Gray Areas of Honor in Private Equity

Years ago a venture capital firm engaged me for six months of due diligence on a $20M founder buy-out deal.??I dug deep into the business operations, the founder and customers and ultimately recommended the investment.?

Then, a month before closing, I felt the sector was turning down and the investment was no longer viable.?I alerted the partner on the deal, to argue against proceeding based on external market conditions.?The fund and entrepreneur had executed a term sheet, but it provided for termination based on changes like my more recent research.

The partner explained that he had a hand-shake with the founder on the deal and that he felt duty- bound to proceed. ?I lauded his sense of honor, but for twenty years I’ve been troubled. His fiduciary duty was to the fund and its LPs.?I’ve since concluded that I would have felt obligated to kill the deal.

With age I see less black and white, and more gray.?Today, I see a third way.?I would have offered the founder a breakup fee albeit much lower than the proceeds they’d pocket.?My message would be, “We are willing to withdraw quietly, we’d label the payment partly a breakup payment and partly a consulting fee." I'd gently remind the founder that the term sheet permitted withdrawal with no penalty payment.

The second half of this story remains a mystery to me.??As predicted the firm failed.?When we (the equity holder) alerted the senior debt source to the impending failure, they offered $14M in additional capital equal to almost two years of burn rate.? The mystery was later explained that the failure would only become apparent after the lead banker had left the lender’s employ.?Finance sometimes works in mysterious ways.