Dealmaking may seem to be all financial figures and legal terms, but ask any experienced dealmaker what the most common cause of failure is and they’ll generally point to people issues. Admittedly, many of these are vendor versus investor issues, but behind the opaque cloak of private equity, you’ll also find many failures attributed to intra-team issues.

Image: Dealmaking, just another game of chess [source: Shutterstock]

I’ve found three common intra-team issues that can lead to deal failure:

• Deal Envy - it’s not so much the envy that damages the deal, but the actions that result. Excessive negativity (as a result of envy) can wear down even the most enthusiastic private equiteer. So, it helps to give your team buy-in as early as possible: share the idea, ask others to become involved, and try to lead with an open mind. As soon as you appear evangelical, your team will likely position themselves to shut you down.
• Deal Disputes – the best way around disputes is to prevent them in the first place. Ensure your arguments are fact-based and keep an open mind. If you appear to have made your mind up without sufficient evidence, your team will likely position themselves to prove you wrong. Also, try not to implicate your team or their actions in your reasoning. People are naturally defensive. So, try not to put them in that position in the first place.
• Deal Fatigue - even a deal evangelist suffers from deal fatigue if a deal subsists long enough. But, deal critics suffer from fatigue much sooner, so it’s important to keep a deal moving if you plan to garner support from the team. Make sure you respond and gather supporting evidence quickly and meet with your team regularly and consistently. A quick deal has many other benefits, but mostly it reduces fatigue.

In summary, there are a few measures you should always take to prevent the above issues: facilitate buy-in to reduce envy, keep an open mind to prevent disputes and maintain momentum to close the deal before fatigue sets in. Of course, the investment has to have merit in the first place, but if you keep one eye on intra-team issues, at least your deals won’t fail for a lack of leadership and skill.

One of my favourite blogs at the moment is Mark Suster’s Both Sides of the Table (the title is a reference to him once being an entrepreneur and now being a VC). Mark put up a particularly interesting post today in which he recounts his experiences with VCs as an entrepreneur (the other side of the table).

Apart from persuading you to read Mark’s blog, I want to comment on a few points from his latest post.

• Unprepared potential investors - I admit to being guilty of this myself; sometimes there’s a whirlwind in the office or at home or with an investee, and whomever I’m meeting with next gets the short end of the straw. But, don’t let that deter you. If anything, it makes it easier to impress me because I’m likely caught up in a shit-storm and pining for a few rays of sunshine. So, irrespective of the investor’s preparedness, entrepreneurs should stick to the points that matter. And, if I don’t know the basics of your product or technology, don’t worry, I’ll ask.
• Arrogant potential investors – please don’t confuse unpreparedness with arrogance. Unless investors warn you at the start of the meeting that there’s an impending emergency that requires in-meeting phone use, then they absolutely shouldn’t be playing with their smartphones. Likewise, anything but full engagement is unacceptable and plain rude. The consolation to the entrepreneur in this situation is that they shouldn’t want to work with pricks anyway.
• Unauthorized reference checks - one of Mark’s annoyances was when he specifically asked a VC not to contact a major customer, but the VC did it anyway. This is so not cool. Private equiteers (and VCs) may postulate that the avoidance of reference checks is due to something sinister, but anyone with an ounce of intelligence knows the damage they can do. You could be breeching confidentiality, you could stir competitive tension, and you could endanger current negotiations. (We all know not to drive the Bentley to negotiations, and well, the same goes for announcing an influx of millions of dollars.)

The happy ending to Mark’s recount is that the VC firm apologised and committed to changing its ways.

We come into this world as children, bestowed with raw innocence and besotted with toys, confectionery and attention. But, before we grow into adults and face life’s major decisions, we develop an odd yearning to matter and to be noticed. And, as we slowly lose that raw innocence and develop this yearning, we develop our cunning and calculation (which we invariably use to satiate our yearning to matter).

Now, this concept of being noticed isn’t always an overtly moral concept; people engross themselves in rather obscure pursuits such as dancing, accounting, palm reading, etc. However, even with so many channels to become noticed, the reality is that many of us will never really matter outside of our circle of family and friends. We’ll never make a dent in global poverty and we’ll probably just add to the raft of existing global challenges and conundrums.

