By Christian Mustad

Published by Campden Family Business, January 13th 2010.
www.campdenfb.com

Through their vast network of relationships, high net worth individuals are constantly made aware of entrepreneurial ventures or private companies looking for investors. When the case presented matches both their own entrepreneurial spirit as well as their passions, a transaction is often consumed, and amounts that can be very significant are invested directly into private companies.

Most family offices or trust structures are to various degrees involved in the management of the direct investments made by their beneficial owners. The stories they tell of these investment situations are depressingly similar. They speak of missing transparency, progressive estrangement, frustration, and ultimately, of value destruction on a massive scale.
Although not readily shared among family offices professionals, these “horror stories” from direct investments are so frequent that they have come to be seen as somehow unavoidable, the common destiny of what is often dismissed as pet investments. But there’s little that’s unavoidable about value destruction in direct investments. There are clear, structural reasons why it happens, and therefore very concrete solutions.

The basic reason for failure is that the inherent riskiness of direct investments is almost universally underestimated. This happens not only when the investment is made in young, entrepreneurial ventures, but also when the target is an established organization. In this last instance, the investor tends to overlook how destabilizing a change of ownership can be for a private company.

When a company bears an interesting – and therefore uncertain – project, the usual scope of information flowing between management and shareholders tends to be plainly insufficient. Why? First, because the centerpiece of information being communicated by management to board members is financial statements. But as we all know, by the time a problem shows up in the financial statements, it has already had ample time to wreak havoc in the company.  Second, because whatever information is provided in addition to that is by definition structured by management and therefore doesn’t represent an objective view of how the company is faring.

This is of course not to say that management should not be trusted. No investment in a private company would be made in the first place if the investor didn’t have a high degree of confidence in the people he entrusts his money with. What needs to be understood is that a management team that takes upon itself to develop a new company, or to bring an existing one to a new level, faces multiple challenges. And herein in lie the key risk, and the main cause, of failure: That while dedicating their energies to tackle some issues, management teams lose sight of other problems that, if not solved, will cause significant damage to the company.

Where the main cause of failure lies, lies also the solution. The management of direct investments is too often impaired by assumptions that must be dismissed. No matter how competent and trustworthy management is, the reality demonstrates that it would be wrong to leave management teams to their own devices in situations that are inherently risky. It doesn’t make much sense either to simply rely on whatever information is communicated to board members by management as a basis for proper understanding of how the company is faring. And neither is it very helpful to believe that only elusive industry specialists can provide insight beyond run-of-the-mill corporate information.

A long track record of monitoring direct investments has taught us that companies do not fail by chance or mere bad luck. In the vast majority of case they fail because one – or several – of the many activities that must be performed by any company if it is to function properly as an organization is simply not performed.

Which activities are we talking about? There are quite a few of them and even a broad description wouldn’t fit the format of the present contribution. Let us just say that they are the concrete outcomes of the management disciplines that academics and practitioners have refined over decades. As such, they can be organized into a manageable whole. Understanding market needs, developing products or services, optimizing production and delivery, managing human, financial or physical resources, etc., all constitute management disciplines, and all correspond to activities and outcomes that can be looked for in any company.

There lies the key to protecting the value of investments in private companies: let management shoot for the stars, dismiss misleading assumptions and regularly perform a “health check” on the company’s vital organs. Based on well founded and established knowledge, such “health checks” none the less propel the relationship between shareholders and management to a whole new level, and constitute the best protection against value destruction.