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Will Europe face its own Forstmann Little case?

The bitter court case involving Forstmann Little and one of its investors, the State of Connecticut’s pension fund, was bad news for the private equity firm. Although the jury refused to award Connecticut financial damages, the negative publicity and drain on resources that the court case brought took its toll on the private equity house. The case was filed in February 2002 and appears to have contributed to the fact that Forstmann Little has not completed an acquisition since 2001. Patrick McCurry reports.

Essentially, Forstmann Little was found to have invested Connecticut’s money outside the parameters of the investment agreements. Worse still, those investments bombed leaving Connecticut with heavy losses. The legal case brought by Connecticut is an example of why, according to one recent poll, private equity fund managers believe they are at more risk of litigation. The case also illustrates the increasing scrutiny LPs are bringing to bear on GPs.

“Investors in both Europe and the US are looking more and more closely at where GPs spend their money,” says Adrian Johnson, chief executive of Legal and General Ventures. But what is the risk of such a case being brought by an investor in Europe and how can private equity firms protect themselves?

Connecticut lost US$122m in Forstmann Little’s US$2.5bn investments in two telecom firms, McLeodUSA and XO Communications. Forstmann Little invested heavily in the businesses at the height of the dot.com and telecoms boom but then, when the boom became bust, invested more capital to try and save the companies.

Connecticut accused the GP of breaches of contract relating to the investment agreement. It originally also filed allegations of violations of US securities law, but these more serious claims were dismissed by the judge.

The jury found that Forstmann Little had breached an investment limitation in the partnership agreement by putting more than 40% of the fund’s capital in a single investment, XO. The private equity house had argued that its interpretation was that the 40% limit only applied to single tranches, not the aggregate amount. The jury also found the investments were not in line with the buyout funds’ private placement memoranda and the limited partnership agreements, which said that investments would be used to obtain controlling shares in portfolio companies.

As part of the Chapter 11 (bankruptcy) plan for McLeod, Forstmann Little did invest more in the business in order to gain a majority stake, but this investment was not made from funds involving Connecticut. The state argued that this ‘fund jumping’ resulted in a loss of at least half their original McLeod investments.

While the jury found Forstmann Little had breached the investment agreements, it also concluded that Connecticut had been kept informed of the investments and had not objected. This, and the fact that Forstmann Little had taken counsel’s advice on the transactions, led the jury to withhold financial damages against the private equity firm. But, after the case, the GP agreed to pay Connecticut US$16m in an out-of-court settlement, to avoid an appeal.

Philip Buscombe, West Private Equity chief executive, says occasionally private equity fund managers will take a risk and go outside the investment guidelines. “But if you do it and don’t get a return then you have a real problem,” he says, adding that GPs raise funds from investors based on a certain investment strategy, management team and so forth.

He says: “They’re investing with you on a certain basis and if you deviate from that radically then you’re in trouble. Of course, if you make money then everyone’s happy.” Another unnamed GP says that private equity fund managers who significantly breach investment agreements are playing with fire. “Of course, you need some flexibility because no fund is going to make money if it is constrained too tightly, but on the other hand you can’t just ignore the investment agreement,” he says.

Another factor in all this is the attraction of hot sectors such as, in Forstmann Little’s case, the tech market. Josyane Gold, a partner at SJ Berwin notes that the investments in McLeod and XO took place at the time of the tech boom: “Houses that perhaps were not traditional tech investors were looking to allocate funds to that sector and finding ways around their investment policy to do that.”

The problem is, as Forstmann Little found out, that hot sectors can suddenly cool, leaving the private equity fund in too deep and potentially facing a law suit from LPs. Nevertheless, it is still comparatively rare, at least in Europe, for disputes between LPs and private equity houses to reach the courts. Rebecca Silberstein, a partner at New York law firm Debevoise & Plimpton, says that this is the first time a private equity firm has been sued by an investor for such breaches of the investment agreements. “Generally, investors know that private equity is a high risk activity and that some of their investments will fail but, hopefully, more will succeed,” she says.

In cases where LPs feel they have been improperly treated by private equity houses, says Silberstein, they tend to get together and visit the GP to try and hammer out some kind of settlement, rather than go to the courts for a resolution.

But the Forstmann Little case is putting private equity houses on their toes when it comes to drafting and interpreting investor agreements, she says. “Ambiguous partnership agreements increase the risk of litigation. For example, percentage limitations are often drafted to apply to aggregate amounts invested in a single company, so if a limit action is meant to apply to separate tranches in a single company, that should be made clear.”

It appears, however, that litigation such as the Forstmann Little case is less likely in the UK and Continental Europe. According to Philip Sanderson, a partner at Travers Smith Braithwaite, most UK and European funds are set up using English law relating to limited partnerships, which makes it harder to bring a claim than in the US. “Claims are more likely to be struck off by the court at an early stage here than in the US,” he says.

