Wednesday, April 28, 2010

Burning down the house

Goldman Sachs has been in the news much more than they would like and are bound to stay in this uncomfortable position for sometime. I have no idea whether this scrutiny is justified, or not, however, the age old conflict of interest monster is resurrected yet again. Over the past 20 years, much of the profits of Wall Street have shifted from gathering data, transforming it into information, which is then actionable by the firm's client. Today, much of the benefit from this data flow inures to the Wall Street firm, acting on its own behalf. With full disclosures, there is nothing wrong with this, and in many ways, it's the capitalistic way of life. But that does not make it right when you, as a client, find yourself on the opposite end of a trade, a transaction, or a bid from your advisor.

It's a trust issue. Plain and simple. In these cases, clients are not too interested in 'Chinese Walls', bolstered by regulations, when fundamental issues of self-interest arise when your competitor is your advisor. It gets your gander up enough to even think about uttering praise for the plaintiff's bar. Perhaps, all jokes aside they do serve as a conscience for the 'little guy'? At least, we know where they stand.

The subject of self-interest and trust comes up frequently in the venture business. One area, in particular, is around a M&A exit. Let me explain. Assume, as a VC, you have backed a CEO who owns 10% of the company and is 50% vested (with full acceleration on an exit). A private equity buyer approaches him and, with your consent, enters into sale discussions. The PE buyer, seeing the wonderful job he's done, puts on the table a wonderful CEO compensation package that post transaction refreshes his equity package (with options set at a value that reflects the acquisition cost).

The CEO, who works for shareholders that includes the VC firm(s) has a huge conflict of interest. He is charged with maximizing returns for existing shareholders, including himself, but has a MUCH greater incentive to gain personal liquidity and 'roll the dice' for another payday by serving a new group of investors. His self-interest is a conflict that the buyer recognizes and in many ways counts on to secure a favorable transaction. It's human nature.

If you've been through this before, a way to save the CEO and shareholders much angst, is to appoint a director as the point on valuation and structuring discussions. Remove the haze of conflict and replace it with a 'clean' transaction where everyone knows where self-interest lays. Understanding that most M&A approaches never reach consummation, it's also a good way to save the Company from much distraction, and the relationship from Burning Down the House.


1 comment:

  1. Great post on conflict Charlie. These situations only gets worst when there are more than one class of shareholder, and can even tax the good judgement of King Solomom, when there are mulitple classes of preferred and under-incented management. As a director, I was recently in a situation where management was negotiating with an seemingly interested buyer....it was a short-sale. The company had a preferred invistor who had been an investor for 14 months, and because of the structure of their preferred was due to get a 3.7x return. Management felt they were getting to little for their 10 years of running the business and the rest of the common (old investors) where going to get 25 cents of their originally invested dollar. Unfortunately, the deal never happened.

    To be an effective fireman and save the house, a few things need to happen. Investors need recognize the physics in the deal and be willing to adjust fairly to get it done. Management should also understand that the components of a going forward compensation plan that is "out-of-market" should be considered deal compensation, not personal compensation....And finally each director needs to recognize that they represent all shareholders, not just the ones that appointed them.

    Most importanly however, is my new knowledge that Tom Jones can still rock-it-out!

    ReplyDelete