Private equity firms often prefer being the first institutional investor in family-owned businesses. There are good reasons for this preference: family-owned businesses often have outdated processes that can be improved, inefficiencies that can be addressed, and overlooked growth opportunities that can be tapped. Under PE ownership, these businesses can be enhanced.
Another reason why PE firms like being the first outside investor is skill arbitrage. PE firms buy and sell multiple businesses each year whereas families generally sell one business in their lifetimes. The sale process includes many technical aspects (financial adjustments, valuation, deal terms, etc.) that are unfamiliar to family sellers. When I mentioned this arbitrage in a class session, the hand of an EMBA student shot up: “Professor, is that ethical?”
"Green Lights"
Certain forms of arbitrage would, in my experience, be seen as inherently fair uses of a PE buyer’s skillset. These can be classified as “Green Lights” – areas where private equity buyers should rightly leverage their advantages.
One example is ideas for new products or untapped markets. PE buyers will have ideas about growing the business that sellers may not have thought of. During the sale process, buyers need not tell sellers about all their ideas for value creation after the acquisition. If sellers knew about these opportunities, they might likely raise their financial projections and seek a higher price for their business.
A second example is access to customers, suppliers, or other business relationships. A PE buyer may know about suppliers who could reduce the company’s cost of goods sold (COGS) and thus enhance margins. Third, PE buyers may have financial insights (for example, ways to reduce working capital requirements) rooted in their experience acumen. These insights need not be shared during the negotiation process – they are the “secret sauce” of the buyer.
"Red Lights"
At the same time, certain practices would inherently be seen as unethical, even if a PE buyer could get away with them. These can be considered “Red Lights.”
One example is outright lying. A PE buyer might be tempted to lie about the valuations they paid for other businesses in the past (saying they paid 4x EBITDA when in fact they paid 6x) to make their offer seem more reasonable. The seller might never find out that the buyer lied (since valuations are highly confidential) but telling the lie would be an ethical breach.
Violating contractual obligations would also be seen as an ethical breach. Breaching a Non-Disclosure Agreement to gain negotiation advantage, for example, would likely be seen as crossing an ethical boundary.
Areas of Moral Ambiguity or "Yellow Lights"
Apart from the relatively clear areas above, numerous areas of moral ambiguity can arise in PE negotiations. Consider some “Yellow Light” tactics a buyer could adopt: suggesting a requested term is “market norm” or “standard practice” when there is a range of norms and practices; cherry-picking data to the buyer’s advantage; not disclosing important aspects of the transaction process, or failing to relay additional approaches to valuation or deal terms. Remaining silent when sellers voice incorrect assumptions (allowing a seller to assume she will remain CEO when the buyer’s plan is to replace her) could also be considered an area of ethical vagueness.
Is behaving in the ways above a form of negotiations savvy? Or do the tactics above cross an ethical line?
Final Thoughts
The context of the deal will likely play a role in how PE buyers view ethical boundaries. When a seller is represented by sophisticated third parties (e.g. sell-side advisors), the skill arbitrage is reduced. In such cases, would PE buyers be more likely to (a) uphold ethical norms because they know the other side is attentive or (b) test the boundaries since they see the counterparty as sufficiently able to protect their interests?
In cases where there will be ongoing affiliation with the seller (e.g. rollover equity and board representation), one would expect buyers to exhibit better ethics. The risk of damaging the relationship through an ethical breach may be too high.
Private equity negotiations require a range of skills. Amongst these skills are knowing where the ethical lines are and having the integrity to respect them.
Aamir A. Rehman is an Associate Professor of Professional Practice at Columbia Business School. He teaches private equity courses in the School’s full-time MBA, Executive MBA, and Executive Education programs.
Professor Rehman is also Chair of Innate Capital Partners, which is a Limited Partner in funds and a direct investor in companies. He serves on the boards of asset managers and PE-backed portfolio companies and has advised family businesses on their sales to private equity groups.