Originally Published in Securities Regulation & Law Report, 45 SRLR 1350 - July 22, 2013.
This article analyzes the legal risks and potential consequences of private equity firms collaborating with one another to create consortiums or so-called "clubs" to jointly bid for acquisition of a publicly listed target company. These kind of transactions are more commonly referred to as "club deals" in the mergers and acquisitions world. From 2003 through 2007 club deals became a staple of the leveraged-buyout (LBO) industry. With the rise of clubs, many large-cap companies came within the reach of private investment firms.
For private investment firms, forming consortiums can be attractive for many reasons. In addition to getting access to large companies, it allows private equity firms to share the burden of writing a large equity check. It also helps in debt financing in LBO deals, since lenders are more comfortable lending when several sophisticated players are pursuing a transaction rather than just one. Further, it is not only a consortium of equity, but also of a superior expertise and talent pool that can help the target company in its operations post-acquisition. A target company may also benefit because it doesn’t have to go through a prolonged auction and negotiation process in which management has to shift its attention to selling the company instead of focusing on the operations. On the other hand, bids from private equity consortiums may be a cause of concern for sellers as consortium bids could stifle the competition, potentially driving down the sale price.
The culture of clubbing by private equity firms initially concerned the Justice Department (DOJ) in 2006. On October 11, 2006, The Wall Street Journal reported that the DOJ launched an investigation into bidding practices of private equity firms, including, among others, KKR & Co. LP, Carlyle Group LP, CD&R LLC, Merrill Lynch Global Private Equity, and Silver Lake Partners LP.1 The New York office of DOJ asked these firms to provide information on deals and their business practices. In 2008, Apollo reported that few of its competitors in the private equity industry have received information requests relating to private equity transactions from the Antitrust Division of the DOJ. KKR further received a request for documents in 2009. It is not known whether DOJ’s investigation is continuing or ended because of lack of evidence.
In 2007 former shareholders of companies filed a lawsuit against clubs of private equity firms composed of Goldman Sachs Capital Partners, Carlyle Group LP, Blackstone Group LP, TPG, and Permira Advisers. In 2008 the Detroit Police and Fire Retirement System filed its own lawsuit against these firms, and other private equity giants, that are accused of colluding in deals to privatize Neiman Marcus, Michaels Stores, HCA, Aramark, SunGard, and PanAmSat. These cases were consolidated into what is now a federal antitrust class action suit, Dahl v. Bain Capital Partners LLC.2 At issue in the suit is whether the "club deals" were an illegal attempt by private equity firms to collude and drive down the prices of the acquisitions they made jointly. Plaintiffs in Dahl allege that bidding clubs restrain competition because they limit the available number of competitors to bid on deals, which artificially depresses buyout prices, thereby harming the shareholders of publicly-traded companies. The defendants in Dahl moved for a summary judgment and asked the federal district court in Massachusetts to dismiss the plaintiffs’ case; the judge by an order dated March 13, 2013 refused to grant dismissal but narrowed the lawsuit to reduce the number of claims suggesting that plaintiffs’ case was overly broad and had flaws.
Civil Litigation Stemming from Club Deals
The following two cases illustrate the judicial response to civil lawsuits and provide important lessons for how private equity firms should conduct club deals.
A. Dahl v. Bain Capital Partners LLC, No. 1:07-cv-12388 (EFH), 2013 U.S. Dist. LEXIS 34771 (D. Mass. Mar. 13, 2013).
On March 13, 2013, the court ruled on defendants’ motion for summary judgment and, as explained below, allowed plaintiffs’ claims to proceed to trial due to certain carelessly worded e-mails from a number of executives of the defendant firms.
1. Antitrust allegations. The plaintiffs brought claims under Sherman Antitrust Act Section 1, which prohibits competitors from agreeing to fix prices or suppress competition among themselves and permits civil recovery of up to three times the amount of damages suffered. Plaintiffs’ first claim alleged an overarching conspiracy by defendants to allocate the market for large LBOs in order to avoid price escalation. The plaintiffs, unable to offer any direct evidence of an agreement by defendants not to compete, relied upon two theories to show the existence of such an agreement.