But, there’s another way. Why waste our efforts on making a difference (especially one that will help others), when we can just create the appearance that we matter? Why bother with impoverished people when we can spend hours a day at the gym to look like we mean business? Or why bother with environmental conservation when we can get a boob job to become more desirable? Or why even build robust businesses that create jobs and support innovation when we can simply spend thousands of dollars on our attire to create the allusion that we’ve made a difference?

Wow, this post sounds really righteous and holier than thou, but that’s not my intention. If anything, I’m just asking… am I trying to make a difference or trying to appear like I’m making a difference. Is making a difference even that noble? Who knows… but what I do know is that in private equity, investment horizons are long enough to separate those that actually matter and those that just appear to matter. (And in life, well, I guess that’s up to you.)

There’s a fine line between advising investees and doing their work for them. And, this fine line is easily crossed as private equiteers try to add their own unique value to portfolio companies.

The typical scenario starts with witnessing something that could be done better. It may be related to sales, costs, relationships, inventory or whatever. You first discuss the issue with one of your C-level execs, you make a few suggestions, you query how your suggestions fared, you make the same suggestions again, etc. Depending on your level of patience, there comes a time when you finally think to yourself “if I want it done properly, I’ll have to do it myself”.

But, this is dangerous… for many reasons:

• You have an entire portfolio of companies, and playing CFO or CTO or COO in all of them is untenable; you’ll sacrifice your performance as a private equiteer to become, at best, a mediocre manager spread thinly
• You’re setting a precedent; the next time you call for something drastic, they’ll expect you to oblige
• You’re creating a dependency; if you’re out to build great companies, you’ll be doing them a disservice by not allowing them to make mistakes, learn from those mistakes and refine their skills
• You may be wrong; yes, it’s possible; while a fresh eye often provides new insight, a weathered eye often has the benefit of previous experience and a more informed visceral intuition

With all of that said, it can be helpful to get your hands dirty in an investee to really understand how it ticks. You are the owner (or part owner) of the business, so it’s clearly in your best interest to help where you can. But there’s helping and then there’s helping; one involves keeping a safe distance (see picture).

I wrote a post recently called the aftershock of hard negotiations. The general premise being, if you must live with vendors in the future (as part owners), then it’s wise to think of your future relationship when negotiating. (Even if you don’t live with them, you should still be decent, but that’s not nearly as convincing.)

So, with that in mind, I want to comment on negotiations again, but in the context of your internal private equity team. There are a few points to consider here:

• Team members are acutely aware of your negotiation tactics (and most tactics in general), so when you try to use them internally, it leads to instant contempt
• Your negotiation style becomes a part of you when you’re dealing with potential investees all day, so it’s not always easy to turn it off when dealing with your team
• You are married to your team; you aren’t selling them a set of encyclopedias; so, even though you may have superior negotiation skills, your team will be there tomorrow to resent you if you treat them unfairly
• Your team talks; there are cliques you can’t even see; don’t treat anyone in a way you wouldn’t want everyone else to know about
• In deals and in life, you often benefit much more from not getting your way

Too often we focus on the tangible and don’t acknowledge the potential value in maintaining good relations. Just food for thought for now.

They say the best salespeople can sell just about anything to anyone: ice to the Eskimos, sun to the Saudis and fire to the Devil. They do this by understanding behaviour, analysing motives and focusing on what matters at the time (which may not be what matters in the long term).

In private equity, we make investments in businesses worth many millions of dollars. The need for negotiation is therefore implicit. But, we don’t just negotiate price, we negotiate terms, contracts, and many other things, which in aggregate, constitute the deal.

I suspect a salesman who can sell ice to Eskimo can also sell a 3x multiple and aggressive anti-compete terms to a founder. But unlike the Eskimo, whom you’ll likely never see again, you may have to work with the founder for many years to come.

If you create resentment now, your great multiple of 3x EBITDA may look like 9x EBITDA in six months when earnings tank due to managerial revolt. You may get comfort from the fact the founder is still invested and wouldn’t want to sacrifice his/her own wealth, but then you’d be ignoring human irrationality and the utopic feeling that comes from revenge.