Nevertheless, just because English law is less welcoming to claims does not mean such claims will fail and the fact that a growing number of UK and European funds are looking to US pension funds to invest makes future claims more likely.

One of the issues highlighted by Forstmann Little, says Sanderson, is that public pension funds in the US do have fiduciary duties to their beneficiaries and they are increasingly under obligation in law to protect their beneficiaries and that may result in lawsuits.

For Sanderson, the most interesting aspect of the case was the fund jumping, which he flags as a technique also used in Europe. He explains that if a private equity manager puts money from one fund into a business, but then that investment gets into trouble, it is tempting to put more money into the business from another fund. “The problem is that the second investment dilutes the first fund and investors in the earlier fund get hacked off, which is what happened with Connecticut,” says Sanderson.

On the issue of whether UK and European GPs can expect more litigation, a poll published in October by risk and insurance services company Marsh, suggests that perceptions of litigation risk are higher.

The research found that nearly four out of 10 private equity practitioners believed that legal action against their firms will increase. Top of the list of parties expected to bring a claim against private equity houses were investors/limited partners. Edwin Charnaud, chief operating officer at Marsh’s private equity and M&A practice, says to some extent the research mirrors the Forstmann Little case, but the perceived higher risks are not necessarily borne out in reality.

“We haven’t seen much actual litigation,” says Charnaud. But he adds that there has been an increase in notifications made by private equity firms to insurance companies of possible legal action, which suggests litigation could become more common in the future.

According to the Marsh research, one of the concerns of insurers is lawsuits from portfolio companies and the grey area occupied by an individual from the private equity house who sits on the portfolio company board. This individual could be seen by other directors as favouring the interests of the private equity house over those of the portfolio company, giving grounds for a legal case.

“What we’ve seen in the last 12 months is private equity firms taking insurance more seriously and ensuring they have cover that is carefully calibrated to the exposure they face,” says Charnaud. “They are less likely to take a commoditised, tick-box approach and more likely to look at ensuring they have the same kind of cover for the private equity firm as for the investee companies, so that the exposure related to directorships is not at variance with the overall fund cover.”

Even though the perceived threat of litigation from LPs may not be reflected in practice, it is clearly vital for private equity houses to try and avoid legal wrangles. This is not simply because of the financial damages that can be awarded, but rather the tarnished reputation.

“Some of the rhetoric used against Forstmann Little was very damaging,” says Rebecca Silberstein: “For example, you had the state of Connecticut declaring that it had been Enronised by Forstmann Little.”

Philip Sanderson of Travers Smith Braithwaite agrees: “One of the big messages to come out of the case was that when you have an investor making negative claims about a private equity house’s judgment then that affects fund raising.”

Silberstein recommends that private equity houses draft broad investment objectives, so they have some flexibility to structure transactions that the firm may want to do even if they are not the main investment activities of the fund.

Full and ongoing disclosure of the firm’s strategy and investments is also key, says Silberstein: “This includes information in drawdown notices and ongoing information provided in reports and at partner meetings. One of the main bases for denying damages to Connecticut was that Forstmann Little had kept the State informed of its investments.”

As for the prospects for Forstmann Little, it is reported that Ted Forstmann is considering retiring. In court he acknowledged that the McLeod investment had not gone to plan but said it would eventually make money for investors.

That may well be. But in the meantime it looks like the lawsuit has seriously damaged the firm’s reputation and heightened concerns at private equity houses in the US and Europe.

But Philip Buscombe of West Private Equity seems relaxed. “I don’t fear an increase in litigation. In fact, because there’s more regulation of private equity and investors taking a much more active interest and talking more to private equity houses, I think there’s less risk of litigation.”

Others take a different view, arguing that when such huge investment sums are at stake it is inevitable that when businesses go belly up, LPs will look for someone to blame.

It is therefore even more important for GPs to stick to the investment agreements, says Adrian Johnson of Legal and General Ventures: “Forstmann Little were by no means the only example of a fund that raised money to invest in buyouts and got diverted into technical stocks at the height of the boom.” He adds: “If you’re raising money to invest in, say, mid-market UK buyouts, you can’t use it for a development capital deal in Italy.”

Another private equity manager, who asks not to be named, says that as more money goes into private equity there will be more winners and more losers: “The losers are bound to check out what went wrong and if the private equity house has clearly broken the rules it could face legal action. But, in the final analysis, the greatest influence is not the law courts, but the market. If you’re consistently doing well no-one will pay too much attention to the agreements, but if things go badly the market will ensure that there is no-one to invest.”