May 24, 2015

Accidents will happen, don’t let them scare you

“What could possibly go wrong?” is a dangerous question to ask when making an investment.

For the answer is anything — and everything. No matter how much time and money you lavish with esteemed advisers on due diligence, carrying out an acquisition is a perilous undertaking. Of course, you must always hope for the best — but you should also prepare for the worst.

The range of problems that can crop up is infinite. Sadly, fraud is all too common. For example, a friend bought a service business where the staff were ripping off a client — who then discovered the defalcation and promptly sued. The company lost the client and had to pay compensation.

I backed a food business where the chief executive stole money to feed his alcohol and cocaine addictions. He left and the firm had to be rescued with an emergency injection of funds. I was also a part-owner of a construction company where a subcontractor conspired with management to overbill for work. The shortfall drove it into bankruptcy.

Difficulties can arise from unexpected directions. In the 1990s, no one worried about pension deficits. I took control of a business that had sold a subsidiary which left behind its pension scheme — that was in surplus. In due course I sold the business to a big financial company. Years later it announced that a yawning hole had opened up in the defined-benefit pension scheme — and the deficiency swallowed all the assets and forced liquidation.

On two occasions, companies I’ve backed have suffered because their founders became seriously ill and had to step down. Both times the subsequent leadership vacuum turned into a full-blown crisis. I now fully understand why banks insist on medical check-ups and life policies for bosses of companies where they are big lenders.

Every company prepares forecasts, and every company needs a plan of action. But looking far ahead can be a fool’s game. As the management guru Peter Drucker said: “Trying to predict the future is like trying to drive a car down a country road at night with no lights, while looking out of the back window.” Too often as an investor, I have simply believed a company’s projections — and paid the price. At these times, the natural optimist in me needs to be tempered by my more sceptical partners. They know that such estimates may be no better than well-intentioned guesses.

Of course, buyers can demand warranties, indemnities, retentions and disclosure from vendors of businesses to protect against possible calamities. But by their nature, unforeseen difficulties are the ones that no insurance can cover. Changes in government regulation, competitor behaviour, currency fluctuations, raw material inflation, strikes, cyber-attacks, acts of God — the list of unpredictable mishaps is legion. One restaurant I owned experienced a terrible outbreak of food poisoning and many customers fell sick. For a time, the reputational damage was severe. But as with so many disasters, the business recovered.

Litigation and personnel claims have been known to emerge after a business changes hands. Perhaps the seller had suspicions that bad news was on the way, but proving they knew is hard. Similarly, cancellation of orders or loss of a big customer are classic setbacks after a proprietor cashes out. And even worse is when a former owner finishes his non-compete contract and proceeds to steal staff, customers and even intellectual property to establish a rival operation. I was once granted an Anton Piller order to search a defendant’s premises for incriminating documents in such a case. We found the paperwork, but the individual became insolvent before the action was decided, so we were seriously out of pocket.

Moving premises, commissioning a new plant or installing replacement IT systems are all fraught with hazards. They almost always overrun in terms of cost and time. You should discount the value of any deal where such procedures are necessary.

All business purchases are freighted with risk. There are so many variables that it is impossible to be confident the transaction will be a success. Of course, this considerable room for failure also creates opportunity. Challenged businesses put off most investors, but messy situations can conceal bargains. When we bought Patisserie Valerie eight years ago, the accounts were so chaotic, it was impossible to tell if it was profitable — let alone what the margins were. It has proved one of the best investments I’ve ever made.

My belief is that one should never be too fearful or cynical when investing. There will always be some reason or other to say no, but never committing capital because of endless doubts leads to certain stagnation. As Tacitus, the Roman historian, said: “The desire for safety stands against every great and noble enterprise.”

Of course, mistakes and accidents will happen — that is part of the human experience. Thus we learn from our errors, but are not discouraged and press on.