The Riverside Company’s Lessons from the Loo

People don’t make movies about smooth sails across the Atlantic, peace negotiations or sleepy Sundays. Disaster and drama sell, so we thought we’d share some of ours.

When all goes well, our private equity work does not capture headlines. We make companies bigger and better. We create jobs. We generate superior returns for our investors. All that’s been true for The Riverside Company since 1988, and we remain a leader in the smaller end of the middle market. Through 23 years in this business, we’ve exited 64 platforms and their corresponding 67 add-ons, realizing a 53 percent gross IRR and a 3.5x gross cash-on-cash return.

Nonetheless, we’ve had our share of reminders that we’re in the risk capital business. These deals are a form of costly tuition during our decades of schooling in private equity, and their lessons are invaluable. To make sure our employees all see how some of our worst deals went south, we came up with “Lessons From the Loo” for our crappiest deals. This introspective process involves dissecting our losers, analyzing them internally, talking about them with each other and our investors—all in an effort to learn and be transparent.

While we proudly post profiles of more than 55 solid exits throughout our 20 offices, we also had to find a home for the deals we’d rather forget. So we put them where they belong—in the rest room, on the wall. Each time a deal has soured for us, we’ve carefully examined what went wrong. We’ve found that simply avoiding a handful of mistakes and heeding a few red flags often prevents disaster. To save you a trip to our offices, we’ve summarized our six top findings here.

1) Fraud Kills

Nearly a decade ago, we found a company with all the hallmarks Riverside seeks in a deal. It was growing rapidly, had a strong market share, a knowledgeable CEO, and a set of innovative products in a growing industry. It was growing so fast, it had liquidity issues and was seeking a buyer. We jumped on the deal.

Almost from the start, it was apparent that something was wrong but the fraud was so sophisticated that it took us a year to uncover it! The financials we saw during due diligence were all lies. The company had overstated its EBITDA by $15 million and its working capital by $14 million. During due diligence, they bugged conference rooms, involved customers and vendors in the fraud, and manipulated documents. We and our auditors missed the warning signs, and we ended up losing millions of dollars.

We found a lot of warning lights in retrospect. The CEO was full of charisma, but the company had more than one example of litigation and sketchy ethics. The second tier of management was inexperienced yet highly compensated. The company would have faced serious challenges if the transaction failed to close. The company saw a lot of turnover in senior personnel and lenders—they obviously smelled something. The company had increasing supplier and customer concentration, and its fast growth allowed problems to be hidden. Perhaps most telling, they placed restrictions on talking to individuals throughout the organization.

On the accounting side, the company engaged in complex transactions and had complicated organizational structures. They created financials “offline” or delivered them in PDF format with excessive adjusting entries. And it always took a long time to get them to us.

This deal solidified our belief that values matter. We strive to do business as ethically as possible, and we look for the same in prospective sellers. While we’ve never seen fraud perpetrated on such a scale since, we’ve avoided plenty of fishy deals thanks to a much stronger fundamental approach. And we created a checklist called the “Profile for Indicators of Fraud” which we now use during every due diligence process. Our own systems, people, and processes are improving every day. We require that all prospective acquisitions allow us to spend at least three days on site with unfettered access to systems, files, employees, and facilities. These safeguards have strengthened our entire diligence process and made us better buyers. Because it can be so hard to detect, though, fraud is still the biggest issue that keeps us up at night.

2) Down Cycles Are No Excuse

The investment world attracts confident and competitive people. There’s a fine line between those attributes and hubris. Many a general partner has lost money thinking they could fix fundamental problems at a company. We’re no different. We once bought a leading company with strong market share in an industry with high barriers to entry. Better still, the company’s strong management team had grown EBITDA despite a cyclical industry downturn—all while integrating four add-ons. We paid what we thought was a favorable price, knowing that there was a lot of room for operational improvements, industry consolidation and other trends favorable to the investment.

