Minority Deals Rise. Will LP Blood Pressure Follow?

You don’t have to travel too far these days to find a poster child for minority investments gone bad. One of the latest: the $500 million that Warburg Pincus agreed to invest late last year in bond insurer MBIA Inc. at $31 per share. Although the firm later bought shares at less than half that price, lowering its average cost per share, shares at press time traded at less than $5 per share.

Limited partners have good reason to worry about minority investments. Many believe that the management fees and carried interest they lavish on buyout shops can only be justified by an especially hands-on brand of ownership consistent with absolute control. In minority-stake deals, by contrast, buyout firms typically lack the ability to press the same levers—namely, the right to hire and fire management teams at will, to issue themselves fat dividends, to sell the company at their discretion. Moreover, buyout shops may have more trouble securing leverage on minority-stake deals; some lenders shy away from them over concerns that the sponsor won’t be able to take forceful enough action in a downturn.

“It’s hard to be a value-added investor in a minority context,” said David J. Ament, a managing partner at Boston and San Francisco-based Parthenon Capital, which typically takes 51 percent to 75 percent stakes in its portfolio companies. In a traditional minority deal, he said, the management team sets the direction of the company, while the buyout firm goes “along for the ride,” able only to prevent deviations from that direction.

Another reason for LP concern: Minority transactions appear to be on the rise. Against the backdrop of a credit crunch that has firms seeking out fresh ways to put capital to work, U.S. buyout firms completed 312 minority-stake transactions in 2007, according to Thomson Reuters, publisher of Buyouts. That was up 37 percent from 228 the year before. Those minority investments with disclosed valuations totaled $20.9 billion last year, up 21 percent from $17.3 billion.

But investors needn’t pick up the pitchforks just yet. Buyout firms have been making successful minority investments for years, and many, such as Cleveland-based Key Principal Partners, make a specialty of them. Since its inception in 1998, the firm has made more than 50 minority investments, against just six majority-stake investments. Its ability to secure half of its latest $500 million fund, closed in late 2006, from outside investors suggests a solid track record.

Minority deals can make particular sense during a credit crunch, because changes in ownership often trigger provisions that allow creditors to call in their loans. Terms and conditions on senior loans have deteriorated so much over the past year that keeping older credit facilities in place can make the difference between a viable deal and a not-so-viable one. In addition, owners of strong companies tend to be more reluctant to sell outright in a depressed market. They may, however, be open to a minority deal to obtain a measure of liquidity, growth capital and outside assistance. For its part, the buyout firm can get its foot in the door with an eye toward taking a majority stake later.

Limited partners would also be surprised at how much control buyout shops can exert in minority situations. Catterton Partners, a Greenwich, Conn.-based firm that recently closed a $300 million growth fund, took a minority stake in Sweet Leaf Tea Co. earlier this year for $18 million. Nevertheless, the firm maintains that it never strays from control-style investing, and points to a strict list of factors, including strong control provisions, to which a company must agree before it will make a minority investment.

What control provisions are typical in a minority deal? Dom DeChiara, who represents mid-sized funds as head of the private equity and leveraged buyout practice at Nixon Peabody LLP, said that buyout firms in minority deals typically negotiate a set of negative controls. These can include the right to veto material transactions, such as acquisitions and dispositions, and to nix executive hiring and compensation decisions.

On the affirmative-control side, provisions to ensure a timely exit are common, DeChiara said. An exit provision might allow, say, for the firm to take control of the board and launch an auction if the company isn’t sold within a certain number of years. The larger the stake, the fewer the number of shareholders, and the more cash-hungry the company, the more leverage buyout firms have to extract such provisions.

Indeed, DeChiara implied that it’s important for LPs to dig into the details of minority transactions before casting judgment on them. Does the buyout firm hold a 49 percent stake in a leveraged company with a myriad of negative controls? That’s not too different from an ordinary buyout. Does the firm hold a 10 percent minority stake in a publicly traded company with limited controls and no exit provisions? Not so buyout-like.

Said DeChiara: “LPs are paying private equity funds to create value. And if you’re only going to own a very small minority piece of a business you’re not going to have the opportunity to create that value.”

For more on minority investments in public companies call John A. Bick, a member of Davis Polk & Wardwell’s corporate department, at 212-450-4350.