Has The Buyout Market Gotten Too Clubby?

At last the scrutiny has come. Long warned that a regulatory day of reckoning would arrive—see antitrust attorney Thane Scott’s guest article in the Jan. 23 edition of Buyouts—buyout firms saw the beginnings of it earlier this month with reports of an inquiry from the Department of Justice. The Justice Department is curious about how sponsors may be working together in anti-competitive ways to depress prices for the companies they buy.While it remains unclear whether LBO firms do this, it has become a serious concern of sharheolders. Chris Young, a director and head of M&A research at Institutional Shareholder Services, a company that advises shareholders which way to vote on acquisitions, says that the shareholders he speaks with aren’t convinced that collusion happens but “are worried about the theoretical possibility that it could happen.” He adds, “I don’t think anyone is pointing to any particular deal, but people think that if something can happen it probably does happen to some extent.”

Meanwhile, the other side is firing back in its own defense. “I haven’t seen any indication or evidence” of collusion among bidders, says Greg Peterson, a transaction services partner at PriceWaterhouseCoopers and head of the private equity effort there. “The DOJ is likely reacting to [the] popular press rather than a deep understanding of the issues. Bidders are fiercely competitive. I don’t think anyone parks their competitive bones on the sidelines.”

Peterson adds that getting this kind of negative press and regulatory scrutiny is understandable for an industry that has grown so healthy, so fast. “This is part of the process of private equity growing up,” he says. Overall, it is a message from the DOJ to let private equity firms know: “We’re looking at it. Make sure you’re clean.”

Indeed, public shareholders recently have been voicing their concerns over private equity transactions, sometimes in the mainstream press, most notably over how private equity deals can create conflicts of interest for management. Public shareholders likely brought the issue to the attention of the DOJ, sources say.

Regardless of the outcome of the reported probe, which at this point is at a non-threatening voluntary stage, at the very least it serves as a warning shot fired by the DOJ that private equity firms should be careful to not engage in any questionable activity.

The DOJ declined comment about the probe. News of it surfaced earlier this month, when reports said the DOJ sent letters to a number of large private equity firms, among them Kohlberg Kravis Roberts, The Carlyle Group and Silver Lake Partners.

Although the details of the DOJ letter are vague, there seems to be two main issues. The first is whether private equity firms refuse to bid on each other’s deals in order to avoid competition on their own deals. The second is whether private equity firms decide to team up 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 antitrust law, say lawyers (see sidebar). 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 antitrust cases that the plaintiff gets treble damages. In other words, if the judge deems that shareholders at a target received a $1 billion haircut because two buyout firms agreed to not compete in the bidding process, the culprits would have to pay the shareholders $3 billion. Treble payouts are designed to encourage plaintiffs to bring their case.

Shareholders WorriedAndrew Shapiro, president of small-cap investor Lawndale Capital Management, suspects that buyout firms may indeed be colluding. “I’m not surprised by the alleged behavior. I believe in my heart of hearts that the behavior goes on,” says Shapiro, who in the 1980s worked at an LBO firm. And Institutional Shareholder Services’s Young predicts that, “if the price is a little fishy to begin with, the fact that it is submitted by a club may become an issue.”

A number of sources interviewed for this article cite their views on human nature when explaining their concerns about collusion. “I think it’s happening,” says one antitrust 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 in the industry say any collusion is just not happening. Investment bankers, for one thing, wouldn’t let the bidders do it since it would reduce their fees, they say. For another, buyout shops are typically eager to be in complete control of deals and prefer to go it alone, they say. 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 for the most part insist that the probe is unwarranted and shows ignorance at the DOJ about how the industry works. Sponsors are too competitive with each other and bankers are too skilled in getting the highest price to, in the words of one banker, “sign some sinister pact in blood in a smoke filled room.”

David Solomon, a banker with Goldsmith Agio Helms, agrees that, at least in the middle market, regulation would be an unnecessary intrusion—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. Goldsmith goes to great lengths, moreover, to conceal the identity of bidders, even from the seller.

Further Scrutiny

The probe regarding club deals is the most recent flap in an industry that has had its share of image problems over the years. When KKR bought RJR Nabisco, the industry was lambasted for being a back-room Wall Street club constructing highly risky, hard-to-understand deals that netted them unseemly profits. More recently, there has been some calls for regulation from the mainstream media over conflicts of interests in MBOs.

One complaint about MBOs is that management teams could sabotage their company in the run up to a sale, disguising its true worth, and then sell for a low price in order to “turn around” the company a short time later. Another concern is that management teams might be biased towards selling to a private equity firm instead of a strategic buyer for a lower price, both to preserve their own jobs, and to obtain the generous allocation of equity that buyout firms are famous for sharing with management. Neither of these issues are new. But both are likely to get more attention thanks to such high-profile club deals as SunGard Data Systems and HCA Inc.

Looking ahead, the earliest further development in the case would come six months from now–the typical period in which the DOJ gets the information it wants, looks it over and decides a next step, says Scott, who co-chairs the antitrust group at Edwards Angell Palmer & Dodge. The current stage of voluntary cooperation is what Scott calls the DOJ’s “lowest threat level.”

Many such probes are abandoned by the DOJ after a short time and the requested materials get locked in a basement file drawer, says Scott. On the other hand, the probe could be “the opening bell of a process that could become prolonged and interesting.” After all, from the perspective of an antitrust lawyer, this looks like the kind of activity the DOJ goes after all the time, even if it has never done so in private equity. Says Scott, “When you have rivals who cooperate, there’s always some deep suspicion. Why are they doing that?”