At last the scrutiny has come.
Long warned that a regulatory day of reckoning would arrive, buyout firms were hit this month with a reported probe by the U.S. Department of Justice (DOJ).
Details of the federal inquiry are sketchy, but the DOJ is curious whether sponsors conspire in anti-competitive ways to depress prices for the companies they buy.
Buyout shops routinely team up to combine resources for a large deal that they couldn’t afford on their own. Just this year, Madison Dearborn Partners, Providence Equity Partners, Texas Pacific Group (TPG) Thomas H. Lee Partners and Saban Capital Group partnered in a nearly $13 billion buyout of Spanish-language broadcaster Univision; The Blackstone Group, The Carlyle Group, Permira and TPG combined in a $17 billion bid for Freescale Semiconductor Inc.; and this month Apollo Management and TPG teamed up to place a $15 billion bid on Harrah’s Entertainment.
But the DOJ is investigating to see if firms are conspiring to get together in these so-called “club deals” (to use Wall Street vernacular) to reduce competition and lower the price. While it remains unclear whether LBO firms actually do this, the existence of club deals is a concern among shareholders.
Chris Young, a director and head of M&A research at Institutional Shareholder Services, a company that advises shareholders when voting on acquisitions, says that his clients aren’t convinced that collusion occurs. But he says that they are worried about the possibility that they do happen. “No one is pointing to any particular deal, but people think that if something can happen it probably does happen to some extent,” he says.
Not everyone agrees. “I haven’t seen any indication or evidence” of collusion among bidders, says Greg Peterson, a transaction services partner at PricewaterhouseCoopers. “The DOJ is likely reacting to the popular press. Bidders are fiercely competitive. I don’t think anyone parks their competitive bones on the sidelines.”In its investigation, the DOJ is reportedly seeking information on certain deals and auctions. Regardless of the outcome of the probe, which at this point is in a voluntary stage, at the very least it serves as a warning by the DOJ that private equity firms should be careful to not engage in any questionable activity.
The DOJ declined comment. But news of the probe surfaced this month when the DOJ sent letters to a number of large private equity firms, among them Kohlberg Kravis Roberts & Co., Silver Lake Partners and Carlyle.
Details of the DOJ letter are vague, but there are reportedly two main issues:
- Do private equity firms refuse to bid on each other’s deals to avoid competition on their own deals?
- Do private equity firms decide to club with other bidders to avoid having to square off against each other?
If this kind of behavior did occur it would be a clear infraction of anti-trust law, say several lawyers. And though it would be difficult to prove—requiring a paper trail exposing collusion—if a civil case went against a private equity firm, the penalties would be steep.
It is standard procedure in anti-trust cases that the plaintiff gets treble damages. In other words, if the judge deems that shareholders of a target company received a $1 billion cut because two buyout firms agreed to not compete in the bidding process, the culprits would have to pay the shareholders 3X the amount, or $3 billion.
“I think it’s happening,” says one anti-trust lawyer. “There is so much money involved and with human nature being what it is, a phone call or two can smooth things over.”
But those involved in the industry say any collusion is just not likely. Half jokingly, they say that investment bankers wouldn’t let the bidders get away with it since it would reduce their fees. Also, buyout shops are typically eager to be in complete control of deals and prefer to go it alone. The only reason club deals have taken hold at the large end of the market is to enable sponsors to overcome limitations of size and industry expertise.
Buyout firms and the lawyers and bankers that work for them insist, for the most part, that the probe is unwarranted and shows that the DOJ is ignorant about how the industry operates. Sponsors are too competitive with each other and bankers are too skilled in acquiring the highest price to “sign some sinister pact in blood in a smoke filled room,” in the words of one banker.
David Solomon, a banker with Goldsmith Agio Helms, agrees that, at least in the middle market, a federal investigation is an unnecessary intrusion, since the competition is just too much. When it comes to companies with enterprise values of between $50 million to $600 million, Goldsmith can show a deal to 300 to 400 buyout shops with five or six making the penultimate cut. Also, Goldsmith goes to great lengths to conceal the identity of bidders, even from the sellers.
Looking ahead, the earliest that further development would come in the case is in six months, which is the typical period in which the DOJ pulls together preliminary information and decides the next course of action, says anti-trust attorney Thane Scott, who notes that it’s not uncommon for similar probes to be abandoned by the DOJ after a short time.
On the other hand, the probe could be “the opening bell of a process that could become prolonged and interesting,” Scott says. After all, many people think there exists a good reason for the probe.
For example, Andrew Shapiro, president of small-cap investor Lawndale Capital Management, suspects that buyout firms are colluding. “I’m not surprised by the alleged behavior,” he says. “I believe in my heart of hearts that the behavior goes on.”