First, plaintiffs argued that an agreement not to compete could be inferred by the various collaborative practices employed by the bidding clubs. Second, the plaintiffs offered a few brief e-mails of executives of the defendant firms to show that the defendants were acting by agreement, and not by their independent business strategy. In response, defendants disputed the existence of such an agreement and cited evidence indicating that bidding partnerships reflect a widely accepted and independent business strategy.
2. The court’s decision. In its ruling on March 13, 2013, the district court in Massachusetts held that private equity firms have independent and legitimate business justification for joining the clubs, such as allocating risk and pooling financial resources together. The court noted that "[j]oint bidding and the formation of consortiums . . . are, as Plaintiffs concede, established and appropriate business practices in the industry. Like the purchase of any other asset, parties may join together to purchase large public companies."3 Moreover, the court found that certain quid pro quo arrangements and invitations to losing bidders were not, by themselves, sufficient to permit an inference of a conspiracy.
The court did, however, find that several e-mails could show that defendants were acting by agreement when they refrained from "jumping" proprietary deals. In one e-mail, a TPG Capital executive wrote regarding a proprietary deal: "KKR has agreed not to jump our deal since no one in private equity ever jumps an announced deal."4 In another e-mail, a Goldman Sachs executive observed that "club etiquette prevail[ed]," with respect to a proprietary deal.5 The court found that these e-mails could show that defendants were acting according to an agreed code of conduct, rather than their own independent interests. Thus, plaintiffs were permitted to proceed on their claim only with respect to an alleged agreement by defendants to refrain from "jumping" each other’s announced proprietary deals.
B. Pennsylvania Avenue Funds v. Borey, 569 F. Supp. 2d 1126 (W.D. Wash. 2008).
The decision in Dahl comes five years after the federal district court for the Western District of Washington dismissed antitrust claims against two private equity funds – Vector Capital Corporation (Vector) and Francisco Partners L.P. (FP) – that allegedly conspired in their joint bid for corporate control of Watch-Guard Technologies Inc., a provider of network security solutions.
1. Antitrust allegations. The plaintiff filed suit on behalf of WatchGuard shareholders against Vector and FP, as well as individual directors of those entities, for anticompetitive behavior under the Sherman Act. The suit alleged that at the end of the bidding process the two funds conspired to withdraw Victor’s bid and then substantially lower FP’s bid, which was the only one remaining. In addition, Vector agreed to fund half of FP’s acquisition in exchange for a 50 percent interest in WatchGuard. The plaintiff claimed that the collusion between defendants depressed the bid price of WatchGuard shares by 18 percent.
2. The court’s decision. The court determined that joint bid agreements for control of a company are not unlawful per se unless it is clear that there can be no pro-competitive benefits associated with the conduct. The court examined the benefits of joint bidding and found that the practice could actually improve competition among bidding parties. For instance, joint bidding allows smaller firms to pool resources and enhance their competitiveness against larger firms. Joint bidders can also spread the risk of the acquisition.
After determining that a joint bid by private equity firms is not per se unlawful, the court addressed whether Vector and FP’s agreement was lawful under the rule of reason analysis. The court reasoned that because any bidder could have entered the process to bid for WatchGuard and made a higher bid, the agreement was not unlawful. In addition, the court observed that the shareholders were free to reject the joint bid and rebid the business. The court concluded by stating that "the illusion of market power arose not from Defendants’ anticompetitive conduct, but from the lack of market interest in WatchGuard."6 Because the plaintiff could not satisfy its burden for establishing market power in a relevant market, the court dismissed its antitrust claims with prejudice.
