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Apologies for the hiatus.
I was travelling and it was different. Not fun, different.
Anyway, at the airport, yours truly runs into an ex-colleague who informed me that he was having an issue with one of his portfolio companies. Now, I remember passing on this particular deal with the statement – “I won’t touch this with a 40-foot bargepole”. I found that I could not have possibly worked with this promoter. My friend thought different. Now, my being right doesn’t mean anything really. There were bigger forces at play when this paradigm changing information was being delivered to me.
Step into my shoes. I am at the Delhi airport. It’s hot and I am wearing a PPE (because I am clearly a masochist). I am having this long conversation and then there is this small bead of sweat making its way down from my neck. Normally you would scratch it away. But I am wearing a space suit. No scratching. Only squirming. And then this guy is telling me his whole saga of broken dreams and dashed hopes in the integrity of the desi promoter. How does one focus?
Anyway, that brings us to the topic for today - Exactly how big is the promoter risk in PE/VC investments?
Sure, you can document everything ad nauseam and ask for the Founder’s car, their house and their firstborn in the papers but enforcement is difficult. Plus, we don’t really want a rep as being an “unfriendly” investor. At some point, this perceived “unfriendliness” needs to be balanced with the responsibility towards one’s LPs, but those shenanigans are a different post, perhaps for later.
Now, admittedly, I am a relative novice in this area. I have been rather lucky that apart from 3 notable exceptions, most companies I was involved in were on the up and up. This kind of a post is very hard to write. I have tried to create a structure, but I am not sure if this works or not. So, you, my dear reader, will have to help and let me know if it makes sense. Please bear with me if I come across as generalizing from small samples or as committing other logical errors – this kind of a narrative is hard to write without breaking confidentiality or resorting to mudslinging.
1. Defining El Dorado.
Let’s start with a simple one. What makes a good investment? Over time, what makes a good investment for me are these points:
Capable and Honest Management that can grow the market cap to at least 3x of what it is today.
Attractive Industry Structure that will allow a well run company to grow more than 25% YoY - ideally without claiming tons of capital up-front.
Insulation from regulatory overreach and exposure to government as a primary customer.
Sustainable competitive advantages that allow the business model and the margins to be defended.
Long term RoE and RoCEs in excess of 25%.
Clear Exit Strategy - attractive to strategic or financial investors.
And I would not blame you if you think you have seen these (or a variation of these) before. I am sure everyone ends up playing a similar riff eventually. Now, most of these are binary filters. You have a visible exit route, or you don’t. You are exposed to the government, or you aren’t. You have Moats or you don’t. Your financial performance is strong, or it isn’t.
The joker in the pack is the management. Now, there are probably as many quotes about “management” in PE as there are investment professionals in India, but for the most part, you don’t know who you are getting in business with beyond a point - especially if you are running a fund. There is a whole other nut to be cracked about how the same stuff applies to GP and LP relationships but perhaps later.
OK, context set, moving on.
2. What is the ideal Founder or CEO?
If you haven’t read the Nomad Partnership letters, I will strongly encourage that you do. They are an amazing resource and the advice contained in them is pretty relevant even now. The Nomad folks’ ideal company was run by someone who had a ton of skin in the game. Now, professional CEOs are still a relative rarity in India. Mostly the firms are run by owners (which is why we use the term promoter here so often). So skin in the game is sorted. What else? Allow me to submit my list to you:
Someone who is Trustworthy - This is the most important, and hardest to define trait. Some promoters are perfectly honest with their investors but screw their employees. Some enrich themselves and their teams and blow up tons of Investor capital to build their personal brands. Some surround themselves with yes men and call themselves kings of the world. I define someone trustworthy as someone who doesn't have a track record of screwing people over. Rest is mostly ineffable. Patterns of behaviour are a strong indicator of what you can expect going forward. There is a reason why we do background checks.
Someone who has Consistency - there is enough research that shows that most decisions take roughly the same amount of mental bandwidth. So I would want someone who is able to be boringly consistent and just put their head down over someone who is chasing the next vanity deal, the next vanity milestone and the next headline. These are the people who act and not react.
Someone who has Longevity - Closely tied with (1) above - someone who has proven themselves by having been in the saddle for some time. Knowledge, responsibility and ownership - all three take time to bed in. Longevity also means someone who has been able to build and lead a stable team for sometime. it requires a knowledge of what works for them and working around their shortcomings. The best way to describe this is a set of constants. A Promoter with Longevity is able to understand their constants and build around them. Which leads us to…
Someone who is Pragmatic - i.e. someone to whom the lord gave the serenity to accept things they cannot change, the courage and capability to change what they can and wisdom to know the difference. It may sound cheesy but the best promoters know their limits very well. They bite off what they can chew and they listen to advice - even if they disregard it completely. Because they are not trying to assault every keep and every castle pell-mell, these folks are also highly focused and great at execution.
