9. Never Too Late: When Problems Arise Post-Investment
Business intelligence is not only essential before you do a deal but also in the aftermath. We know that background checks are occasionally overlooked. Maybe you skipped the background check because the deal was referred to you and you thought you knew the management team of the company you were acquiring. Priorities of a deal are often focused on the outcome, namely profits. In doing so, some critical steps are neglected. Sometimes you get lucky, and things move smoothly. Other times...not so much. Unfortunately, methodologies to resolve post-acquisition problems are not taught in most MBA programs.
When post-acquisition problems arise, there are many investigative solutions within your reach. As mentioned in previous chapters, talking to former or current employees often reaps more information than you would think.
The Situation: Buy Now, Pay Later
A client of ours purchased Pretendz, a telecommunications company that had revenues of $30 million. The following year after the company was sold, the revenues of that company had dropped 50%. Our client called us in a panic: What happened to the revenues?
After conducting a limited forensic review, we decided it was best to talk to the current employees of Pretendz to see if anyone could explain the reason why the company revenues had fallen. When we contacted the current employees of the company, most of whom were recent hires, everyone seemed equally perplexed by the decrease in numbers. Then we decided to identify some former employees of the company and reached out to them, too. One of these former employees told us what really happened. Apparently, when the Pretendz management team heard rumors the company was being acquired, they had quickly implemented an incentive for new customers: Sign up now and pay full price, but in six months if you stay with Pretendz, your cost will be decreased 50%. The Pretendz management team had misrepresented the company earnings by not disclosing the sweetened customer deal.
The Tactic: Employee Reunion
Of course, there is no master online database that provides you with names of former employees of every company. But the key is to identify relevant people who worked in specific departments or held specific positions at a company who would be privy to information you need. Sometimes we find these former employees through our review of media articles, and other times we find them by screening resume postings.
When we talk to former employees, or conduct interviews of any kind, our goal is not to intimidate or force someone to admit to something; it is rather to give the person an opportunity to tell his or her side of the story. With the information we gather from these interviews, we then take into account personal biases or motives (for example, did the person who spoke negatively about a former boss have an axe to grind for not getting that promotion he or she wanted?). We then verify or debunk the allegations. Only then can we properly assess the gravity of the comments made during an interview and relay to our clients the necessary information.
How to Get the Most from an Interview
As investors, you know how to talk to people about EBITDA, ROI, and strategic initiatives. Conducting interviews of the management team of your potential target companies, hedge fund managers, former employees, references, or employees suspected of misconduct is an acquired skill. As learned in the FBI, there are some critical components and basic rules you can follow when interviewing someone. These include the following
• Come prepared. You should know the answers to most of the questions before you ask them. Yes, the interview is designed to give the candidate an opportunity to explain himself. But, wherever possible, you should have a general sense of what the answers should be if the candidate tells the truth. One of the goals of the interview is to determine the person’s honesty and credibility.
• Do not be too aggressive or confrontational. If you know or suspect the individual has been engaged in bad behavior, phrase your questions so that the person ends up admitting guilt. If you start with, “I know you did this,” then the person will be on the defensive and less likely to respond. If you find the person is lying about something, do not say: “Liar!” Instead say something like, “Interestingly, we found a person with your name that has a bankruptcy or has been involved in a lawsuit...does that in any way relate to you, or does it jog your memory in regard to something?” You never know what you are going to learn.
• Start with general questions. When you conduct the interview, ask a lot of general questions about a person’s work history: what they do, who they work with, when they started, where they were previously, and so on. Do not at first hone in on anything specific. This allows the interviewee to get comfortable with the interviewer and the process of being interviewed and also gives you time to evaluate the interviewee. More importantly, it gets the person talking. In the beginning, we do not get into any of the challenging areas, and then the interviewee does not really know what is considered important. Of course, later on in the interview, we have some control questions where we know the answers.