So what’s my point? I think it’s important to play it fair with founders and managers for the sake of the future. While significant value can be created by a great entry price, significant value can be lost thereafter. I’m not suggesting that you capitulate to founders’ demands, but I suggest we all practice a little foresight. Nothing can beat the power of a fully-aligned, determined and resourceful team (of investors and investees), even a low entry price.

PeHub reported a somewhat scathing piece in The Economist about the value-add of private equity. One of the lines that caught my eye was:

“You are far more likely to achieve billionaire status by running an asset management business than by setting up an operating business”

This may be true by looking at raw statistics; obviously there are many more operating businesses out there with many lesser qualified owners (than those running PE firms). I think the question that’s more relevant (though likely untestable) is whether a suitably qualified person is more likely to achieve billionaire status from an operating or asset management business. Anyway, it’s mostly trivial, though in the same vein, I think the media trivialises how easy it is to do well in private equity. Sure, some people do very well, but in a previous post I showed how financially unrewarding life can be in private equity.

One of the other lines to catch my eye was:

“Aha, I thought, evidence that finance, not good management is at work.”

Private equiteers typically (emphasis on typically) aren’t entrepreneurs. They often aren’t even senior managers from operating businesses. So, would that suggest their greatest value-add is in private business managerial improvement? What would it suggest if we knew most private equiteers were lawyers, accountants, consultants, b-school grads, etc?

When we talk about experiential value-add for private equiteers, I tend to think of the following:

• Financial and legal engineering – it’s true; most private equiteers have a financial, law or consulting background, and unsurprisingly, they use this background to create value the way they know how
• An external eye – you don’t necessarily need a private equiteer for this, but someone with business experience can often find simple and obvious improvements in even the best-run businesses
• Value creation experience – by fact of investment in various businesses and involvement in various value creation strategies, private equiteers have experience creating value, and that can be handy

Just my thoughts.

This may sound a little strange, but whenever I look around a private equity shop, including my shop, I think to myself what on Earth are we all doing? I don’t mean this in an existential sense (although that begs answering too), but more in a productive sense. We seem to spend way too much time in perfunctory meetings or way too much time analysing the past to predict the future. And, it disturbs me that this is the life of the average private equiteer.

Now, I know it’s human nature to lament our long working hours and to celebrate our stoic commitment, but let’s spare a moment to be honest with ourselves. Success in private equity is partly making good investments and partly making good investments better. Success isn’t a PowerPoint presentation, it isn’t a founder’s mistake in 1943, and it certainly isn’t a rhetorical discussion where we lionise ourselves for great work (that we haven’t really done).

If we are looking to make great investments, then we should discuss great companies, call them, visit them, sell our wares and make investments happen. If we are looking to make existing investments better, we need to visit them, understand them, distill their drivers, talk to the market, model initiatives and make improvements happen.

The problem is that most people would read those steps and exclaim that’s exactly what we do!. But, I don’t see it. I see meetings that disrupt discussions without tangible results. I see analysis that is so technical that you’d think we were exploring permutations of DNA pairs in the human genome. I see hubris attached to accoutrements, guest lists, gated estates and public appearances. I see inefficiency.

What I’d expect to see in my private equity Elysium, is a truly cooperative team, a team completely open to sharing opinions, a team with humility, thoughtfulness, self-honesty and a focus on those oh so simple objectives. A team that is so opposed to conventional wisdom that it doesn’t even know what constitutes conventional wisdom. A team that spends most of its time either in thoughtful discussion or out discovering the world, not sitting at a computer or in box-ticking meetings. In this fantasy world, my team would kick ass.

Contrary to what some industry elitists may think, private equity doesn’t transcend the greater finance industry. It is exposed to the same biases, the same aversions, the same subjectivities, and the same contradictions. It’s foremost a sales game, but also a game of control and discipline. And with that in mind, I’d like to discuss a range of human behaviours rarely talked about in the industry. I believe they have a profound effect on performance and differentiation in the private equity industry.

