When to Cut Your Losses: The Dilemma of Stopping Funding for Underperforming Companies

Investing in private companies can be a rewarding endeavour. It requires careful evaluation of potential returns and risks associated with each opportunity, along with a long-term commitment to building each portfolio company’s value. However, not all investments turn out to be successful. Unforeseen obstacles, such as changes in market dynamics, heightened competition, regulatory shifts, or disruptive technological advancements may hinder a company’s performance and viability. Good management teams anticipate such challenges, and can nimbly course-correct to stay out of trouble, and even capitalize on certain opportunities that others may overlook. However, there are times when a company may encounter obstacles that appear to be insurmountable and in such cases, investors face a daunting decision: whether to continue financing the company or to cut their losses.

There is an old adage in the investment business that goes like this:

“We’ve never made a bad investment, but we’ve had some bad outcomes”.

Investment success hinges on many factors, some of which may go beyond the control of investors or the management team. To ensure success, good investors and management teams always think in terms of options, or alternative courses of action. Unforeseen events can happen at any time, being able to quickly assess the situation and determine if value can be created out of the current set of circumstances is the first step in the decision to continue funding or not.

The decision to stop funding a company should not be based on a single factor or a snapshot of the situation but on a holistic and dynamic analysis of the expected value and risk of the next investment.

Financial and Psychological Consequences of Continuing and Discountinuing Funding

The decision to stop funding a company is often both a rational and an emotional one. Those who are responsible for the investment have a strong attachment and commitment to the company and its management team as well as a desire to see it succeed. Human nature causes reluctance to admit failure with a hopeful anticipation of a potential turnaround. These psychological factors can create a bias in favour of continuing to fund the company, even when the evidence suggests otherwise. Beware of optimistic assumptions in these cases….always focus on the downside risk. The upside usually takes care of itself.

Continuing to fund a poorly performing company can also have negative consequences for the portfolio. It is important to consider the long-term interests of the whole portfolio before investing in turning around a portfolio company. Turnaround work consumes valuable resources like time, money, and attention that could be better utilized for other investments or opportunities. The opportunity cost is challenging to measure but must be considered. The decision to keep on funding usually delays the recognition of loss and at best tends to prevent the carrying value of the investment from being as low as it should be. Alignment of interests between investors and the management team takes a lot of work to achieve in these circumstances.

These issues are largely driven by human nature and are very important to consider in achieving success if the inclination is to continue funding.

Implications of Crystallizing a Loss

If the company can’t be saved in a way that is beneficial for the portfolio, and the decision is made to write the investment off and cease operations, then the portfolio must compensate for that loss to maintain its value. To build value in a manner that meets or exceeds investor expectations, the remaining investments in the portfolio need to perform very well indeed.

Taking into consideration the factors outlined above, it’s crucial that the decision is not driven by emotions or biases but by objective and realistic criteria that reflect the expected value and risk of the investment. Below are several criteria to guide the decision-making process when deciding to stop funding a company.

• 📈 Comparing the company’s projected cash flows and possible future value with the expected rate of return and opportunity cost of capital. It is important to keep a close eye on these factors. Does crystalizing the loss make sense? Can sufficient value be recovered fast enough to justify the resources required?
• 🧩Reassessing the strategic fit and alignment of the company with the portfolio and the investment thesis of the investor. Presumably, the original thesis was sound, but has the ground shifted? Are there options to adjust the course that could generate early improvements in value?
• ✒ Exploring the attractiveness of alternative options, such as selling, restructuring, or merging the company. Good private equity investors always have options, and both the PE manager and the fund investors should focus on the fund performance more than an individual company. If a swap or sale preserves some value and provides a better upside while consuming fewer resources, then it might be the smart move.
• 🌐Assessing the current and expected market and competitive conditions is crucial to determining the feasibility of achieving a turnaround or recovery. Turnarounds are hard work and require both good management choices as well as thoughtful applications of capital. They are time-intensive, and not for the faint of the chequebook.
• 💵Considering the carrying value of the investment is crucial. It’s important to continuously apply realistic carrying values to companies so that decisions can be based on realistic outcome expectations. An inflated valuation can cause unnecessary delays in making the right decisions. It may be smart to take the carrying value down to nil so that decisions to stop funding are easier (remember the psychological issues!)
• 🤝Willingness and the ability to change management. Most turnarounds require changes to the management team and can sometimes require wholesale management changes. This is a risk factor, as building a management team that works well together, particularly in stressful situations, can be challenging. Before starting down the road of turning a portfolio company around, be sure the investor’s team has what it takes to change management. As always is the case, the quality of the management team will make or break the outcome.

These criteria may vary depending on the stage, sector, and size of the company, as well as the preferences and goals of the investor. However, they should be applied consistently and transparently, and reviewed periodically to ensure that the decision to stop funding is based on sound judgment and evidence.

Conclusion

The decision to stop funding a company when it’s not performing up to expectations is one of the most difficult and important decisions that a private equity investor must confront. It requires a comprehensive evaluation of the factors that influence the company’s performance and value, as well as an understanding of the financial and psychological drivers of continuing or discontinuing the funding. The decision should not be driven by emotions or biases, but by objective and realistic criteria that reflect the expected value and risk of the investment. By making the right decision at the right time, the investor can optimize the portfolio’s performance.

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