Summary of Legal Risks and Potential Consequences
Based on the foregoing, one can reasonably assume that in general, in the absence of a contractual prohibition to club deals, club deals are permissible and not per se unlawful. However, private equity firms that engage in potentially anti-competitive practices under the guise of a permissible club deal could be liable for monetary damages to former shareholders of target companies, subject to DOJ investigation and civil and criminal prosecution resulting in fines up to $100 million for corporations and $1 million for individuals as well as imprisonment up to a period of 10 years. We are yet to witness how the Massachusetts court will rule on the outstanding claims in the Dahl case, which we expect will provide further guidance on the subject. It is important that the factual record support the business purpose of concerted actions. E-mails and other evidence of conspiratorial actions that contradict independent decision making and lack of a quid pro quo increase the risk considerably.
It is pertinent to note that the board members of a target public company entertaining a club bid may be subject to fiduciary duty breach claims under Delaware law. Although there is no court precedent against the board members on this specific issue, a board’s acceptance of a lower price offered by a bidding club instead of following its Revlon7 duties to fetch the maximum price for its shareholders may be in breach of their fiduciary obligations under Delaware law.
Timing of the formation of a private equity consortium could be of relevance in understanding the legal risks and consequences. One could form a consortium from the beginning to conduct diligence, prepare and submit the bid and negotiate the acquisition of the target. Consortium could also be formed during the auction process before submitting the bid or even after submitting the bid. Sponsors could also form a consortium after an agreement has been signed, if the target permits formation of a consortium for acquisition. Probability of being subject to a lawsuit or DOJ investigation would be lesser if the sponsors form a consortium from the get-go.
Internal Controls and Governance of Clubs
Once the investment firms form the consortium, there are governance issues that each member of the consortium should deal with. If they have equal ownership interest in the consortium, governance matters could be less of an issue. However, if there is disparity in ownership it could lead to conflicts among the members, mostly about control of the board; the selection of debt financier, the accounting firm leading the consortium, and/or the law firm leading the consortium; operation strategy; exit strategy; timing; or other issues. It is important for consortium members to gain clarity on governance and control issues as soon as they agree to form a club.
Guidelines for Club Deals
The following lessons from the recent court order in Dahl and the federal district court’s decision in Pennsylvania Avenue Funds can be used as guiding principles by investment firms in their participation in bidding clubs.
forming bidding clubs or consortia to bid for a control of a public corporation is not per se illegal
e-mails are a great way to communicate, but the words in them could be interpreted to give a different meaning and used as evidence against the investment firms; e-mails between executives of the defendants are being used as the basis for claims in the Dahl case
each member of the club should adopt an independent business strategy allowing them to make decisions based on those strategies
investment firms need to think carefully before "jumping" deals if they have clubbed with the stalking horse bidder in the past; so-called "club-etiquette" not to jump deals may be risky
avoid creating exclusive clubs of few investment firms, which could go to show there is a broader agreement; if the club deals are with different private equity players, it is harder to prove that they colluded
avoid any quid pro quo arrangements with club members; however, the court in Dahl mentioned that quid pro quo arrangements on their own are not conclusive evidence of collusive conspiracy
if you have signed an agreement with the target company, include a matching rights provision, it may prevent private equity funds from bidding as could it be a losing battle since you have a matching right
document your reasons for standing down from a potential deal once you have made a bid
try to form your club from the get-go instead of joining the club after losing the auction; giving a place at the table to losing bidder may have some risks as it may give the appearance that the bidding was "rigged" from the outset
where there exists a contractual prohibition against clubbing, the actions of a private equity fund to perform due diligence and financing investigations through a "front private equity fund" could impose liability for tortious interference or other tort for aiding and abetting the front fund to breach its contract with the target.
1 Dennis K. Berman & Henny Sender, Probe Brings ‘Club Deals’ to Fore, WALL ST. J., October 2006, available at http://online.wsj.com/public/resources/documents/dahlvbain.pdf.
2 No. 1:07-cv-12388(EFH), 2013 U.S. Dist. LEXIS 34771 (D. Mass. Mar. 13, 2013).
3 Id. at *51.
4 Id. at *56.
6 Pa. Ave. Funds v. Borey, 569 F. Supp. 2d 1126, 1134 (W.D. Wash. 2008).
7 Revlon Inc. v. MacAndrews & Forbes Holding Inc., 506 A.2d 173 (Del. 1986).