• Emotional Bias: when emotions related to a potential outcome prematurely affect the decision, emotional bias is said to exist. In private equity, the emotions of closing a deal create a bias towards making the deal a success. I spoke indirectly about this in my recent post, the superficiality of most due diligence. In my opinion, this is the single biggest threat to the objective appraisal of a potential deal; we tend to want to close deals more than anything.
• Loss Aversion: this occurs because it is human tendency to rank avoiding a loss higher than receiving a gain. Ask yourself how you would feel if you lost 20% on your stock portfolio versus missing the opportunity of a 20% return on a potential investment. In private equity, we think it’s fine to miss great opportunities, yet sinful to invest poorly. This has become dogma in the industry because it appears a more conservative and agreeable argument.
• Congruence Bias: private equiteers love to talk about hypothesis testing, almost as if everyone else just shoots from the hip. The problem is, most private equiteers only test hypotheses directly and only reject hypotheses in extreme cases. For example, a typical hypothesis is “the company’s customer base is sufficiently fragmented?” The subjectivity alone creates bias, but so too does the use of direct testing (testing the positive case rather than the alternative case). One solution is to test the alternative case and have to prove “customer base fragmentation” beyond reasonable doubt.
• Framing Bias: framing is about using past experience and other external information to give something context. Framing makes daily decisions more efficient; if you consider every decision with a clean slate, you’ll go crazy. However, conventional framing threatens objectivity in private equity. Conventional framing shows what people want to believe, rather than what’s true. It’s important to learn to reframe important information to understand it in its entirety. For example, if a founder wants to sell a business, it doesn’t automatically mean it’s bad, he may just want to sail the world or climb Everest.
• Information Bias: when we talk about the competitive advantage of our firms, we talk about superior information.  When we negotiate deals with founders, we talk about asymmetric information. When we’re pressed on an issue we say we don’t have enough information. We just love information. However, as great as information may be, it needs to be the right information. Information bias is about seeking information that has less and less influence on the target decision. This occurs in private equity because more information is viewed as better analysis. But we lose site of the big picture; we get caught up in the process; we often fail to sit back and ask what the most important information could be.

I’ll leave it at those for now, which I think are the most salient cognitive biases that affect the industry. My suggestion to combating these biases is to acknowledge them, make them known, discuss them, and try to work around them with your team.  Pull each other up every time they seem to creep back, not in an adversarial manner, but in a constructive and friendly manner.

I received a couple of emails in reference to yesterday’s post, In it for more than the carry. Some commented that a $100m fund is a micro fund. Some commented that they received a bigger percentage of carry in their first few years. And, some suggested there’s nothing wrong with entering private equity with carry at front of mind.

Those comments are dually agreed and noted. However, when discussing the average scenario, you have to draw a line somewhere and stick to it. Upon reflection, I’d say the average fund that many of us are managing is in the range of $50-500m. While a $1b fund is not necessarily mega, I do think it is a large fund. Maybe I should have used $200m instead in my example (100 is always such a rice round number to work with).

On the topic of percentage of carry, many first year private equiteers don’t even get carry. And, you’ll really be surprised to see how much carry is transferred outside of the investment team and/or to the founders. The founders of a fund are just as diligent with negotiating carry as they are with negotiating investee deals; don’t for a minute think they’ll become generous just for your sake.

As for the last point, maybe I was being a little disingenuous with claiming that real private equiteers make carry their last priority; it’s simply not true. I guess the message I was looking to convey was carry could actually end up being a lot less in real terms than fledgling private equiteers expect. They often dream of numbers and conveniently exclude management fees, external entitlements and founder avarice. So, I guess the real message is to learn to love the job and the money will follow.

Private equiteers live for the carry (carried interest). We get overly qualified at college, we leave our own profitable ventures, we accept meagre salaries, we work our glutes off trying to close deals… all for the carry. Some equiteers (admittedly lower in the hierarchy), do it for the potential… of potential carry (that is, they’re not yet signed up to carry, but one day hope to be).

However, it’s important to look at carry with a clear mind, one not too blinkered by riches. Moreover, in writing this post, I’m hoping that some of you aspiring private equiteers will enter the industry with carry at the bottom of the priority list. If you can do this, then you’ll be able to self-motivate even if your fund explodes and there’s no carry to go around.

