Avoid Compounding Bad Investments by Misattributing Failure

One of the most expensive mistakes investors make is not losing money on a deal—it is compounding that loss by misidentifying why the deal failed. 

In private equity, negative outcomes often harden into blanket prohibitions: entire industries, sub-sectors, business models, or deal structures written off based on a single bad experience. Over time, experiential bias replaces analysis, and investors confuse signal with noise. 

The Situation: A Firsthand Example 

In one of our deal guide’s first PE role, his deal team received a CIM from an investment bank representing a Professional Employment Organization (“PEO”). At the time, the deal guide’s fund already owned a payroll processing company that was performing well. While the deal team needed to get up to speed on the co-employment model PEOs operate under, the deal team and investment committee liked the broader HR and business process outsourcing (BPO) model—particularly the recurring revenue and strong free cash flow characteristics. PEO adoption among small and mid-sized businesses varies meaningfully by state, but this target’s growth profile and competitive positioning were compelling.  

As the associate on the deal team, our deal guide dug in—researching the space, evaluating the business, stress-testing the forecast, and building the model. The deal team arrived at a reasonable valuation view and presented the opportunity to the investment committee (“IC”) at the Monday morning meeting (“MMM”). Without much discussion, the deal team received IC approval to submit an IOI and move forward.  

The only real discussion point was that the implied equity check pushed the upper bounds of the fund size. To address this, the deal team decided to approach a fund they had successfully co-invested with in the past. 

After receiving clearance from the investment banker to partner up, the deal team brought the co-investor up to speed. The other fund was receptive—especially since our deal guide’s firm had done the bulk of the upfront work and the other fund had not previously seen the deal. The PE firms submitted their joint IOI and were invited to a management presentation. 

Where Things Went Sideways: Co-Investor Bias Took Hold 

Things unraveled when the other fund delayed discussing the deal internally with their IC. When they finally raised it at their weekly deal review and mentioned that it was a PEO, one of their senior partners reacted emphatically. Their fund would never invest in the PEO space. 

He viscerally described having invested in a PEO many years earlier and losing money. The experience clearly still stung. That loss had hardened into a little-known firm-wide rule: PEOs were off-limits, no exceptions.  

Because the co-investor’s senior partner refused to allow his team to attend the management presentation, our deal guide’s PE fund was forced to withdraw from the process. 

However, this could have been avoided had there been a dispassionate assessment of why that prior deal failed. 

Post-Mortem Deal Review: Why the Earlier PEO Deal Failed—An Objective View 

A more objective post-mortem of this other fund’s poor investment in the PEO space would likely have attributed the outcome to the following factors, in order of impact: 

• Untrustworthy sellers and operators, likely engaging in fraud. Client payroll funds were improperly commingled and used for business—and possibly personal—purposes. 

• Inadequate accounting and financial reporting infrastructure. This was likely a diligence miss pre-close and a governance failure post-close, allowing improper behavior to persist undetected. 

• Industry immaturity at the time of investment. The PEO industry was more nascent then, with weaker regulatory oversight and greater difficulty scaling beyond core states. While these elements were still considerations at the time of our deal guide’s review of the PEO space (as they are even today), the industry had materially matured by the time our deal guide’s fund was evaluating this opportunity. 

• Economic downturn-driven client churn. As small and medium business (“SMB”) clients retrenched, increased churn exposed the company’s true financial condition. The downturn did not cause the failure—it revealed it. As the saying goes, the tide went out and exposed who was swimming naked. 

Importantly, while recession sensitivity is a real underwriting consideration for PEOs, it was not the root cause of this deal’s failure. 

The Cost of the Wrong Lesson 

Bad deals leave scars—especially if you had a front-row seat. If it was your decision, your deal, and your problem to clean up, the emotional imprint can be lasting. But failing to conduct a rigorous, honest, and dispassionate post-mortem only compounds the loss. 

The capital loss and time loss are what they are—painful, but finite. Writing off an entire sector because you misidentified the root cause of a failure is different. That mistake continues to cost you future opportunities. 

The Crux: The Aftermath 

Pulling out of the process after receiving a management visit understandably frustrated the investment bank and the institutional shareholders selling the business, and it dented both PE firms’ reputations in the market. 

While some members of our deal guide’s own IC were sympathetic (many investors carry their own “touching the hot stove” experiences), the episode caused the fund to rethink the other firm’s reliability as a co-investment partner. They became more selective about showing them future opportunities. 

And what became of the PEO? 

It ultimately went through three or four separate private equity ownership cycles, with each sponsor generating strong returns, before being acquired by one of the larger strategic PEOs. 

The earlier loss was not inevitable, but the lesson drawn from it proved costly. 

When a deal fails, the capital loss is finite—but misdiagnosing the failure can quietly cost you far more in foregone opportunities.