you close, “better” reputations and deeper connections you have. I guess the PE firms in China look at the whole portfolio: even if there are 2-3 fraud deals out of 10 deals, they can still make good returns. Plus, after PE firms “package” these deals (including fraud deals), they can sell to the market via IPO as an exit strategy. With the help of the prince and princess of the untouchables in China along with the investment banks, the game can go on forever as long as there is no “revolution” anytime soon.
Doesn't this assume that the target company officers and directors are willing to cooperate with the PE comp?
If I were running an excellent public company with a bright future, add on to that possible stock options and a nice salary, the last thing I might want is for some PE firm to step in and pull the rug out from under me.
Most of your comments can also be applied to most takeover events and are not limited to PE.
Im sure there are plenty of takeovers where the 'due diligence' is a bit of a laugh
John - once again a thought provoking post.
However, just because a PE firm can borrow in the mid single digits (and don't believe the markets are closed for LBO's - the big 4 are lending in the mid 5%'s these days) that they are actually targeting that level of return. They are juicing their expected un-levered returns. That gives them some advantage but increases their risk proportionally.
If you as a real money (all equity) buyer, purchase something and it goes down in value, you still have something of value. A leveraged purchaser will quite possibly have nothing left - that's their disadvantage.
Your point on DD is spot on. Many, many firms use DD as confirmation of what they already believe, and internal politics of most PE firms means that deal sponsors are committed to a deal and will (sometimes) hide negative DD.
Any tables of PE firms ratios between deals closed/dropped? That would be very interesting .....
Nice article. Another reader's comment on " The investors might have lost money, but the senior officers may have gained a lot (my speculation only)" echoes my own speculation as well.
John - have u looked at the recent focus media take-private deal?
Hi John, your blogs are an interesting read as usual. The article from thestreet.com you refer to is in fact quite old. What is interesting is at the end of the article Heckmann claims his new company in China is growing and has been buoyed by the boom in China and that investors who trusted his instincts will do well in the end.
Fast forward to just over a year from when the article you refer to was written and Heckmann has divested the China asset. In fact Heckmann virtually gave away the China company with no money changing hands and Heckmann only getting 10% equity stake in the acquirer (possibly a shelf company up until then) According to 10K filings the sales at the China unit were down to around 30 million when Heckmann sold the China company and the company had been losing money ever since the acquisition by Heckmann. Heckmann has now written off over 600 million spent on the acquisition! So much for the investors who trusted his instincts doing well!
I was aware just how bad the outcomes were for Heckmann in China.
Just when he thought it could not get worse and he expressed optimism it gets worse.
I know several private equity deals as bad as this though.
And unlike Heckmann the victims have not come to the confessional - yet.
Maybe you can also define good DD by how completely and precisely you uncover and quantify hidden assets and liabilities.
Yep v interesting article
Heckmann seems to be losing his touch. The China deal was a disaster. He's also made a couple of doozies in water management in the oil patch. He bought into the Haynesville and Barnett areas just as dry gas drilling was about to nosedive, apparently in an effort to change the story from China.
The stock is now trading below book. Looks like there are write downs on those assets coming
Speaking as someone who has been involved in PE dd, while I take John's point about judging PE houses by whether they walk away from deals, I think there is an important secondary aspect to that dd which is in reality as important, maybe more important, in practice. It's used as a price chip mechanism to give the buyer leverage to reduce their bid.
In truth, the idea that dd will uncover something that causes the buyer to actually walk away is very rare-its basically a load of accountants and lawyers poring over detail. That's not, generally, the kind of thing that causes fundamental assumptions in the valuation model and investment thesis to be questioned.
One important caveat: my view is based on deals in Western economies only. In China, I fully agree that dd ought to lead to a number of deals aborting...I doubt it does, though...
I agree leverage is a key advantage in PE business - they can and do borrow a lot of money at returns I would consider inadequate.
But legal insider trading is a much much bigger advantage. They can know with a great deal of certainty what they are buying.
I have only ever been on one proper due diligence team and we did walk away.
We walked away for a reason we did not even consider before the DD team started up.
This team was looking at an American banking franchise and we understood that they managed credit risk (quite successfully in this case) in a manner completely incompatible with our systems. No choice but to walk.
But the notion that a PE firm would almost never walk away based on due diligence is frightening.
Especially in China.
We walked away from these guys. You might want to give them a look. Might be some money to made here. I'll let you guess the direction.
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