Then sales continued to decline. There were issues with management. In the end, we had to make more space on the bathroom wall. So what went wrong?

Well, we learned the hard way that market leadership is not worth much when the industry is unpredictable and low-margin. In this case, the down cycle in the industry masked the company’s non-cyclical reasons for underperformance. Hence, what we thought was a relatively low multiple price became a clear lesson: Low multiples don’t guarantee success, but may guarantee failure. Our biggest takeaway from this deal, however, was to avoid companies with declining sales. Such deals have rarely been kind to us.

3) Change Managers Whenever Necessary

If management is bad or mediocre, change it. Now! When you do change managers, pay up for the best talent possible. On more than 140 platform deals, we have changed CEOs approximately two-thirds of the time, and CFOs 75 percent of the time. We’ve never felt that we moved too quickly, but we’ve often lamented that we should have moved sooner.

In one case, an outstanding CEO declined to remain on board and co-invest in the deal. This should have been a message. Instead, we started with a weak management team led by an internal sales manager who was unfit for a CEO role. At the end of Riverside’s long and fruitless ownership, there had been three CEOs, three CFOs, and two law firms. We could never build a coherent and successful strategy due to all the movement at the top. As a result, a promising investment consumed years of staff time and resources while producing a small loss.

If you know you have to replace an executive, do it right away. We now use interim CEOs and CFOs when necessary, relying heavily on our internal operating partners and outside directors, and we search for the best people possible, paying top dollar whenever required. Choosing and incentivizing the right management is still the single most important thing we do.

4) Never Lose Control

We’re not suggesting that you can wish away market fluctuations or avoid every pitfall. This is about controlling the things you can, like:

Avoiding businesses where you have no control over key third parties. We once acquired a company that received 75 percent of its inventory from one source. Whenever that supplier had quality problems, they became ours. When they dumped inventory or raised prices, it wrought havoc on our company. In the end, the supplier situation contributed to a poor performance with the investment.

Changing IT systems. One of our companies went through an IT implementation shortly after acquisition and just got it all wrong. For awhile the company was completely unable to track performance indicators and was flying blind! The system had problems that directly affected customers and the bottom line, including inaccurate inventory management, tardy product shipment, and billing errors.

Costs. Especially at the start of a downturn it’s crucial to cut expenses sooner rather than later. Often the management team that did well during the good times is reluctant to cut when sales start to head south. Over the years, we’ve built a large operating team to help management teams address these issues. At the same time, we’ve built the Riverside Toolkit, a group of more than 20 vetted resources that help our portfolio become more effective in crucial areas like sales, manufacturing, and pricing.

5) Sell When You Can

We’re in the business of maximizing investor returns. It’s risky, and our investors can earn small returns on plenty of safer investments. You always think you can squeeze a bit more value out of a deal, even if it might be a lemon. We’ve found that if a deal is underperforming after two or three years of ownership and a buyer comes along offering a reasonable price, it’s often best to get out right then and there. We have finite resources, so hanging on to middling performers is a waste of time and money. Several of our deals that have lost money could have been exited for a gain at one time, but we were greedy and in retrospect not as smart as we could have been.

We’ve taken steps to boost our exit process, most notably with the Riverside Realization Review. We developed this recently, after we underexited during the last bubble. The process forces us to justify not selling, rather than waiting for the “right time” or the perfect buyer. It’s already helped us to kick start exit processes several times this year.

6) Be Committed To Making New Mistakes

These painful lessons do not represent our biggest mistake—we’re saving that for its very own guest article in 2012—but they do represent mistakes from which we’ve learned and improved. As we said, we’re in the risk capital business, and we would not have been able to produce 23 years worth of superior returns while helping so many companies thrive if we never made a mistake. In a sense, we’re committed to making new and different mistakes in the future, continuing to learn, and becoming even better investors.

Stewart Kohl and Béla Szigethy are Co-CEOs of The Riverside Company