Breaking Point: Who Cracks Under Pressure?

Heat and high pressure have a way of magnifying the significance of flaws—a fact well-known to potters, glassblowers and private equity investors.
 
Under ordinary circumstances a particular biotech executive might be a paradigm of ethical behavior. She could easily enjoy a 40-year career at a pharmaceutical company without demonstrating a single serious lapse in judgment.
 
But install that same executive at the helm of a biotech startup. Have her put her life savings at risk. Then tell her the company’s prospects for raising a second round of financing hinge on the results of the latest clinical trials. Your odds of having picked the right executive for the job may be lower than you think.
 
So, what percent of people have flaws that, under pressure, could lead to unethical behavior? What percent behave poorly under any atmospheric conditions? Such questions are practical ones for firms racing to put money to work before investment periods expire.
 
David Morgenthaler, founding partner of PE firm Morgenthaler, which operates both venture capital and buyout funds, says he learned important lessons about human nature while serving as a commanding officer of two different companies of men (about 1,000 altogether) during World War II.
 
Morgenthaler came up with a rough rule of thumb for his troops. About two-thirds of them had a “good, healthy mental attitude” and wanted to do a good job. About a quarter wouldn’t instigate trouble, but they could easily be led astray. And up to about 5 percent were simply criminals. “They are just wired differently,” he says. “They don’t feel they’re transgressing any moral code.” He adds: “Nothing but fear controls them.”
 
His experience in the war “absolutely” informed Morgenthaler’s approach to assessing executive talent later in his career, he says. He hasn’t hesitated to knock someone out of the running for a job for the mistake of, say, claiming to graduate from a college after only attending. “If they’ll cheat on a little thing, they’ll cheat on a big thing,” he explains. “And under real pressure it becomes very likely they’ll cheat exactly when it will cost you the most.”
 
Morgenthaler says he can point to just five “consequential” examples of cheating on the part of management out of the more than 300 companies he’s backed since founding the firm in 1968. That performance “will get you an ‘A’ in any class,” he says, although he puts the cost of those incidents, most involving revenue that shouldn’t have been recognized, in the nine figures in lost profits.
 
Jim Mintz has come up with his own rule of thumb for executive behavior based on his 16 years leading The Mintz Group, which conducts some 5,000 background checks a year. In an article in the latest edition of Buyouts magazine (a peHUB Wire sister publication), Mintz says that he gives executives a flawless report card only about 10 percent of the time when conducting a background check for a potential investor. About 80 percent of the time the background check turns up at least a modest red flag—a DUI arrest, an unresolved tax lien or a rough patch of some kind. The remainder of the time, the background check turns up something so significant it can remove a person from participating in a deal or scuttle the deal altogether, Mintz says.
 
While these are anecdotal cases, they are too scary to be brushed off as outliers. Keep them in mind the next time you feel pressure to complete a deal—lest the temptation to cut corners on due diligence coincide with another’s temptation to disregard his or her moral compass.