UK: Do Ethics and Corporate Finance Mix?

There are people and professions we all love to hate. The Traffic Warden, they’re all jumped up little Hitler’s aren’t they; the Estate Agents, wide boys that do what for their money? Lawyer, I need to be careful what I say as I can’t afford the exorbitant litigation fees! Stereotypes like this are common and often unfair (except for Estate Agents, of course), the result of misconceptions and too little knowledge of what exactly these people do and why.

That is not to say that some Traffic Wardens aren’t a little over zealous or that some Lawyer’s don’t overcharge (I’d better get myself a good Lawyer,) but this is the result of individuals overstepping the mark, not usually a problem with an industry as a whole.

So what about the world of corporate finance? Corporate finance has not got a good reputation and it knows it. When most people think of corporate finance they think of Venture Capitalists (VC’s), as they are the most visible face of this industry. And, historically, VC’s have not conducted themselves in a manor that would have endeared them to anyone but this has been more the result of arrogance than ethics. However, the ethics of the corporate finance community is continually under question, the expression ‘vulture capitalist’ continually quoted and the belief that to seek investment from such sources is a necessary evil, rather than a positive move, is prevalent.

But, is this justified? Is the world of corporate finance predatory or is it, as it surely should be, nurturing? To answer this we need to examine what drives the industry and what pressures it is under.

Lets start at the beginning, with the consultants and intermediaries.

To most entrepreneurs and management teams the world of corporate finance is a mystery full of unanswered questions: How do you find the right VC or angel investor? What will the potential investor require? Will the investor ‘take over’ leaving them as employees within their own companies? As a result, companies seeking corporate finance will usually use an intermediary of some description, be it their accountant, a corporate finance boutique, Business Link (God help them!), even their Lawyer (more fees). These ‘advisers’ should have the answers and industry knowledge to help clients achieve their funding goal.

So why, when the majority of plans come via such ‘professional’ intermediaries, do over 98% of all plans submitted for funding fail to secure it? Is this a case of consultants exploiting clients? Consultants of all descriptions are being treated with increasing suspicion, ‘they’ll borrow your watch, tell you the time and keep the watch’ is a frequently quoted phrase. But while there maybe cynical intermediaries out there such high failure rates are more the result of a lack of commercial skill and realism than of cynicism.

The corporate finance market is driven by contingency fees. As a result, if clients don’t get funded, intermediaries don’t get paid. It is in the interest of both parties to succeed. Most clients who approach such intermediaries are convinced that the only solution to their business need is investment and few consider that they are not fundable, although many businesses aren’t. But, often, the advisers concerned do not have the experience to analyse a business and prescribe the best solution. Many companies in the corporate finance arena are populated by accountants (and let me make it clear, I have nothing against accountants); their skill base is purely financial. They are often not ‘commercial’ animals nor do they have the strategic skills necessary to dissect a business and prescribe alternative solutions. This is not to say that they are unable to assess a companies funding potential but rather that they may have no other solution to offer. In such circumstances the temptation is always to try and assist. However, such help is often misplaced. If you are unable to recognise that a strategic alliance, a merger or even a trade sale may be the best, or possibly the only route to business growth then it is likely that the wrong route may be pursued.

Intermediaries need to be more honest with themselves and their clients about the right course of action and the likelihood of success. Sometimes the truth, ‘you are simply not fundable’ may hurt, but not as much as the failure to achieve the funding objective. This is not an ethical issue but a professional one and is indicative of a young industry still finding its feet.

So, while we may not be perfect, we intermediaries aren’t such bad chaps after all (yes, I am one of those consultants). But, what about the investors themselves? Investors come in many forms but the one most people are aware of is the VC.

To understand the VC you must first understand how they make their money. VC’s raise their investment funds from city institutions, pension funds, business, local government and private individuals - it is easy to forget that most VC’s have investors of their own to provide returns for and answer to. These funds generally have set life spans and the VC must show a return greater than open market rates to its investors within the life of the fund. The VCs earn their money through running yield on the investment and a carried interest in the capital gain. Bare in mind, VCs are always raising more money for new funds based on their historic performance against industry norms. Therefore, the stage their fund has reached (how much has been invested and the age of the fund), the performance of that fund to date as well as the state of the economy and the performance of individual market sectors will all contribute to the investment policies of a VC.

Got that? Good. In other words, VC’s are here to make money for themselves and their investors. And, like any supplier they can loose a contract if they don’t perform. So, VC’s do not have a philanthropic agenda and why should they, they are in business too. But does that mean that expressions like vulture capitalist are justified? Well, sometimes yes, every barrel contains the odd bad apple. But there is a fine line in business between good business practise and cynicism. The markets are currently depressed; company valuations are low and a lot of businesses are struggling. It’s a good time to invest if you’re a VC. You get more for your money. And, in some market sectors, such as technology, the number of struggling companies makes the market ripe for consolidation; the VC’s have spotted this (although so has my Mum, its not rocket science).

So, are the vultures circling? In my view no, this is simply business. Such initiatives will save some businesses. It’s true that others may be subsumed with their owners getting little benefit but, if this were the case, then those businesses would probably have failed anyway. It is better for the shareholders to realise some value than no value at all. Business is tough, it’s certainly not fair, but that doesn’t make the actions of investors (or other companies) who capitalise upon such circumstances wrong or unethical. The issue is, did the investor offer a fair deal in the circumstances. If they did, no one should have any complaints. They are simply doing their job. And, the best VC’s can add real value, as well as money, to a business.

I said earlier that VC’s had got themselves a bad name due to their arrogance. This is far more to do with the way they used to treat investment prospects, never acknowledging the receipt of plans or letting people know they had been rejected. They used to communicate only with those prospect they were interested in dealing with and ignore the rest. They were aloof and unapproachable. Today, most VC’s are far more considerate. They know that, historically, their industry has not conducted itself well but their industry is maturing.

The VC’s have a reputation to live down, as do the consultants. In each case there is basis for their reputation but in each case the facts have often been misinterpreted and the wrong conclusions reached. That is not to say that it is all unjustified but rather that most corporate finance practitioners are doing, or at least endeavouring to do, a good job. The need to change these perceptions will drive the industry down an ever more professional road in the future, although this cannot happen soon enough for both clients and those of us in the industry who are trying to do things differently today.

So, do corporate finance and ethics mix? Yes. Without ethics the industry would struggle to exist and it certainly wouldn’t grow. It still needs to get its house in order but much of this is about removing the ‘smoke and mirrors’ that has led to the misconceptions that currently exist. Ethics and business are not mutually exclusive, but to achieve the balance requires conscious effort. The industry has a long way to go to be top of the popularity stakes, but until that happens we have one consolation, we’re still near the top than the Traffic Wardens, Estate Agents, Lawyer…