LBOs Suits and Elections

LBO’s and their creators have been the object of perhaps envious scrutiny as long as these deals have been done. Similar complaints have been at new deals where private equity funds buy control, then upstream dividends, and resell the target at a profit (hopefully). This particular suit involves the former rather than the latter, though the attack rhetoric is generally much the same.

On November 13, 2006, an investor group filed a class-action lawsuit against 13 private equity firms for bid-rigging which deprived the investors of the target company the full economic value for their holding. Justice has launched an informal investigation into alleged collusion covering LBOs. Bloomberg provides a more complete story at: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aKTQ50WmoW6w

What actually happened was that the suit, was specifically referenced to the HCA LBO.

Further the 20-page complaint doesn't provide any details on how the firms allegedly fixed prices.

The following describes the issues raised and whether they are particularly valid.

The first issue, though tangential, is share repurchase. For small ones, the arguments against them might hold. For big ones, it is very hard to argue that they are not a valid strategy: many have been done, and fortunes made.

I had first addressed this subject in response to Morgan Stanley’s reentry into the private equity market. http://news.glgroup.com/cm/analysis/logs/?a=p&lid=7002&pid=4767. My feelings were that Morgan Stanley has a lot of depth and could have restarted with people in the firm. The reason they hired out of Goldman was because they thought they were getting a club membership too. I would amend that to say that the deals are so big, like this one, that building working coalitions is important, and is a skill that gets stale quickly. You need people doing it everyday, and they have to have an inventory of political favors and trade goods to draw on.

The best place to start is a brief review of recent history. From the Bloomberg article, it would seem that the lawyers have seen a little smoke and are hoping to find a real fire, somewhere. The Justice Department has launched an informal investigation into charges that the buyout firms colluded on leveraged buyouts. A similar suit accused 12 investment banks, including Goldman Sachs Group Inc. and Merrill Lynch & Co., of rigging initial public offerings of technology companies in the late 1990s. A federal appeals court last year ruled that the case, which claimed that the firms required investors who received IPO shares to buy additional stock in the after-market, can go forward. So it seems that this opinion has opened the door for this suit, as well as recent election results.

The suit was filed in Manhattan federal court by shareholders who claim they were shortchanged because the firms restrained bidding for leveraged buyouts such as the $33 billion takeover of hospital chain HCA Inc., the largest LBO ever. If granted class action status to represent tens of thousands of shareholders in dozens of LBOs and being a federal anti-trust case, triple damages would be in order if the plaintiff wins. The suit alleges that the originators conspired to "artificially fix, maintain or stabilize" buyout prices giving investors a lower price than if "free and open competition" had existed between the bidders.

Note well that the 20-page complaint doesn't provide any details on how the firms allegedly fixed prices. Now to turn to what prima facie evidence that there might be of collusion.

• One indicator or possible collusion is the relatively few firms involved. 13 is a small enough number firms, and considering the number of people involved, collusion would be possible. If there were collusion, there would also be groups that would pay a little more to get in, and such don’t appear to be in evidence.

• The next issue is cost of entry. The sums involved are enormous, so much so, that firms willy-nilly have to form ad-hoc groups to deal with them. In instances such as this one, there might not be enough money to have a competitive bid or firms available for any alternative bidding. Trading desks would be a very poor mental image of these operations as execution costs are quite high.

The next step is to examine at least some of the agreement provisions relating to the merger. The best place to start are: Form PREM14A(preliminary proxy statement) and the Form SC 13E3 (going private transactions) both filed August 9, 2006.

• The SC 13E3 contains copies of the slide presentations by Credit Suisse and Morgan Stanley. Notably, they suggested a target price of $48.75 well below the $51.00 at which the deal was done.

• MS and CS present the premiums paid in large U. S. public cash transactions.

• MS and CS provides a check list on page 34 of their presentation on what steps the company should take in seeking alternate bid:

Finally, we are left, after legal posturing and judicial self-righteousness, the question of fact: Did the originators conspired to "artificially fix, maintain or stabilize" buyout prices giving investors a lower prices than if "free and open competition" had existed between the bidders. A review of it shows the following:

There are not a large number of participants in this market, and the costs of entry are high. Some of the deals are so big that they require multiple parties. Even if size is not the issue, multiple partners help reduce portfolio risk.
These deals are expensive to do, requiring a lot of man-hours to complete. The firms in question are loath to loose their sunk costs by chasing other deals, as can be seen by the terms of this one.

This market is not a zero-sum game, unlike the law. Companies change, the market changes, creating new opportunities. In this market, deals are like buses, and there is always a deal stream: you just have to be ready to find new opportunities.

The logic of the legal brief related to the victimization of the shareholders by company. The use of enthymeme is priceless here: the lawyers are assuming and hoping to sell the image of innocents (Ma and Pa Kettle) investors being fleeced by villains. Actually Barclays Global Investors, Ltd and Dodge & Cox each own roughly 10% of the share O/S. Neither one would allow themselves to be fleeced: the dollars are too big and they do not want to get sued for a violation of fiduciary duty. I suspect that they were the reason the per share offer improved, as noted above.

I think the best comment on the whole story comes from an uninvolved lawyer quoted in the Bloomberg article: ''said Sean Boland, the co-chair of the antitrust practice at Washington-based law firm Howrey LLP, who isn't involved in the case. ''But sophisticated people are going to say, 'I see the smoke, where's the fire?''' Why now, then?

• The ongoing investigations and suits might make it appear that there are legal opportunities.

• The congressional election results have emboldened many trial lawyers, with dreams of a return to ‘the class-action heaven’ of the Clinton years.

I suspect that the suit will be granted class-action status, and if it goes to trial, the result will be indeterminate, being no more than a test of legal skill. The filers made no mention of factual details in their complaint, and there is no reason to believe they will provide any if and when this case goes to trial. In instances like this, it helps to check as many sources as possible. As an aside, this deal is the first time, I actually got to see the full presentation made to sell and LBO.