Private Equity Reform: Taking Aim at the ‘Bad Boys’

Know thyself, Socrates might have said, but you should also know thine enemy. Unfortunately, the enemy doesn’t always look like one – as many veterans of failed deals can attest.

In a financial world that runs on relationships, our ability to read the room and sense when appearances are deceptive is not always the best. The fraudsters and bad apples are making it very hard for honest people in finance to earn a living. They have also given Congress a reason to live.

One of the mandates of financial reform is to keep so-called “bad actors” from being able to participate in private placements. Bad actors — formerly known as “bad boys” in 1996’S NSMIA before these gender-neutral times — include anyone with felony or misdemeanor convictions in connection with the purchase or sale of any security.

If the amendment goes through, private equity will have to get as used to running background checks as banks currently are. peHUB spoke with Kroll senior managing director Peter Turecek, who specializes in due diligence and business intelligence. Turecek gave us a primer on how private equity players should think about the brave new world of background-checking.

peHUB: How common is background-checking in private equity? How does it work?

Turecek: It depends on how you define background-checking. In most of my world, it’s what PE firms and investment banks do in vetting management teams for IPOs, management teams for M&A and joint venture partners, and speculative deals. The other possibility is pre-employment screening. If a private equity firm or hedge fund is seeking capital, they can also do a check to find out what’s being said about them, so they’re not caught by surprise while raising money.

So it’s like they’re essentially engaging in vanity Googling.

Yes – but on steroids.

So what are the ins and outs of getting used to background checks? How do they work?

There are different kinds. There is a distinction between due diligence background checks for deals and pre-employment one for people. Pre-employment can be different because in some cases you have to tell the subject you’re looking at them and you have to sign a release, and there’s a limit tp how far you can look. Califronia, for isntance, has pretty restrictive limitiations on what you can look forin a background check.

How long does a background check take?

It takes about two to three weeks, on the longer side if you talk to human intelligence sources.

What falls under “human intelligence sources”?

Public records don’t tell you everything. Lawsuits are one-sided, for instance. People can file papers and make all sorts of horrendous allegations against you. It would look very lopsided if someone were to read the complaint and then your reply. We look for people who might know them: people they might have done deals with, investors, all the way down to the ex-spouse. Human sources flesh out issues and add color to the stuff in the public record or raise flags about things that don’t make it into the public record: “Bob is a great manager, but after 4:30 he drinks like a fish.” They can tell you if someone is a hard partier outside of work.

So are there many dodgy folks that are revealed by background checks? Do deals get killed?

All the time.
I’ve killed deals in a half-hour when we found an outstanding arrest warrant. The decision usually rests with the client in whether they want to consummate the deal after we tell them what we’ve found. Every client has a different threshold of pain. There are some cases where we’ve found that people had a serious criminal past, but the client says, “That was 12 years ago; they’ve changed a lot; keep looking.”

Are a lot of these records private?

If we’re lookign through criminal records, that’s all public record stuff. We look through media, Internet, do verification calls, make sure their resumes work out, make sure their college degrees were not on the eight-year plan.

Why would the eight-year plan be a problem?

Well, we found one guy who did two years in college, four years in jail for $250,00 check fraud, then another two years in college. He actually ended up at Fortune 500 company. We were looking at him because he was on the management team of a company doing an IPO; we represented the bankers. He got yanked that night from the IPO. They issued a new version of the S-1 and his name wasn’t even on it.

A reporter wouldn’t even have noticed his name missing from the S-1, but that would be an interesting story.

That’s why we go through SEC documents and look at footnotes. You can find accounting details, too. Employment contracts are sometimes in there, which are juicy. It’s not just how to look or where to look, but how to connect the dots. You look at past history to understand how this person operates.

The major concern of Congress and state securities regulators is really egregious fraudsters like Madoff and Allen Stanford. How do they get through the system for years without going through background check sor being stopped?

These are people with a lot of chutzpah and a lot of charm. They make it a very exclusive club to invest with them, which makes people keep their guard down. Sometimes depending on the type of fraud that’s going on, it may be hard to see from the outside. Someone like Madoff would be hard to stop with a light-level background check. if you dug deep and started analysis, you might have seen things that raise flags. Others you see right away, like Arthur Nadel in Florida [the “mini-Madoff“]. You can see from the records that they disbarred him, and in the decision called him dishonest and untrustworthy. He stole escrow money to pay off a bookie. If you’re not getting access to the books and records it’s going to be tough to spot, though.

One of the more troublesome areas in PE lately is the area of placement agents, who sometimes occupy the gray area between finance and politics. Andrew Cuomo, for instance, has been livid about them. Do you see them come up for background checks?

Only a little. The placement agents usually don’t end up on the radar screen.

Any parting thoughts on background checks for private equity mavens?

Seriously, you need to be doing them. Too many times people assume that others have done background checks. just like the banks do, all PE shops should be doing pre-employment checks when they’re hiring people. That’s a good way to stay out of trouble. Make sure that the people you’re hiring to run the businesses get them too, and those on the back end; there’s a number of secretaries we’ve done checks on who were stealing money from their bosses. A lot of the time people come to the firm by word of mouth, so people feel that they know them. You’d be surprised what you find out.