Not All Investments in Good Companies are Good Investments

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During my time working in equity research, I learned the characteristics that comprise a good company.  These are: high return on investment (ROI), high growth, and low risk.  Other factors are either derivative, duplicative, or erroneous.  That a company exhibits these three characteristics is, however, insufficient to conclude that an investment in that company is a good investment.

We are occasionally, and with increasing regularity, asked by clients to review investment opportunities.  As a threshold matter, we seek to determine whether the target company is “good” by the criteria listed above.  “Good” is a subjective term which is a worthwhile simplification that helps, in turn, to describe better or worse.

The spectrum is important because an investment in a bad company can be a good investment and we’ll begin in earnest by discussing this variation.  Much of the merger and acquisition market, particularly strategic activity, is driven by acquirers who believe they can make a target company better by buying it and managing it themselves.  In fact, this outcome is often achieved.

A change in management presents new opportunities in terms of personnel, products/services, markets, marketing, branding, asset management, investor relations, operational processes and everything else important to a company and its conduct.  The new management team can indeed increase ROI and growth while reducing risk.  If so, they have made the company better and better is more valuable.

If the improvements are sufficiently monetized, they have made a good investment in an otherwise bad company.  The inverse is just as obviously true: that bad management can reduce value.  Conversely, good companies often offer bad investments, at least by our standards.    Aside from management (as discussed above), other key factors include governance and valuation.

Common provisions include the ability for the sponsor to retain virtually all rights to unchecked authority or the authority to change the rules of the investment ex post, such as the right to: (i) make material decisions without your consent; (ii) unilaterally change voting mechanisms; (iii) issue additional equity; or (iv) hold somewhat more exotic rights, such as attorney-in-fact powers.  That is, if a member other than you, whether majority or minority, has the right to marginalize your voice in the investment – this is a bad investment for you – regardless of whether the company would otherwise be considered good.

We recently reviewed a pitch deck offering an investment in Class B units with an attendant Term Sheet which listed (unquantified) preferences for Class A units and Class C units.  The capitalization table, however, included a single Class: Class B.  Therefore, from the materials presented, there was no way to value Class B units as all the economic value of the company could have been reserved for Class A’s rights to cumulative, unpaid yield.  You are saying “what?” and that is a good question!

As for direct valuation, the company employed the Guideline Public Company methodology, which is a theoretically useful and valid approach.  However, the application of the quant was skewed in numerous locations.  First, the cohort was selective, ignoring the second largest company only because the multiple was about half the remaining list, this resulted in an overvaluation of about ten percent.  As for the public multiple, they used trailing twelve months (TTM) EBITDA which is not inappropriate, but then used that multiple with their own future (FY21 as of Sep-20) expected EBITDA, resulting in an overvaluation of 25%.  Additionally, no discount for lack of marketability was taken, which is necessary when benchmarking against public companies.  This discount typically approximates 30%.

While it isn’t our principal line of business, we’ve vetted a good number of angel, private equity, and venture capital deals.  As a non-lawyer working in a law firm, I’ve learned that an investment decision is legally limited to the information in the offering documents.  However, the investor often (perhaps mostly) bases the investment decision on everything but the offering documents such as conversations and marketing materials (e.g. a pitch deck), which are not part of formal offering documents.

Unfortunately, bad investments are regularly offered – because bad investments are often raised.  As always, the cheap man spends the most.

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