CT Treasurer Puts Forstmann In Hot Seat

Forstmann Little & Co.’s active financial support of its troubled telecom portfolio is proof that the buyout giant is tireless when it comes to fishing for investment success. Whether it had a fiduciary responsibility to also know when to cut bait, however, could soon be tested in a Connecticut courtroom.

Late last month, State of Connecticut Treasurer Denise Nappier – whose office has invested nearly $200 million into a pair of Forstmann Little funds – publicly accused the investment firm of treating the state’s money so irresponsibly as to warrant possible litigation.

While some market watchers have dismissed the statement as election-year grandstanding, Private Equity Week has learned that a lawsuit could indeed be filed as early as this week. Specific charges may include breach of fiduciary responsibility, violation of contract clauses and violation of securities laws.

“This office is not afraid to litigate when there is a legitimate need to do so,” says a source within the Treasury. “I have seen no indications that this is just a scare tactic or threat.”

For its part, Forstmann Little issued a statement that strongly disputed any breach of fiduciary responsibility or other wrongdoing. It even went so far as to imply that Connecticut will actually benefit from some of the same telecom transactions that have Nappier so riled up.

“The woman [Nappier] lost money and seems to go after anyone Connecticut invests in who loses money,” says a source familiar with the situation. “There is always a risk of losing money when you invest… her argument just seems so esoteric.”

In other words, the buyout industry likely is in store for its most contentious partnership battle since angry investors ousted the Madison Group’s general partner in 1995.

They Keep Going…

At the heart of Connecticut’s displeasure are Forstmann Little’s continuing attempts to reverse the fortunes of telecom services provider McLeodUSA Inc., which filed for Chapter 11 bankruptcy earlier this year.

Forstmann Little first became involved with McLeodUSA back in 1999, when it pumped $1 billion worth of convertible preferred stock into the Cedar Rapids, Iowa-based issuer for a 12% ownership stake. At that time, public markets were humming along and McLeodUSA stock was trading at more than $30 per share. The company even said its business plan was fully funded, and few pundits criticized Forstmann’s increasing telecom exposure.

But by last summer, everything had changed for companies like McLeodUSA, as well as for XO Communications Inc., another Forstmann Little telecom company. Rather than succumbing to market despair, however, Forstmann Little believed it could resuscitate its telecom portfolio just as it had done for past seemingly lost causes like Gulfstream Aerospace and General Instruments Corp. As McLeod’s stock headed downhill, Forstmann Little suspended coupon payments and pumped an additional $100 million into McLeodUSA for an ownership stake of approximately 20%. It was around this time that Forstmann Little made similar strides to save XO Communications, and sources say this is when the Connecticut Treasurer’s office began sitting up and taking notice.

In the fall of 2001, Forstmann Little proposed a massive restructuring plan for McLeodUSA that included an offer for the portfolio company’s yellow pages business. After being outbid by a consortium of other private equity houses early this year, Forstmann Little revised its plan and ended up investing $175 million more for a majority ownership stake in the bankrupt telecom company.

Unlike the first two McLeod investments, however, the most recent deal did not involve any Forstmann funds in which Connecticut’s Private Investment Fund is a limited partner. Instead, it involves a new fund that Connecticut did not sign on for.

Getting Paid

It is important to note that Forstmann Little funds pay carried interest back to limited partners on a deal-by-deal basis, rather than following the industry standard of aggregated returns.

In practice, this means that while both GPs and LPs get paid proportional carry on a successful investment, the LPs take more proportional loss on a bad investment than the GP does. Aggregated returns – which involve adding up all wins and losses at quarter-end or year-end and divvying up the pot proportionally – were established at most firms 10 to 15 years ago in response to growing pressure from public pension funds like CalPERS. Kohlberg, Kravis, Roberts & Co., for example, instituted aggregated returns on its 1996 fund, and has maintained them through to the current Millennium Fund offering. It was, as one GP says, “the sharp side of the double-edged sword that our industry accepted when we began taking a lot of public money.”

This is important because Connecticut seems to believe that the deal-by-deal structure will help Forstmann Little GPs on the distressed-rate restructuring deal while Connecticut loses money on the initial $1 billion investment. Since Connecticut was only in on the $1 billion deal, it believes it could end up with nothing while Forstmann Little walks away with coins jangling in its pocket.

A source close to Forstmann disputes the scenario by saying that Connecticut’s equity in McLeodUSA has risen even though it didn’t invest in the latest fund. The source also disputed an allegation by Nappier that Forstmann Little had been unresponsive when it came to answering questions related to the McLeodUSA restructuring.

Day In Court

As for whether any of this will come to the level of breaching fiduciary responsibility is unknown.

“A breach of fiduciary responsibility is generally a difficult claim to make because you have to make sure you’re not simply applying 20/20 hindsight,” says Robert Cleveland, general counsel and director of corporate development for Hamilton Lane Advisors.

At the same time, however, many attorneys were quick to point out that Nappier has a strong track record when it comes to litigation involving state investments. Just last year, she won a fraud case against Triumph Capital Group related to widespread corruption within the office of her predecessor, former Connecticut Treasurer Paul Silvester.

“If she wants her money back, she often does a good job getting it back,” says one lawyer who has practiced in Connecticut.

The issue of contract clause violations would be a bit more cut-and-dry. Although Private Equity Week was unable to obtain a copy of the Forstmann Little’s partnership agreement by press time, it did learn that the GP deal does not have any restrictions against over-exposure to a particular company or industry sector.

What is known is that both LPs and GPs will pay close attention to the case.

“On the one hand, you don’t want LPs raising their hands and complaining every time we sneeze,” says a partner at a major buyout fund. “On the other hand, though, LPs have always been paranoid about no one caring about them, and I’m concerned Forstmann Little could feed into that if they stand up in court and argue that a deal’s a deal no matter how sour it went. After all, this is supposed to be a partnership, and a partnership can’t work without some semblance of mutual respect and responsibility.”

Dan Primack can be contacted at: Daniel.Primack@tfn.com.

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