• Ask targeted questions. If you were confronting the owners of Pretendz, you would ask questions that lead you to the answers, such as, “How did you come up with the discount idea for your customers?” “When?” and “Why?” as well as “How long did you intend for this discount to last?” The answers to these questions will yield more questions that will ultimately bring you to the answer you are looking for.
• Follow the answers closely. Be a good listener. If someone is lying, the story will often have holes in it. You must pay attention to what the person is saying so you can be ready to address the false tales and discrepancies. Let the person talk, even if it means a few seconds of awkward silence.
• Tag team. Two-person interviews are best. If you know the interview is going to be challenging or will broach difficult topics, bring someone with you. One person will ask the questions, and the other can take notes and observe the interviewee’s facial expressions, squinting, twitching, or nervous habits. Both interviewers should pay attention to how the interviewee uses his hands, looks directly at the interviewer when answering certain questions (or not), overemphasizes certain words, rests his elbows on the table to support his face, and so on. Look for a number of nuances in someone’s demeanor or reactions that help guide you in coming to a conclusion about the person being interviewed. Sometimes you can see an obvious pattern of lying when you just focus on a person’s behaviors. You have seen the one-way glass in crime shows on television. Although I had that in the FBI, I do not have that now. Two-man interviews achieve the same goal as the one-way glass.
• Leave the door open for follow-up. At the end of the interview, ask the interviewee if it is okay for you to call back/come back with any questions or clarifications should they come up. It’s not an interrogation; it’s an interview. This allows you to go back, review and analyze the answers, maybe even get some additional information to confirm or deny the person’s statements, or deny the person’s statements.
The Situation: The Misled Lender
A lender gave a sizable line of credit to Duped, LLC. Months later, Duped filed for bankruptcy. The lender hired us to find out what happened. Again, we relied on former employees. We searched resumes, job postings, and corporate databases to find any employees who previously worked for the bankrupt company. We found a handful of people and located them. At first, the calls we made to former employees were fruitless; we did not develop any new information to explain how or why the company went under. Then we found a former Duped manager. When we asked him if he knew anything about how Duped could have possibly ended up in bankruptcy proceedings, the guy laughed and said, “Don’t you know?”
Weeks before the deal had closed, Duped officers hired 50 non-English speaking temps and rented a slew of antiquated computers and printers. The temps, who were deliberately hired because of their inability to communicate in English and thus unable to tell the lender what was going on, were merely acting as busy employees hard at work, only for the day of the walk-through. What the lender saw: diligent employees and buzzing systems. What the Duped officers knew: a successfully staged operation that would revert to empty offices and meager balance sheets the next day.
Thankfully, our client was able to recover their investment, as they were secured creditors in the bankruptcy proceeding.
Insuring Investments
Whenever fraud or theft is suspected, we recommend our clients immediately notify their insurance companies (this will not cause rates to increase). Most companies have fidelity coverage, and common fidelity insurance policies cover up to $1 million, at a minimum. Once the insurance company is put on notice that you have a possible claim, you are required to get back to them generally within 90 days to let them know the status of the situation. During this time, you are required to commence an investigation into the problem and report back to the insurance company with your findings. (That is where we come in.) If the investigation reveals that misconduct or theft did occur by an officer and you have an investigative report that proves the case, your fidelity insurance will reimburse you accordingly (and often cover the cost of the investigation as well).
In addition, another way to prevent fraud is to monitor your portfolio company’s activities because circumstances change. This means conducting biennial background checks on your management team and constantly checking media sources, blogs, and other Internet postings to ensure there is no new potentially damaging information about the company. Staying on top of your portfolio company means more than just inspecting the revenue stream.
Protecting the Innocent
Post-investment research is not always initiated to resolve challenging internal problems. Sometimes after a deal is done, you just want to make sure you understand what transpired, especially when you are involved in distressed investments.
