Private equity moved from the boardroom to the courtroom last week, as Forstmann Little & Co. began defending itself against civil charges brought by The State of Connecticut.
The case was first filed in February 2002, and accused the New York-based firm of breaching its fiduciary responsibility to Connecticut, which had invested a total of $198 million with a pair of funds managed by Forstmann Little. Connecticut also claimed contract clause and securities law violations, and had publicly stated that it was hoping for restitution in excess of its original investment. As Connecticut State Attorney General Richard Blumenthal said at the time: “We want more than the $100 million-plus they wasted and wiped out. We want to make Forstmann Little the poster child for fair-dealing in the investment community.”
Forstmann Little responded less stridently, but with equal resolve. It issued a statement reaffirming its commitment to fiduciary responsibility, and argued that any limited partner losses were caused by the telecom bubble burst, not by fund mismanagement.
Most legal experts believed that the case would settle out of court because both sides had a lot to lose from a public showdown. Forstmann Little had subsequent lawsuits to worry about if it were to lose, and an indelible stain on its reputation either way. Connecticut had its own fiduciary responsibility to worry about, as its pension system could be viewed as litigation-happy, and therefore an unattractive limited partner for future private equity funds.
“Most civil cases don’t go to trial, so the odds against this happening were pretty good,” says Carl Metzger, a partner with Testa, Hurwitz & Thibeault. “One of the differences here, however, is that the alleged damages are so high and the parties’ versions of events couldn’t be more different.”
He adds that a settlement could still occur up until a jury verdict, but various sources say that neither side is known for its accommodating style. “Teddy [Forstmann] hates to admit when he’s wrong, which is part of the reason he’s in this mess,” says a money manager familiar with Forstmann Little. “And Blumenthal and [State Treasurer Denise] Nappier have dealt with these sorts of things aggressively in the past, and won. I don’t see any reason why they’d change now.”
Phoning In The Losses
The case largely revolves around Forstmann Little’s continuing attempts to save telecom services provider McLeodUSA Inc., which would file for bankruptcy protection before reorganizing itself in late 2002.
Forstmann Little first became involved with McLeod in 1999, when it invested $1 billion worth of convertible preferred stock for a 12% ownership stake. At the time, telecom was just one degree cooler than the Internet, and McLeod’s common stock was trading at more than $30 per share.
By the summer of 2001, however, everything had changed. Rather than succumbing to market pressures, Forstmann Little insisted that it could resuscitate a telecom portfolio that also included a sizable bet in XO Communications Inc. As McLeod’s stock dropped, Forstmann Little suspended coupon payments and pumped an additional $100 million into the company for a 20% position. The buyout firm made similar moves with XO Communications, which apparently is when Connecticut began to get concerned.
In the fall of 2001, Forstmann Little proposed a massive restructuring plan for McLeod, which included a $535 million offer for McLeod’s directories business. The Forstmann bid, however, did not include a breakup fee. The result was that Forstmann got outbid by $65 million, and McLeod began finalizing plans for bankruptcy. As part of the Chapter 11 plan, Forstmann invested an additional $175 million for a majority ownership stake.
This final deal raised Connecticut’s ire, because it did not involve any Forstmann funds in which Connecticut was a limited partner. The pre-bankruptcy deals, however, had used Connecticut funds, and the state argues that this fund-jumping arrangement resulted in an improper wipeout of at least half its original McLeod investments (via Forstmann).
Such losses are particularly difficult for Connecticut to swallow, because Forstmann Little funds do not follow the industry standard of aggregated returns. Instead, it pays carried interest back to its limited partners on a deal-by-deal basis.
In practice, this means that while both GPs and LPs get paid proportional carry on successful investments, an LP takes more proportional loss on bad investments than does the GP. 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 ever since.
At least one LP has asked Forstmann Little to suspend this practice as a goodwill gesture reminiscent of how VC firms accelerated claw-back provisions or reduced fund sizes. Forstmann Little has not acceded the request, and argued that the deal-by-deal structure better aligns LP and GP interests. The firm did, however, discontinue management fees charged on lost investments in XO Communications.
When the six-person jury trial began last Tuesday in Rockville, Conn., the charges still included a breach of fiduciary responsibility and contract clause violations. Superior Court Judge Samuel Sferrazza had previously thrown out the securities law violations considered to be among the most serious charges but denied a defense motion to dismiss the entire case.
The judge also ruled against a defense request to disallow the introduction of fund placement memoranda that included certain spending restrictions contained in side letter agreements. He did, however, prevent the admittance of a Power Point file used during Forstmann Little’s fund-raising presentation.
After opening statements, the prosecution called Ted Forstmann as its first witness. He acknowledged that the McLeod investment had not gone according to plan, but said that it eventually would make money for investors. He also said that his firm had followed the letter of its limited partnership agreements, and that any internal disagreements over the McLeod investments were the normal course of business for a private equity partnership.
Future witnesses are expected to include other Forstmann Little executives and Connecticut Treasurer Denise Nappier. The trial is expected to last around one month prior to jury deliberations, assuming no settlement is reached.
Waiting On A Verdict
The case is being closely watched by many private equity investors and lawyers, not the least of which are other limited partners in Forstmann Little funds.
Sources say that a ruling for Connecticut could prompt similar lawsuits against the firm, and virtually assure that public pensions and some private ones – would be precluded from investing in future Forstmann Little vehicles. This assumes, of course, that there will be future Forstmann Little funds. Ted Forstmann is rumored to be contemplating retirement from the firm, and it is unclear whether or not his younger partners would want to maintain the Forstmann Little name in his absence.
On a larger level, Carl Metzger of Testa Hurwitz says that a finding against Forstmann Little could embolden LPs in other firms to pursue litigation, particularly if the fiduciary responsibility breach is confirmed. If Forstmann Little prevails, Metzger says that it will reinforce the idea that private equity is a high-risk asset class, and that losses are not grounds for lawsuits.
Buyouts will continue to cover this trial via its Website and the PE Week Wire email service.