The Infamous Re-Trade

Duane Street Capital (“DSC”) recently participated in a limited auction and, alas, lost to a higher bid. While this is a common reality of the private equity business, sometimes losing outcomes result from adherence to a higher ethical standard than one’s competition. Having gone through a difficult period for investment, many professionals are facing increased pressure to deploy capital as they must “use it or lose it”. These pressures are impacting the way deals are being done (and “won”).

Examining this lost auction raised a number of questions about my responsibilities as an investor and the way we engage in competitive auctions. First and foremost, how ethical is a re-trade to a post-LOI deal? Are there grey areas or is it black and white? Second, what is a buyer’s responsibility to a seller during the buyer’s due diligence review of the business (pre and post LOI)? Is there such a thing as too much due diligence? And third, what factors in the traditional business auction allow unethical behavior to be rewarded?

The DSC Investment Process
As a small fund, one of our competitive advantages is the time and attention we are willing to devote to companies. This focus starts from the day we are introduced to a business. We believe that our speed and depth of research make us great collaborators for the businesses we work with. In this case, the sellers had expressed their desire to move quickly as they were concerned about changes to long-term capital gains rates in 2010. Within two weeks of being introduced to the company, we had traveled to meet management for close to 10 hours of diligence sessions and two dinners, 3 hours of phone conversations with the CFO, 5 detailed meetings with industry experts, 1 consulting engagement to analyze a specific driver of the business, and countless hours of other research.

As is common in our investment due diligence process, we identified the strengths and challenges facing the company. In addition, we listened to the sellers to understand their objectives; both financial and non-monetary. Using this information, we tailored a structure and valuation that best reflected the opportunities for the business and the desires of the selling parties.

So, why did we lose?
We did extensive research, listened to the sellers and management team to understand their objectives, and combined this intelligence to structure a highly tailored offer. Lastly, and most importantly, we developed a great relationship (personal and professional) with the management team. We were often told that DSC was management’s “favorite” group, which I will choose to believe was a genuine statement and not just auction politicking on the part of the intermediary or management team. However, after all of our work, our intel suggests that we were outbid by close to 25%. How, might you ask, could such a price discrepancy exist?

TMI (Too Much Information)
Through our diligence, we found that while the business appeared simple, it was actually extremely nuanced. During the course of our work, we uncovered risks that were buried well below the surface. In our recap calls with the intermediary and seller, post LOI, we were told that we did 3 times as much due diligence as any of the other parties in this limited auction. Thinking back to where we stood after having done a third of the work, I recall being comfortable with a valuation at least 25% higher than we offered in our LOI. I am obviously biased and unfortunately lack the benefit of complete information, but it did strike me as an odd coincidence that we were outbid by a price that, earlier in our investigation, we would have been comfortable submitting.

The Re-trade
Reflecting on the outcome, I am confident that the other buyer did not understand the business as well as DSC. They probably missed a number of key business challenges, that, with a few more diligence sessions, they will surely discover. At which point, they will most likely try to re-trade their price. And, because the seller is already in exclusive discussions with this buyer and negotiating with lenders, lawyers, and the like, the seller will be hard-pressed to walk away from their current suitor over a revised price that will probably look very much like the DSC LOI. There is a reason that pros call post-LOI sellers “pregnant” with a buyer. It’s really hard to walk away when you have already spent money negotiating documents and have gone to banks or other intermediaries as a team.

It is quite common for buyers to engage in this form of unethical behavior (i.e. impregnating multiple sellers with false hopes of a high price, only to re-trade later based on “new” information they have discovered during their due diligence). There could be many legitimate reasons why our competitor could have won without an ethical breach. For example, they could have been very straightforward with the sellers about their level of comfort with their proposal (i.e. “we have a lot more work to do and this is only a preliminary indication”). That being said, why does this ethical dilemma exist?

