A client approached us with an interesting proposition: Would we be interested in participating in a deal to buy the real estateand equipment of a pecan processor who fell into foreclosure? Ourclient, a senior banker with a major national bank, came across thisdeal in the normal course of his business and thought some of ourclients might potentially be interested. So we took a look at it.
This particular business processes almond mash, the waste stream ofother almond processors. Using more meticulous processes, this companyis able to get food grade product out of cast-offs and previouslydiscarded processing waste. It sounded like an interesting idea.
According to the cash flow forecasts it looked like it could be awinner. The deal could have been structured to our specifications andreturn on investment of 30% or more was not out of the question. But themore we looked at it, the more the tried and true principles we teachto our clients pushed us away from this deal.
Here was our thought process:
Is this a business that we understand? Clearly the answer is no. Wedon't know the first thing about processing pecans or the nuances of thenut business.
Would this investment provide a diversification benefit? Probably. We don't know much about the true cashflow cycle on this kind ofbusiness, but it probably isn't too tightly correlated with major stockmarket averages. In that sense, it would make a nice contribution to theoverall portfolio.
Does this business rely heavily on a single manager? Definitely. Thesuccess of this business depends totally on the involvement of thefounder. If he were to leave for whatever reason, I would be stuck with apecan processing business that I don't know how to run. This is a risk Icannot diversify away.
Finally, is this business likely to become a sinkhole for additionalcapital? Very possibly. The business opportunity exists because theprevious owner ran out of capital when he misjudged the supply anddemand dynamics of the pecan market. If additional capital was neededagain, where would investors go to find it? Likely we would end up withthe previous owner - in bankruptcy.
The final blow to this idea came after talking with another clientwho has built a very successful national agricultural business. He saidhe wouldn't touch it with a ten foot pole. That was good enough for me.
The reason I'm posting this project is to demonstrate that you neverknow where you might find a good opportunity. It is always good to keepan open mind. But whenever you look, make sure you stand on a foundationof solid principles. It will help you separate the almond from themash.