Calling the bluff

Yesterday, I met the owner of a manufacturing company in which we are private equity investor. 

Between mouthfuls of scalding Teochew congee, my business partner informed me that he intends to “sacrifice profit margins to continue fulfilling the value proposition that he has always held out for his customers.”  

“I think we should absorb the higher costs of production so that we can remain competitive,” he continued. I stared at him glass-eyed and all my brain could hear was yadda yadda yadda 

“Does this mean that we are going to lose money?” I finally asked

“Little bit,” he smiled; making a mini-gap between thumb and first finger for emphasis.

“How much?” 

He pulled a deep breath and said, “I think we will be down by only 80%.”

“O-n-l-y 80%?” I flinched, feeling my blood pressure hit stratosphere. “What is causing the higher production costs? Labour? Raw Materials? Machines?”

He cocked his head to one side and started rubbing his forefinger against his lips. “I should say it’s labour. Ya, definitely labour. We increased our headcount in January.”

“How many new staff and in which department?” I probed.

“Three new managers.”

“Let me get this straight. Are you saying that because of these three new managers, the company is going to shave its margins significantly? Who are these three managers? Your children? Relatives?”

“Actually, I should also say that higher costs because of more expensive raw materials. And our machines are old. We need to upgrade,” he continued, ignoring my question. 

I scrunched my nose. I could smell bullshit coming.

“How about sales? Is the company coming up with new products or getting new customers?”

He waved his hand dismissively. “Sales, you don’t worry. We know what to do.”

“How much have you sold this year?” I pressed.

“Maybe $2 million or $3 million. Very competitive market. But since you are here, I might as well tell you. Actually I am thinking that maybe we should diversify into property.  My son..I mean, one of our new managers, showed me this property development project recently.” He reached for a piece of paper in his shirt pocket and unfolded a site map of the property.

I leaned back and laughed harshly. “How are you going to pay for this project?”

“You don’t worry. We will issue new shares to finance the construction. I will cover you. 20% stake, free of charge. I hold it for you. You don’t have to declare to your Board. Trust me.”

I did a quick mental calculation. 20% stake is alot of money.  

I shook my head, incredulous that his audacity. No. 

His eyes narrowed. “People like you don’t understand business.  Investors, fund managers, analysts.. they want more, more, more. They don’t understand why we have to sacrifice something in the short term to grow better, bigger, stronger in the long term. They never run businesses before. They are not entrepreneur like me.” He ranted, jabbing himself repeatedly in the chest with his forefinger.

I waited for him to cool off and said calmly,  “We invested in your company because we believe in its prospects and your ability to deliver your profit targets within three years. So far, you have delivered 60% of the total. Let’s focus to deliver the remaining 40% on this 3rd year. After that, we will reconsider your property project idea.”

“You don’t have worry. I will not only hit the profit target this year, I will get someone to buy you out. I don’t think you understand how I run my business. I don’t want you as my investor anymore.” He glared at me.

I smiled tightly. Nothing gets a man all fired up like a good old confrontation with his ego.   Over the years, I have learnt three hard rules about private equity investing: (1) Always stay cool. Emotions sink ships. (2) Trust no one. It is harder to trust than be trusted. (3) The first offer is never the best offer.

I have no doubt he will deliver on his profit targets. But buying me out? Nah. I am calling his bluff. The private equity investment circle is small. If one leaves, you can bet the next investor would only come in at a deep discount. He will rake through the numbers with a fine-toothed comb to see if he can drive the asking price lower. As I have said, the first offer is never the best offer. That’s rule #3.