Right. Now what?
3. Context is for Kings, Redux
AKA Misaligned interests lead to Missing Principal (and we can forget about returns anyway).
OK, I am going to get this one out of the way quickly. Last time I used this phrase, I was sent at least 15 emails from folks who kindly pointed me to the fact that context is king and not for kings. This is lifted straight from an episode title of the Star Trek Discovery series. Michael Burnham asks Captain Lorca why he wants her on his ship, to which he replies:
Universal law is for lackeys, context is for kings.
i.e the King1 gets to interpret the context. Everyone else has to follow the law. Period.
Now, there is a reason why context means a lot in terms of the management team or the promoter’s interactions with the investors, and why people like yours truly get paid a lot for aligning interests via structures.
Context is pliable. You can structure a context using contractual terms and tools like profit sharing to align interests temporarily. There isn’t much else to do2. Once the money has left the investor’s account, they are pretty much at the mercy of the Promoter (unless it’s a control deal) so a lot of time has to go in fixing this stuff ex-ante. Ex-post options are remarkably limited in India.
I don’t tend to worry about bad promoters. My way to look at it is this - the incidence of bad promoter traits in India is a certain percentage - lets say x%. What that means is that if you make 100 investments, you are likely to run into at least x bad promoters. It’s a cost of doing business. If we end up with one, we need to see if we can align our interests with them. If not, stop fretting, check what red flags were ignored, learn to never make that mistake again and move on. Anything else is a waste of time and energy and the rest of the portfolio probably needs your attention more.
Most misalignments are due to a failure of imagination. We don’t anticipate chicanery (catchall term, too lazy to expound this one) and so we don’t necessarily protect against it - at least initially. As we take our licks from the gods of PE, we learn. Our term sheets grow from 10 pages to 27, and agreements run into hundreds of pages. We get good at creating complicated structures spanning 6 jurisdictions and 3 stacked instruments to make sure the Promoter is incentivised to not screw us over. Tax Free.
I wanted to write a long tome on the shit I have seen, but Anand Sridharan beat me to the punch and I am happy to report that he actually writes far, far better than I do. Now if I write what I originally wanted to, it will seem like I am copying. So instead, I will refer you to his very well written posts.
I will limit myself here to offering some ways to handle the agency problem via incentives. Find a way to align your and the Promoter’s interest so that it is profitable for him to deliver your desired outcomes compared to other things.
Here are a few other (very questionable) insights from my relatively short career:
Red flags are often found in patterns - each individual event/item has an explanation, but once we step back and start looking at the larger picture, patterns emerge.
Co-Investors can be hell - by their very nature, PE funds often find themselves with different agendas in the same Investee company. Clear understanding and discussions on the motivations and timelines of your co-investors ex-ante is very, very important.
Focus - distracted managements are usually recipes for disasters, as are legacy creation M&As.
Family Drama - a history of family drama immediately makes a company a no-go for me, except when companies are being divested because of said drama.
Passing over Managers for Laadla - hard to fix problem. Laadlas can be capable but most often are not. And the ones who are not often tend to think too much of themselves because of a fancy US management degree. Because this leads to a demotivated management, and hands reins to someone who hasn’t held leadership responsibility running the show. Again - instant no-go.
Bad Incentives - self explanatory. Management must have skin in the game, and they should stand to win big when the investors win big.
Hit by a truck - have personally experienced this. The founder leading the firm leaves or worse, passes away. This one is a significant mixed bag. Smartest course is to evaluate everything ab-initio. It’s almost like being handed a new set of cards at the river and being asked to place a bet. Sometimes the cards are better. Most often, they aren’t. Step back and re-evaluate. In my case, we found an equally capable CEO designate who was able to step into his expired brother’s shoes and execute like a boss. We were incredibly lucky.
As always, I look forward to hearing from you. If you liked this post, pls feel free to share this or subscribe to this newsletter using the links below. I try to write a 1000-2000 word essay once a week.
I am not sure if there is a PC word for “King” yet - Ruler-person maybe?
I assume here that diligence, BG checks, etc have all come without red flags, that one is comfortable with the PE risk inherent in the investment, and that risks and uncertainty have been clearly understood. only variable is the management team and their motivations (or lack thereof).