Investing in the mid-market this autumn? Why you need to be a paranoid optimist
So, we got through the initial lockdown period, hopefully relaxed a bit over the summer and it’s now back to school - and back to investing. The deal pipelines of Catalysis clients and the CF advisers appear busy again which is encouraging. But, to state the obvious, there are more uncertainties than we faced six months ago. The pandemic seems to be having another burst; the economy may lurch as government support is scaled back; the shape of Brexit is as murky as ever - but now just round the corner. So how to decide how much to focus on patching up investees, as well as get the balance right between digging out possible bargains and sufficient prudence to avoid the zombies?
One approach is to take some succinct and sound advice from some friends of ours:
> Tom Raymond from Armstrong Transaction Services offers insights on investee strategies in recessions and getting more benefit from CDD activity. Watch a short interview
> Lushani Kodituwakku from Luminii Consulting has ideas on looking strategically at smaller tech companies and then using DD insight to create better value creation plans. Watch a short interview
> John Nicholson, a serial tech executive and Chair, is full of thoughts about how to navigate this strange recession and how generalist investors can safely look into tech opportunities. Watch a short interview
But it is also helpful to get one’s overall mind-set right and that’s where it might be helpful to consider the wisdom of one of the most successful entrepreneurs ever. Unusually, he was also an amazing writer.
Andrew Grove’s role in building Intel from start-up to the leading semiconductor manufacturer is legendary and his book High Output Management is still just as practical a guide to how senior teams can get things done even if it was published 37 years ago.
Grove’s relevance to our specific issue of investing in a time of uncertainty is his thinking on how to balance optimism and prudence. He observed that ‘CEOs act on leading indicators of good news, but only act on lagging indicators of bad news’ because ‘In order to build anything great you have to be an optimist’. In other words, CEOs should bring optimism to their companies and strategies as part of their job description. Likewise, investors won’t do much unless they possess some form of optimism about future opportunities and their ability to spot them despite the difficulties.
But Andy Grove also provided the other half of the equation too. His catchphrase was ‘Only the paranoid survive’. The implication is that you earn the right to optimism by assuming that there are more ways of failing than succeeding. Then you do the hard work to identify the real risks and either navigate round them or wrestle them to the ground. For investors that translates into the sometimes painful requirement for deal leaders to be simultaneously sceptical buyers and dynamic sellers of their opportunities.
As Catalysis, we experience the same tension between the need to be upbeat and developmental when working with teams, while also remembering the brutal reality that lots of plans don’t work as hoped in practice. The two stories below offer examples of how thin the line between optimism and paranoia can be in practice.
Mid-Market War Stories
From hero to zero
The Founder/MD of the food importation business – we can call him James - was excited. He reckoned he had at last found his successor after much looking. The candidate – Robert - had a decent managerial CV and after, three long meetings, James had concluded that he possessed the following qualities:
Entrepreneurial spirit;
Business passion & understanding;
Strong leadership skills;
Results oriented & profit focused;
Excellent persuasive & negotiating skills.
An impressive mix if true! James’s older sister – who didn’t work in the business but liked to keep a watchful eye on her sibling’s occasional wishful thinking – persuaded him to get a second opinion before signing Robert up. My challenge was how to make sure that any conclusions would be taken seriously – so I suggested that James join me for the whole interview with Robert. We gave ourselves four hours to explore the detail of his past roles.
What emerged as walked through Robert’s history was broadly a validation of the CV and his interesting track record in other consumer-focused businesses. However, his attitudes and methods were very different to those practised in James’s company and apparently James hadn’t described that culture to Robert. Where James could be people-oriented to the point of over-indulgence, Robert was someone who indeed provided strong leadership, but of a very directive type, which he was very proud of.
From two hours in, James was getting twitchy at the contrast in values and styles; by three hours he was starting to steam. By the time we said goodbye to Robert, James was almost beside himself: ‘There is no way that man is coming into my business!’. The experience was enough to persuade him that not only should he not hire Robert, but also that he should postpone his idea of handing the business over to someone else. Twelve years later he is still there.
The moral of the story is that while it is normal to become enthused by strong track records in individuals and teams, looking from a different perspective can radically alter your view. In this case, a candidate had been truthful from the start but hadn’t been asked the right questions.
The flaky narcissist
My UK investor client was looking at an Irish software business – and it turned out that Irish investors had kept their distance. We were on unfamiliar territory and risked playing the role of naïve outsiders. I was asked to reference the CEO who was effusively helpful in providing a fifteen-person list of big names – major personalities in banking, professional services and wider commerce.
Initial research turned up an unusual quantity of press coverage, all positive and apparently orchestrated by a PR firm. This was curious for what was a successful but still small company. The CEO seemed to know everyone but there was something grating – and artificial - about the breathless brilliance of the person and the company. My suspicions aroused, I decided to speak to all fifteen referees and asked my Irish entrepreneur friend Barry to give me some ‘under the radar’ help.
The formal referencing proved fruitless. Everyone was happy to speak but no-one had much more than superficial good impressions to offer. Our CEO had worked hard to cultivate important people but without letting anyone see inside his business. The informal calls, though, were more interesting. Barry was getting strong negative feedback – including expletives from a mild-mannered accountant he’d never heard swearing before – but none would agree to go on the record with me, let alone the client.
So, on the one hand, we had fifteen positive reviews from the great and the good; on the other, a handful of negative but anonymous sources. To reach robust conclusions we needed something more concrete. We finally tracked down the former FD of the business who had moved abroad and was minded to reveal the truth but nervous about his old boss whom he described as vindictive. Rather than provide a reference, he provided instructions on how to identify the financial games that were being played. When we reported the revenue recognition manipulation to the client, they told us that the FDD team had also just raised concerns about the same thing.
Like other narcissistic fraudsters, the CEO created a trap for himself. He had exaggerated the numbers to look more impressive to his network and then had to fake continued success. The business itself was decent – albeit smaller than portrayed – but the CEO had made it unbackable until the facts caught up with the story.
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