Edgewater Funds, which invests through a family of funds called Edgewater Growth Capital Partners, brought suit against diversified private-equity shop H.I.G. Capital over a deal that traced its roots to the merger of two ATM services companies around early 2006. Affiliates of H.I.G. Capital acquired senior debt in the company, called Pendum, after it ran into operational troubles. Edgewater Funds accused H.I.G. Capital, which eventually took control of the company, of running an auction for its assets in violation of the Uniform Commercial Code.
What makes this court case remarkable is not so much the legal issue at the heart of the dispute. As it happens, a colorfully-worded opinion issued late last last month by Leo E. Strine Jr., the chancellor of the Delaware Chancery Court, found that H.I.G. Capital had in fact conducted a “commercially reasonable” auction and that Edgewater Funds would have to pay a loan guaranty of some $4 million.
Rather, what makes the case notable is the court’s description of how Pendum came to be troubled. The merger that created the business got off to a poor start, according to Strine, and Pendum was soon an “operational mess” that had broken loan covenants. Buyout shops so routinely ring up multiples of their equity on deals that it’s important to be reminded of the risks now and then—especially for lenders and limited partners tempted to expand their private-equity portfolios in search of easy profits.
In an e-mail an attorney representing Edgewater Funds said the firm does not comment on pending litigation, but noted that the court had not rendered a final judgment and that the firm could appeal the decision. I was unable to reach executives at H.I.G. Capital for comment.
Edgewater Funds had set out to acquire companies that provide services to operators of ATMs. Around January 2006, according to the opinion, the firm oversaw the merger of two businesses to form Pendum—Bantek West Inc., which provided armored cash delivery services, and Efmark Premium Armored, which provided ATM repair services. Pendum ended up borrowing about $70 million in senior debt from a star-studded syndicate that included Merrill Lynch Capital, GE Capital, LaSalle Bank and Wells Fargo, and “millions more” in subordinated debt from Dymas Capital (which later sold its position to Allied Capital).
It’s not clear just how healthy these two companies were when first acquired. But according to its Web site, Edgewater Funds tends to target fast-growing, profitable companies generating $20 million to $500 million in revenue and run by “outstanding management teams.” David Tolmie, responsible for managing the Pendum investment according to the opinion, is one of seven partners, including an associate partner and a managing partner, listed on the Edgewater Funds Web site. Backers include public pension funds, endowments, foundations, funds of funds, public corporations and insurance companies.
Heavy leverage contributed to the company’s downward spin, according to Strine. “Edgewater wrote a relatively small equity check and saddled the acquired company with the obligation to pay back a heavy load of acquisition debt,” he wrote. ”Edgewater’s ambitions exceeded its ability to integrate the businesses, develop a clear managerial chain of command, and execute an effective business plan.” Within a month of the merger, the court wrote, Pendum went into default on the terms of its senior debt by falling short of an EBITDA requirement. Here’s what happened next, according to the opinion:
- Edgewater Funds negotiated a “a series of extensions and other accommodations” with creditors to give the company some breathing room. As part of one of the amended credit agreements the firm agreed to guarantee about $4 million of the senior debt;
- By year-end 2006 the company’s performance had deteriorated to the point where the balance sheet was showing a negative stockholder equity of about $28.7 million;
- Around early 2007 Edgewater Funds and Allied Capital invested an additional $8 million in the company—but it wasn’t enough to overcome liquidity problems stemming in part from the loss of the company’s biggest customer, Washington Mutual;
- Next Edgewater Funds consider selling the business but the company wasn’t in position to get an “unqualified” going concern opinion from its accounting firm;
- As a condition of one of the credit amendments lenders “demanded that Edgewater Funds propose a strategic restructuring or other permanent solution to the company’s inability to function profitably” but, while the firm looked at options, it “failed to propose a solvent path forward,” Strine wrote;
- In September 2007 affiliates of H.I.G. Capital began purchasing a large position in the senior debt at less than 80 cents on the dollar;
- Lenders told Edgewater Funds that they would not continue to finance the company unless the Edgewater Funds-appointed board members resigned;
- After its directors resigned, Edgewater Funds seated four new directors associated with a restructuring firm chosen by the senior creditors;
- In light of the default, the board and H.I.G. Capital took advantage of a term of the loan to sign a foreclosure sale agreement in December 2007 letting the firm hold an auction for the company’s assets after a market check;
- The market check produced no buyer and Pendum Acquisition Inc., an affiliate of H.I.G. Capital, made the only bid for the assets; it is not clear from the opinion how much H.I.G. Capital paid or whether creditors recovered their money; H.I.G. Capital still lists Pendum as a portfolio company on its Web site.
In ruling that the auction was commercially reasonable, Strine found that “Pendum had been insolvent under Edgewater’s managerial control, unable to pay its bills, and thus any sales process had to be conducted in a time frame that recognized that economic reality.” He found Edgewater Funds’s argument to the contrary “without merit” in part because a number of parties, including Edgewater Funds itself, had been invited to bid for the assets but failed to do so.
Edgewater Funds, which was acquired by Lazard in 2009 as it was in the market seeking to raise a $750 million fund, no doubt has many successful deals under its belt. But Pendum does not appear to be one of these. And thanks to its decision to bring suit against H.I.G. Capital the world knows a lot more about a deal that the chancellor of Delaware Chancery Court describes as having gone south—and fast.
Reuters Correspondent Tom Hals, based in Wilmington, Del., contributed to this column