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[New Project] New Canadian Equity and Social Values Fund

The current turbulent economic conditions is a great opportunity for opportunistic investments. History indicates that during economic downturns three main events occur:
1.  Increased educational attainment. Individuals seek to improve their skill sets through increased educational attainment (such as a post secondary degree or certification in another field) or certification to increase income potentials.
2.  Increased entrepreneurial activity. [...]

November 2008
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BEWARE – Is Your Private Equity Firm / Investment Banker Ethical?

How important are ethics in today's society?

Prior to the demise of Lehman Brothers and the selling off of Merrill Lynch to Bank of America, I was evaluating the level of transparency and ethics of some of the world’s most recognized private equity firms. My list included firms like Comerica, Wachovia, Wells Fargo, Bank of America, and many others. The idea was to determine how these firms go about identifying, selecting, and evaluating potential clients for their private equity/investment banking services division.

Typically, private equity firms have a standard due diligence policy when taking on new business. Unfortunately, some of these firms undertake unethical and illegal activities on the major shareholders of a potential client. Although majority shareholders have an expectation of privacy, private equity firms perform full background checks on the financials of these shareholders.

Private equity firms claim it is a risk management procedure in an effort to mitigate against potential risk exposures. I found out that this is not entirely true. Just like any business, private equity firms are in the business of making money. As such, they only take on business that they believe will have the highest return for the least amount of effort. 

This moral hazard is lead to the current financial mess in the United States. Private equity firms were taking on riskier business based solely on the “name” of the potential client. 

When it came to new business, evaluating a potential client’s current shareholders is not an adequate way to manage future expectations. Moreover, as we all know, past performance is not an indicator of future success. The reason we approach investment bankers and private equity firms is to tap their intellectual and capital raising resources is to move our organization to a “higher” level of performance. For example, due diligence on a company’s current shareholders/directors seeking to raise new debt/equity is simply a waste of time.

That brings up another point: the debt and equity deals undertaken by the firms. There are three players involved in the deal 1) the issuer, 2) the private equity firm’s shareholders (or other buyers) and 3) the private equity firm themselves (acting as an intermediary or placement agent). Private equity firms receive a commission from the issuers and in some cases the buyers as well. The private equity firms have an incentive to discount the actual cost of equity or debt because if the issuer does well, the debt or equity will be worth more. If the issuer does poorly, then the interests (debt or equity) is already at a discount and will be divided among the creditors when the issuers’ assets are liquidated. For quite some time now, academic circles have insisted that the investment banking/private equity industry is fundamentally flawed.

(Test – Ask yourself why the economy is doing so badly. Find the root of the problem, not the symptoms.)

For decades, private equity firms have availed themselves of operating in an unregulated market. Furthermore, according to Grant Thornton in August of 2007, less than 25% of private equity firms have a formal code of ethics. Grant Thornton’s survey also indicated that private equity firms believe they are in a better position to regulate their own behaviour. Clearly, private equity firms should be more transparent and disclose more about its activities.

So what can issuers do to protect themselves?

Work with private equity firms that have a code of ethics.

Here is what I suggest

1) Ask the firm to forward their code of ethics. Trustworthy private equity/investment banking firms will forward their code of ethics immediately or have it posted on their websites.

2) Ask questions. Get the private equity firm to explain in detail what their policies and procedures for establishing new clients. (Watch out for the “reversal”). Associates are trained to only provide certain information to clients. They are trained to reverse the situation and ask a lot of questions about your firm. Do not get intimated, give them the typical “you are browsing” rhetoric.   

3) Work with a firm that has a well known, recognized and fair operating policy. It is quite easy for clients to find out if private equity/investment banking firms are fair and respectable. The private equity industry works on a great deal word of mouth. Private equity firms that treat one client poorly may regret it in the future.

I restrict my blogging to no more than 10 minutes or I will be here all day! (Some of us are actual working)

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I look forward to hearing from you!