MARKET SCAMS

[thepennyking]

Going on Background
March 19, 2004

By Alex J. Stockham

With all that’s gone on in the world over the past three years, background checks have emerged as an essential piece of due diligence for private equity firms.

In addition to searching for possible links to terrorist organizations, private equity and venture capital firms are also on the lookout for other nefarious behavior, such as lies on resumes, hidden unsuccessful job tenures and unreported criminal indictments. While it may be rare that a potential investment’s manager or owner is a criminal, it needs to be checked. The firms hired, such as Kroll Inc., BackTrack Reports and James Mintz Group, to check into someone’s past say private equity industry players often use their services, but sometimes it’s already too late. A firm may have already made up it’s mind about investing.

According to Randy Shain, a co-founder of BackTrack Reports, private equity and venture capital firms will call him to check up on a prospective manager late in the deal cycle.

“Calls are invariably followed up by them saying they’re in a rush,” Shain says.

That adds up to firms not having learned the lessons they say they’ve learned over the past four years. While there has definitely been a “flight to quality” on the part of private equity firms and an increase in manager-centric strategies, the background check continues to come late in the game.

One reason, Shain says, is it is hard for private equity firms to justify the expense of a background report if a deal is not set to go through. After all, if the chances are slim that a manager will be backed, why go through the trouble of making sure they’re all that they say they are.

Peter Turecek, a managing director for Kroll Inc., adds that while it may appear to be cheaper to hire a background consulting firm when the deal is already close to being done, it may prove costly in the long run if a discrepancy is discovered.

“I always stress to clients that it’s always cheaper to do thorough due diligence at the front of a deal than doing damage control on the back side because a deal goes sour,” Turecek says.

If a deal does go south, not only do lawyer fees and advisor fees go up, but a firm also has to deal with the negative press. A damaged reputation is much more costly for a firm than a thorough background check on a manager.

BackTrack’s Shain says his firm may have come up with an intriguing - and rational - solution to get more business from private equity and venture capital firms. Basically, BackTrack’s fee depends on whether or not a deal goes through.

“We should be the first option - before attorneys and accountants,” Shain says. “The deals you don’t do, don’t pay as much. Pay us more on the ones you do.”

Turecek says he has seen an increase in the number of private equity firms utilizing background checking services, but there is still room for improvement.

“Firms are checking out new management and looking for skeletons in the closet before they invest,” Turecek says. “But until all companies are doing this, we’re not seeing enough of them doing it.”

Kroll Inc. has also been getting the word out about itself among the private equity and venture capital community, Turecek says. The firm has been sponsoring tables at conferences and speaking at seminars and sessions. He adds that his clients have been asking for Kroll to check out a manager that may be invested in and for potential hires at a portfolio company.

Private equity being an industry based on relationships, earlier background checks into management are a prudent thing to do, Shain says.

“Before you get emotionally attached to a deal, it makes sense to know who you are dealing with,” Shain says. “Meetings and dinners are nice, but it is by no means systematic. People think they can feel people out.”

Shain adds private equity’s comparison to baseball - where batting .300 with a few home runs and a few strikeouts is considered excellent - is misleading. It’s not that a strikeout in private equity was a risky deal that just went bad, it is probably a deal that shouldn’t have been done at all. There was no reason to be fooled by a pitch. Some of the headaches may have been avoided if firms would have looked into managers.

“People [firms] were investing with didn’t have the experience or reputation that would allow [a private equity firm] to succeed,” Shain says.

Despite thorough background checks, an indiscrepancy - even a major one - may not be enough to squash a deal. What ends a deal differs depending on the firm, Turecek says.

“Each client has a different threshold for pain,” Turecek says. “A lie about education may be enough to kill a deal.”

Other firms, Turecek says, have a much greater tolerance for manager impropriety. One Kroll client had the firm look into a manager that was discovered to have been the “bag man” - the person who takes the money from the client to the hit man - in a murder-for-hire more than a decade prior.

“The client said to keep looking,” Turecek says.

As the economy improves and private equity firms look to deploy capital, they’ll likely need background check services. Shain says his firm has seen a 20% increase in business from 12 months ago and they’re getting more calls from and for private equity firms. Rest assured, limited partners are doing their homework on their potential G.P.s as well. Shain says L.P.s tend to focus on the internal operations of a private equity firm as opposed to searching for criminal or unethical behavior.

One question limited partners will ask is what the turnover rate is like. If people have left, limited partners want to know why. If it’s just due to lack of lead flow, that’s one thing, but if there are larger issues, such as poor management from the top, that may be important for a limited partner to know.

It appears what is good for the goose is good for the gander. Conducting background checks have become part of running a stand-up business - something for which both sides of the private equity aisle can cheer.