Why Does a Seller Choose Price over Certainty?
How important is the fact that you have done enough work to give a seller comfort that the deal you have put on the table will actually close? To answer this question, first one should understand the concept of “overconfidence” in behavioral finance. It holds that people tend to be “overconfident” in personal assessments as they are influenced by what they want to believe. For example, when asked if you are an above average driver, most people will say “yes” as they would not want to think of themselves as poor drivers, when in-fact, 50% of them will be less than average. Or, if you ask a public markets investment manager if he/she can beat his/her benchmark, the vast majority will say “yes”, when evidence would suggest that about 75% will not. In the case of sellers, often they are overconfident that a less informed, higher, bid is an accurate assessment of their company’s worth. Wanting to believe this reality, a seller will discount the fact that his bidder has done less work. Instead, a seller will put more weight on the investor’s “judgment”, disregarding the fact that he/she may not have spent the time necessary to gain in-depth knowledge of the seller’s business.

However, let’s examine our seller’s faith in investment “judgment”. One might argue that maybe the winning bidder, whom we have learned was another PE firm, knew something about the future that DSC didn’t, or that they had a rosier view of the business risks. Maybe they are simply smarter, and figured-out how to bid more based on the merits of the business in a third of the time. While these are certainly valid points of view, I would argue a counterpoint. I would argue that most people with access to more than $10 million of equity capital are bright individuals (this is probably “overconfidence” at work). And if these investors are reasonably smart, then they are valuing companies based on the discounted value of their future cash flows. Further, most private equity investors are promising to deliver their limited partners ~25% annualized returns (in other words, they are using 25% to discount a company’s future cash flows). So, if two intelligent private equity investors have a difference of opinion on the value of a business, it is most likely to be attributed to their view of the business’ potential for future earnings. In mega-buyouts, where most companies are multinational or at the very least, multi-product or multi-service companies, a 25% discrepancy would seem very plausible, but in the world of $2-$8mm EBITDA companies, where businesses tend to have one business line or niche, a 25% difference in valuation is large. So, unless the winning bidder in our auction was using a different discount rate (i.e. not 25%) or was able to better assess the future potential of this company, I would argue that they overpaid and will most likely try to re-trade the price somewhere down the road. Furthermore, if experience holds, the seller will probably accept the re-trade instead of opening-up the auction again to other bidders.

What is the Right Diligence/Bidding Strategy?
In summary, there is a possibility that DSC did not win this auction because of lack of investment judgment or lower discount rates. However, it is more likely that a bidder, with less information, was willing to make a bet on the future that, had they been better informed, they would not have been comfortable making. It is also likely, that the seller was willing to accept this valuation, knowing that it was less well informed, because the seller was overconfident in their attribution of probability to closing a deal with the less informed bidder. Lastly, and stay tuned to find-out, I would expect that his deal will close on terms that better resemble the DSC LOI than the proposal they received and accepted from our competitor (and, BTW, I expect that our competitor will close this transaction, because they were in-fact successful in getting our seller “pregnant”). So, in a sense, our buyer, who did less work, will be handsomely rewarded as the proud new owners of a company at a re-traded price.

So what is the Lesson?
In competitive auctions, how should a buyer approach a pre-LOI diligence process? Should you only focus on “deal breaker” issues and growth opportunities? Unless due diligence has helped you to rationalize a higher price, depth of knowledge can be a disadvantage. You may find yourself competing against an ethically “flexible” bidder who is willing to make an offer knowing they will re-trade later. So taking the ethical high ground will be rewarded with the difficult task of explaining the concepts of certainty and “overconfidence” to a seller.

What did DSC Learn?
By analyzing this situation, we better understood the mentality of those who might bid and re-trade later. Personally, I believe this practice is ethically reprehensible. In founding DSC, my goal was to create an organization that holds itself to the highest ethical and moral standards. As a result, DSC will continue to differentiate ourselves by working harder than our competition and better utilizing our vast resources to create the most concrete and well though-out proposals for business owners. In addition, we will make every effort to educate sellers on the risks inherent in choosing price over certainty.