The Vanishing Club Deal

But a funny thing has happened since October 2006, when the DOJ began firing off letters asking some of the biggest buyout firms for documents that might illuminate anticompetitive behavior. Club deals, once a popular way of completing expensive leveraged buyouts while spreading risks among several sponsors, have begun vanishing from the landscape.

In 2006, a majority of all going-private deals valued at more than $1 billion involved two or more buyout sponsors, according to law firm Weil Gotshal & Manges. The trend was even more pronounced if the price tag surpassed $5 billion, when buyout shops clubbed on 91 percent of deals, according to Weil Gotshal.

Nonetheless, the law firm’s research hinted at a trend that has grown into full flower in 2007. Even though club deals remained popular in 2006, the number of private equity sponsors taking part in the deals began to shrink compared to buyouts in 2005, according to Weil Gotshal. That’s become even more pronounced in 2007. The biggest completed LBO in history, The Blackstone Group’s $39 billion purchase of Equity Office Properties, had one sponsor. Kohlberg Kravis Roberts & Co., the most active buyout firm so far in 2007, is going it alone on nearly all of its big deals, including the $29 billion purchase of First Data Corp. And the deal that will soon become the biggest in history, the pending $46 billion takeover of TXU Corp., is being led by just two firms, TPG Capital and KKR. Compare that to the 2005 buyout of SunGard Data Systems, an $11.3 billion deal that required equity contributions from Silver Lake, Bain Capital, Blackstone, GS Capital Partners, KKR, Providence Equity Partners and TPG Capital.

The upshot? With fewer sponsors taking part in the same deal, buyout firms are shouldering a greater share of each LBO’s risk—risk that appears to be increasing amid a tightening interest-rate climate. At the same time, fewer club deals means less chance that institutional investors will get exposed to the same deal through several funds, a source of much frustration in the early years of club deals. And, regardless of whether there’s any collusion to stamp out, the single-minded focus on competition will drive prices higher.

To be sure, the DOJ investigation doesn’t fully account for the declining appetite for club deals. With fundraising through the roof, buyout firms are sitting on mammoth piles of capital, making it unnecessary to team up with competitors for every big deal. In deals where the sponsoring firm has an equity shortfall, limited partners are stepping to the plate to provide co-investments, while investment banks have been willing to provide bridge equity that later gets syndicated out to institutional investors. Another source of co-investments have been hedge funds, as evidenced by KKR’s recent bid for Laureate Education, a $3.8 billion offer that relies on no fewer than seven passive investors, most of which are hedge funds.

“Capital that is more passive, that allows sponsors to do what they do best, which is add value, is interested in opportunities to co-invest with many top-tier sponsors today,” said Wray Thorn, managing director of private equity for Marathon Asset Management. “Many general partners would prefer themselves and a group of more passive investors to a club of active general partners.”

Breaking Up Clubs

But the fallout from the DOJ investigation is clearly being felt.

Often prompted by counsel worried about antitrust suits, sell-side advisors that previously would have turned a blind eye to the anti-competitive effects of clubbing have become more willing to break up the clubs, or at least reduce their size. “The investment banks and the sellers have gotten much more sophisticated, in part because of the DOJ investigation, in part because of the press attention to it, in part because lawyers have focused more attention on these issues,” said Thane Scott, a partner in the antitrust practice of law firm Bingham McCutchen LLP.

Bruce McDonald, who joined law firm Jones Day two months ago after a four-year stint in the DOJ’s antitrust division, said sellers are exerting more control in auctions, such as by telling bidders that they won’t accept clubs on a particular transaction, or by insisting that they get to pre-approve who’s in the club. “They can say, ‘We think we’re going to get a better price if you’re not collaborating,’” said McDonald, who did not work on the buyouts industry antitrust investigation while at the DOJ.

A high-profile example came earlier this year, when Goldman Sachs oversaw an auction for the plastics division of General Electric Co. The investment bank limited cooperation among financial sponsors, and the division was eventually sold to a Saudi Arabia-based strategic buyer. Some press reports suggested that this was vintage Goldman Sachs, but it was hard not to view the firm’s hard line in the context of the DOJ investigation.

In any event, Goldman Sachs appears to have started a trend. A buyout pro who spoke on condition of anonymity said his firm is now routinely asked to sign confidentiality agreements in big deals that forbid contact with any other equity sponsor. And an attorney involved in a number of recent buyout deals told Buyouts that one of his clients, now participating in a non-Goldman Sachs auction, was prevented from joining up with a bigger sponsor and might have to drop out of the race. “They’re very rigid about this,” the lawyer said of the investment banks. “It’s like any auction. You get a better price when you have 10 bidders instead of three.”

Needless to say, the power that investment banks wield in auctions gets multiplied in a sellers’ market. In the past, these sell-side advisors might have been wary of alienating buyout firms, which have become an enormously lucrative source of fees. But if the top-tier investment banks are breaking up clubs, it becomes much easier for everyone else to follow suit in the interest of serving the client. “Antitrust law empowers you to insist on a competitive market,” Bingham McCutchen’s Scott said. “It’s not a surprise that investment banks, who know quite a bit about competition, are pretty good at using this tool box in order to squeeze all of the benefits from a competitive market.”

Indeed, not long after the federal probe became public, a plaintiff’s lawyer filed suit in Manhattan, naming most of the marquee buyout firms and investment banks as members of allegedly collusive schemes to drive down prices on three big LBOs of 2006. “They wouldn’t bring an action if there weren’t the whiff of a government inquiry,” McDonald said of the class-action lawsuit. And private cases, as opposed to government suits, carry “far greater risk” for buyout firms, he said. That’s because they require a lower standard of evidence and are generally less burdensome to prosecute than federal antitrust cases. That said, if the government investigation doesn’t result in anything substantial, then private actions will likely shrivel, McDonald said.

So far at least, the government investigation has been something of a black box. Because the DOJ sent letters to buyout firms—rather than issuing search warrants or what are known as “civil investigative demands”—it appears the DOJ didn’t enter the inquiry with specific information about particular criminal violations, McDonald said. In the nearly nine months since the inquiry began, very little, if anything, has become public.

At this point, the government’s lawyers and economists in the Southern District of New York are most likely feeding information into large electronic databases, looking for tell-tale signs and patterns in everything from meeting schedules to deal structures, Scott said. Competitive markets largely behave in certain predictable ways, Scott said, as do uncompetitive markets. If, say, the actual price for a club deal deviates from what the expected price would have been, that might indicate suspicious activity.

Just because no findings have been made public doesn’t mean that nothing will emerge, Scott said. “When the DOJ says your client is off the hook, that’s the kind of news that gets out in about three minutes,” he said. “And when the DOJ says they’re recommending litigation, that’s the news [that] travels by horse and buggy.”