Backing a company that’s cooking the books, investing in an unpredicable market with low margins, waiting too long to sell and ending up in the red.
Co-CEOs of The Riverside Company Stewart Kohl and Béla Szigethy provide a rare glimpse into these and other mistakes it has committed in an article in the latest edition of sister magazine Buyouts. It’s a glass of cool water in an industry where nearly every firm claims to generate top-quartile returns but where investors increasingly value candor and humility.
That Riverside has had plenty of good deals is beyond dispute. In its 23 years the firm has exited 64 platforms and their corresponding 67 add-ons, realizing a 53% gross IRR and a 3.5x gross cash-on-cash return. The firm, which closed a $1.17 billion fund in 2009, has proudly posted profiles of more than 55 solid exits throughout its 20 offices.
But Riverside doesn’t repress memories of its bad deals; rather, it embraces them and the lessons they teach. In fact, it has a posters titled “Lessons from the Loo” posted—where else?—on the wall in its office restrooms around the world (see picture above). The article in Buyouts, picking up on the theme, includes six lessons, which you can see summaries of by clicking through to the slideshow.
[slide title="Fraud Kills"]
The trap: A fast growing company with strong market share, an impressive CEO and new products in a burgeoning industry.
Warning signs: The CEO was charming, but Riverside uncovered “more than one example of litigation and sketchy ethics.” The second tier of management was “inexperienced yet highly compensated.” The partners also noted a high turnover in senior staff and lenders with “restrictions on talking to individuals throughout the organization during due diligence.”
The reality: The fraud was so sophisticated it took almost a year for Riverside to uncover. The partners discovered it had overstated its EBITDA by $15 million and its working capital by $14 million. What’s more, during the due diligence process, “conference rooms were bugged, customers and vendors were involved in the fraud, and documents were manipulated.”
Lesson learned: Now, for all potential deals at least three days are spent on site with access to all employee information, files and systems.
[slide title="Down Cycles Do Not Excuse Underperformance"]
The trap: A high profile company with a strong market share in an industry Riverside describes as having high barriers to entry. The management team had grown EBITDA inspite of a cyclical industry downturn. Riverside paid a favorable price and noted “potential for operational improvements and industry consolidation.”
Warning signs: Sales continued to decline and there were issues with management.
Lesson learned: Avoid companies with falling sales. Riverside warns: “Low multiples don’t guarantee success, but may guarantee failure. 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.”
[slide title="Change Managers Whenever Necessary"]
The trap: Weak management team and an unsuitable CEO.
Warning signs: Riverside explains that an outstanding CEO declined to remain on board and co-invest in the deal. This should have been a warning. By the end of Riverside’s unprofitable ownership, there had been three CEOs, three CFOs and two law firms.
Lesson learned: If management is under par, change it immediately and pay for the best managers possible. On more than 140 platform deals, Riverside has changed CEOs approximately 66% of the time, and CFOs 75% of the time. The firm also uses interim CEOs and CFOs when necessary.
[slide title="Never Lose Control"]
Lesson learned: Control the things you can. Riverside warns:
• Avoid businesses with no control over key third parties. Riverside once acquired a company that received 75% of its inventory from one source. Whenever that supplier had quality problems, so did the company.
• Change IT systems. One Riverside company underwent an IT implementation shortly after acquisition which backfired. According to Riverside, the system had problems that “directly affected customers and the bottom line, including inaccurate inventory management, tardy product shipment, and billing errors.”
• Costs. Riverside says: “Cut expenses sooner rather than later.”
[slide title="Sell When You Can"]
Lesson learned: According to Riverside, if a deal is underperforming after two or three years of ownership and a buyer comes along offering a reasonable price, get out. “Hanging on to middling performers is a waste of time and money.” Kohl and Szigethy note that several unprofitable Riverside deals could have been exited for a gain at one time. The Riverside Realization Review encourages the partners to justify “not selling, rather than waiting for the right time or the perfect buyer.”
[slide title="Be Committed to Making New Mistakes"]
These lessons represent mistakes from which Riverside partners have lived, learned and improved. Kohl and Szigethy finish with these pearls of wisdom: “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.”