Let’s look at a very simple example. Your firm runs a $100m fund with a 20% carry entitlement. There are four founding executives and eight investment executives. It’s likely that, let’s say, 25% of the carry is taken up by anchor investors, parent companies, previous founders/partners, etc. (Yes, when you leave a fund, often you are still entitled to accumulated carry on that fund.)

The founders will take a large part of the remaining 75%, a very large part, and may leave the other eight executives with say 20%. As a newer member of the investment team, your entitlement is lower, so let’s say 1.5%. However, you don’t earn that 1.5% upon joining the team though; it will likely be broken up so you earn 0.15% per year for 10 years.

Now let’s say your fund has a 2% management fee. But, management fees are usually based on committed capital, which reduces as money is distributed back to investors. So, let’s say $15m in fees. That’s about $85m invested. If your team manages to double the investment (which isn’t unreasonable in the right environment), total carry will be $17m. In your first year that you earn 0.15%, that equals about $25k of carry.

If all goes well and you stay with the fund for 10 years, your total carry will be $250k. For simplicity, if you get that in five equal repayments in the last five years of the fund and you use a discount rate of 15%, the PV of your carry is only about $50k. To be a little less conservative, add the nominal amount of $25k to your current salary of say $100k (this is PE remember), and your annual earnings, including carry, are $125k. This is a fairly typical scenario. Sure your fund could return 4x cash and you could have 10% of the carry, but these are extremes.

So, I’m not trying to dissuade new private equiteers, but rather put carry into context. My advice is that you make sure you’re in private equity for the right reasons: you like to do deals, deal with business owners, research different industries, etc. The money will follow if you have the passion for those things, but you’ll be sorely disappointed if you’re only entering for the carry. It still takes 10-15 years to run your own fund and make the real money, especially in mid-market.

Or, with the right background (started and sold a successful business, Ivy League MBA with summa or magna, etc), you may get a foothold into a large fund and become entitled to a smaller piece of a much bigger apple pie.

I trust you know the story, The Emperor’s New Clothes.

In short, swindlers promised the Emperor the finest suit from the finest cloth. The cloth was so exquisite it was apparently invisible to those unfit for office or unpardonably stupid. Not wanting to be categorised as such, the Emperor agreed the suit was exquisite and accepted it. As the Emperor paraded his new suit, the townsfolk commended him on his fine choice of loom.

Of course, there was no suit (it was invisible because it didn’t exist) and it took a small child to express this observation before everyone else caught on. The Emperor ended up short a few pesos for the privilege of running around town naked and the townsfolk were shown to be so impressionable that they couldn’t distinguish a clothed Emperor from a naked one.

There are plenty of messages in this fairy tale that transcend private equity (and most other industries). For me, it emphasises the importance of having a voice, thinking independently and being unabashed in expressing an opinion.

At the moment, if deals are looking a little naked (high multiples, poor fundamentals, underperforming industries, high risk, high valuation, etc), differentiate yourself by opposing the townsfolk (other general partners) and calling out said nakedness. Make it known you’re an independent thinker whom has learnt from recent events and is sensitive to current conditions. It’s the perfect time to be genuine in exposing your independent thinking; not so much for self-promotion, but for self-preservation and the preservation of your fund.

You may see the term entrepreneur-in-residence (EIR) bandied around from time to time. In the broad strokes, it simply refers to a person with extensive entrepreneurial experience interning with a private equity or venture capital fund to learn the game. The word interning is used loosely because EIRs often have deep business experience and are really only interning to learn the distinct skills of a private equiteer or venture capitalist (deal making, running a fund, etc.) 

The EIR term triggers a question in my mind: how disparate are the skill sets of entrepreneurs and private equiteers? Also, irrespective of how disparate they are, how disparate should they be? 

In times of unpleasantness (now), I really think private equiteers need to get their hands dirty. And, to be a part of the solution, rather than the problem, the private equiteer needs some serious entrepreneurial nous. Standing on the proverbial pedestal proclaiming to add value only via deal making is a sure way to differentiate your firm on the downside. Of course, someone still needs to run the fund from an administrative, regulatory and financial viewpoint, and this takes a specialist skill set, but your firm needs much more than that to differentiate in this market.