Risk returns

Due diligence and risk management prior to a deal has become more important, as recent LBO lawsuits demonstrate.

A private banker once told me that his super-high-net-worth clients typically have an instruction that trumps all others, and it isn't “make me a lot of money.” No, it's an emphatic “do not lose my money.”

This mandate is more sophisticated than it sounds. The measurement of the potential downside of a deal and the projection of the upside of a deal take place in a different parts of the brain. Optimists are better at projecting upside, and GPs are typically optimists, as are most good long-term investors.

But nothing ruins a fund more than a bad deal, which counterbalances the successes and empowers the mediocre deals. Many GPs see it as their first duty to preserve capital, whereas realizing great returns from the outperformers is a kind of optionality icing on the cake.

This issue of PEI Manager focuses on due diligence and risk management, where downside protection is job one. In a turbulent market, many GPs are finding that the work done prior to the closing of a deal is enormously consequential in the event that the deal doesn't go as planned, as witnessed by the burgeoning batch of lawsuits in the LBO market.

Our main feature this month, written by Jennifer Harris, compiles intelligence from three top attorneys who tell PEI Manager what they view to be the greatest risks in the unfolding market (see p. 20). You'll not be surprised to learn that our attorney sources all advise that these risks can be mitigated by proper negotiation and documentation prior to the deal closing, and crossing all the regulatory Ts and dotting all the compliance Is.

Of course, when you're doing deals at 100 miles per hour (see buyout market, 2006), who has time to pay attention to, for example, MAC clauses, or the risks in a company's pension fund (see p. 26).

Also in this issue is a look at the spreading use of forensic accountants, who do more than just verify a company's books. They interview many employees of the target company and run balance sheet items through advanced computer models to look for irregularities. Rob Kotecki also reports that GPs who hire forensic accountants need to be aware that costs and timelines can increase if something “interesting” turns up, which of course is exactly what these professionals are hired to look for.

Enjoy the issue,

David SnowDavid.s@peimedia.com