Because rumors spread as fast as California wildfires, this type of research is often crucial when seeking clarity on an issue. We have seen instances where individuals have been wrongfully accused of criminal behavior by authorities or regulators. The news of someone’s wrongdoing is front-page material, but the news of a person’s innocence is a small-font entry on the back page (if at all).
The Situation: The Faultless Fraud
Derek Legitt, an entrepreneur, was approaching his 75th birthday and decided he wanted to sell his business and retire. A few years before, Legitt was named as a co-defendant in a securities fraud case. The case gained national attention because the main perpetrator, Nicholas Baddude, caused hundreds of people to lose significant amounts of money. It was alleged in the criminal case and in numerous media reports that Legitt was a co-conspirator in the scheme. While Legitt was never indicted, his name was linked with Baddude, and his reputation had been tarnished. Because of this, Legitt knew that he would have trouble selling his company. So Legitt called us.
Because we are not in the business of public relations, we explained to Legitt that we could not conduct an inquiry directly for him because then people would question the legitimacy and independence of our research. So Legitt hired us through his legal counsel so that we could properly conduct a meticulous investigation designed to figure out what happened in the securities fraud scheme and to determine Legitt’s culpability.
We read through the hundreds of media articles that discussed Baddude and found every one of them had connected Legitt to the fraud. When we reviewed the court documents, we found Legitt had been named as a defendant in the criminal case, but he was never personally charged with any wrongdoing. We realized the only way to truly resolve the issue was to start talking to people involved in the case. At the outset, we decided it was best to get a formal statement from Legitt about what had happened. If he was truly innocent, then why was he even connected to the scheme? Through a series of interviews with Legitt, he explained he was an officer of a bank where the fraud took place. Baddude had several accounts at Legitt’s bank, and because Legitt was an officer of the bank, he was named in the criminal case. Everyone assumed Legitt had to be involved. Legitt repeatedly said he knew of Baddude but had no knowledge of the fraud. To confirm Legitt’s statements, we needed to see what Legitt knew and when. We asked him for access to his email accounts (both work and personal), and with the help of his former associates at the bank, we were able to review relevant bank documents and his old email account at the bank.
Our team of investigators spent days organizing this information into two sections: information that may have incriminated Legitt and information that exonerated him. In the incriminating pile, we had a series of email messages to and from Baddude about his accounts at the bank. In each message, Legitt made clear assertions and requests for clarification about status and activity. And in every response, Baddude was shifty. This was the only information we uncovered that would have connected Legitt to Baddude.
We then met with the attorneys on both sides of the criminal case, the FBI agents, and prosecutors involved—and even Baddude himself. The meeting with Baddude was entertaining. He was in many ways impressed that he was able to pull off the fraud for as long as he did. He felt the need to tell us about the numerous times he almost got caught. Because sitting in a prison and talking to a convict is not the most pleasant of atmospheres, we pressed Baddude about his relationship with Legitt. Baddude simply said, “That poor guy got played.” Baddude said Legitt had no idea what Baddude had concocted at Legitt’s bank, and while we would not describe Baddude as remorseful about Legitt being implicated in the scheme, Baddude did seem somewhat distressed about it.
The Tactic: Don’t Stop Digging
All of our interviews, meetings, and document analysis produced the same result: Legitt was innocent. We compiled all of our efforts and conclusions into a written report for Legitt’s attorney. Then, when Legitt was shopping his business, he would tell all of his corporate suitors to discuss the investigation with his attorney. Once the potential buyers read the report, a thorough investigation conducted by an independent third-party, they would have comfort in knowing they were not buying a business from a dishonest man. And if questions arose in the future, our report would show the matter was properly vetted. Ultimately, Legitt successfully sold his business.
In Legitt’s situation, the research went beyond what could be found in the public domain. The information unearthed was necessary for Legitt to continue his professional endeavors without feeling as if he had a misplaced scarlet letter on his head.
Never take information on face value alone. As illustrated in the stories of Legitt, Duped, and Pretendz, the extra steps you take to uncover the truth directly impact the success of your deal.