Private Equity Story Time: Fraud and A Lynx Farm*

Sometimes, even great PE sponsors make mistakes.

I worked with some of the top private equity practitioners as a BigLaw lawyer. They were sharp, strategic, and often ruthless. Watching them work was beautiful. Sometimes, even great PE sponsors make mistakes.

Here is the fifth Private Equity Story Time story. These stories are intended to pass along the lessons I learned from some of the sharpest PE practitioners in the world and can be applied to independent sponsors and small Searchers.

We represented a very active sponsor in a strategic add-on. It was just over $100m. The PE buyer needed this acquisition to finalize a portfolio company they planned to package and sell in the coming year. They were getting to the 5-year mark when their investors wanted them to sell. They offered over 12x adj. EBITDA for the business.

The PE Buyer advised us they wanted to do abbreviated due diligence and move quickly to closing. I scheduled a due diligence call with Seller’s owner-operator.

I have two goals for an initial due diligence call with management.

First, I want to gather information on what is important to the business so I can truncate my diligence requests to not overwhelm a founder-seller. I also want to get a feel for where we need to go deeper and where we do not have to focus. For example, if the seller tells me they have form agreements with customers and an involved general counsel with quality credentials, I will review the form agreement and put a representation in the purchase agreement that they only use the form agreement. Done with customer contracts, unless something comes up.

Second, this is my opportunity to build rapport with the seller and seller’s team. I try to make small talk, find commonality, and create a relationship throughout the call. I want to end the call with the seller knowing we are interested in a collaborative path to closing.

In this case, I got on a call with the Owner and could immediately tell he was dumb as a fox. He knew everything about the business, but was appeared deceptive in ways that raised my hackles.

I asked him what he does for fun. He said he has a passion for rescuing lynxes. He had pictures of lynxes all over his office. He said he had a farm where he raised them. I said, how hard is that in the U.S.? He said, oh no, my farm is in Costa Rica where I got citizenship a while back. Then he said, I plan to retire there.

I thought this was interesting. I had done a dive on extradition laws many years ago in school and knew Costa Rica does not extradite its own citizens.

There were a few other irregularities, but no smoking guns. We suggested to the client that we increase the escrow from $2m to $10m for 12 months. We suggested it to Seller. Seller flipped out and threatened to walk. Our client proceeded with only $2m in escrow.

We told the client to slow down because we have not received critical diligence items. Client said to push to closing.

We sprinted to closing and closed on December 31st. We circulated fed reference numbers and the seller responded saying, “Oh I forgot to add #NoBacksies !!! LOL”.

We chuckled and moved on from a tough deal.

Two weeks later our client calls us and says there was massive fraud in the financials that the quality of earnings provider missed. The business was worth a fraction of what they paid. Because of the high multiple this was a huge hit. The client said, what do we do?

We had indemnifications and a $2 million escrow. For the rest of the loss, we had to go after the Seller directly. We asked, have you tried serving the Seller?

The client said, yea, it looks like he moved to Costa Rica and has no assets left in the U.S.

 Instead of sailing into a huge sale of the portfolio company, the PE group wrote off a huge loss.

I now encourage buyers to listen to themselves when their hackles go up or when they feel pressured to close over uncertainties. In every deal, there is some amount of uncertainty, but do not ignore the feeling that a seller is being dishonest.

I have a rule in my life, anytime I feel someone else is rushing me, I go intentionally slow until I am sure the next step is the right one.

When in doubt, slow down, and dig more, because once you close it is hard to go back.

*Names, monetary amounts, and identifying information have been changed and sometimes combined with other stories.