Club deals and DOJ investigation considerations for private equity investors



January 22, 2007

Private Equity Newsletter

by Bradley C. Vaiana, Partner, and Peter Nurnberg, Associate

The DOJ investigation

In 2006, the “Club Deal” (a transaction in which a consortium of private investment funds collaborates to offer a joint bid for a target company) became a staple of the leveraged buyout universe. With the recent explosion of mega-buyouts and the rise of clubs, many large-cap public companies are no longer viewed as “untouchable” by private investment funds. Recent buyout speculation has centered on companies with household names, such as Home Depot, Dell, and Sprint-Nextel. With the ever-expanding size of private equity funds, the migration of hedge funds and their vast pools of capital into the leveraged buyout space, and the increasing collaboration between private equity funds and hedge funds, the size of buyouts has continued its upward trajectory. Industry insiders predict that a $100-billion buyout is now a possibility. However, the proliferation of club deals is not without controversy. In the last few months, questions have arisen challenging the validity of the bidding techniques used by private equity funds and other club participants during the auction process.

It has been reported that, in October 2006, the U.S. Department of Justice (“DOJ”) antitrust division sent informal letters to Kohlberg Kravis Roberts & Company, Silver Lake Partners, the Carlyle Group, Clayton Dubilier & Rice, and Merrill Lynch & Co., requesting information about their business practices and participation in recent high-profile auctions. In these letters, the DOJ expressed heightened concerns that investment funds may be “conspiring” or “colluding” as part of a club to artificially reduce the purchase prices of the companies that are the targets of buyouts. These charges appear to be focused on two actual or perceived industry practices: first, private equity firms “sharing the market” by declining to participate in certain auctions, with the understanding that other private equity firms will reciprocate by declining to participate in other auctions (thereby reducing the number of bidders in each auction), and, correspondingly, depressing the prices to be realized by the seller; second, private equity firms teaming up with one another to avoid protracted and costly bidding wars, once again depressing the prices to be realized by the selling stockholders.

Given the preliminary nature of the DOJ inquiries, it is much too early to predict with any sense of certainty the possible outcomes of the investigation. However, there is considerable speculation within the private equity community that the DOJ’s inquiry is simply much ado about nothing. The viewpoint of the U.K. Financial Services Authority (“FSA”), for example, is generally considered at odds with that of the DOJ. A November 6, 2006, FSA “discussion paper” regarding the current state of the private equity industry made no mention of club deals being anti-competitive. The FSA reportedly arrived at its position based on the fact that target company stockholders are not obligated to accept bids submitted by would-be acquirors and because of the pro-competitive justifications for club deals, such as facilitating larger transactions and diversifying individual firm risk. Nonetheless, given what is at stake and the likely ripple effect within the private equity community if the DOJ is successful in bringing charges against such funds, the investigation should not be summarily dismissed as frivolous or baseless.

In the event of a successful action by the DOJ against private equity and hedge funds, it is likely that the limited partners in such funds will face the lion’s share of any penalties and fines levied by the DOJ, given the financial benefits the limited partners have realized as a result of their participation in such funds. It will be interesting to see whether the general partners and controlling persons of such investment funds are asked to step forward to bear a portion of the penalties or fines themselves, perhaps in the form of a haircut on management fees or a clawback against their carried interest allocations. It will also be interesting to see if those limited partners in private equity funds who are penalized for collusive practices consider removing (or attempting to remove) the general partners of such funds, either for cause or, where available, without cause, which typically requires a supermajority vote of the limited partners.

Protective considerations

Regardless of the outcome of the DOJ investigation, there is always the looming presence of the plaintiff’s bar to contend with.

Despite the long odds— and displaying a certain degree of opportunism, as of the date of this publication— at least one lawsuit has already been filed in the Southern District of New York against several well-known private investment funds that have been active participants in club deals over the course of the last several years.[1] Given the deep pools of capital available within private equity and hedge funds, we would expect that class action lawyers will continue to pursue these types of claims if there is even a slight chance for a lucrative payday.

Therefore, regardless of whether the DOJ decides to pursue criminal or civil charges against private equity funds and other club participants, all investment funds contemplating any collaborative activity in this area would be well-served to consider adopting procedures designed to preempt potential antitrust concerns or anticompetitive charges in future auctions. Such procedures might include one or more of the following:

  • The club participants should be able to demonstrate a legitimate business purpose for such participation, other than merely reducing the competitiveness of the auction process (e.g., reducing the size of the investment in relation to the size of the fund or the ability to compete in auctions that would otherwise be beyond their fund’s capacity, etc.).
  • An investment fund should adopt internal controls and procedures to limit or prohibit the sharing of information with other funds or companies that are not part of their club and that may also be participating in the auction.
  • If an investment fund has lost an auction, it should give careful consideration before switching teams to the winning club. Similarly, the auction winner should hesitate to invite any member of a losing auction team to join its winning team, as these practices may give the appearance that the bidding was “rigged” from the outset.
  • If, going into an auction process, an investment fund knows that it will be unable to win the bid without teaming up with other funds, it should consider reaching out to such funds and forming the club during or before completion of the auction process. While this approach may still reduce the number of auction participants, it is less likely to taint the losing bidders with the stigma of having put in sham bids.
  • Where possible, an investment fund might seek alternative means of raising capital that would not require teaming up with the “competition,” perhaps looking to its own limited partners to co-invest alongside the investment fund to achieve greater scale.

The measures suggested above could provide an extra layer of protection against a lawsuit or DOJ charge that a participant conspired or otherwise colluded with the “competition” to fix the ultimate winning bid. Of course, at this early stage of the DOJ investigation, it is premature to suggest a foolproof safe-harbor approach for club participants to adopt in the auction process.

It is not yet clear how the markets generally, or the private equity community in particular, will react to the DOJ investigation. Just recently, several private equity and hedge funds have joined together to form the Private Equity Council, a trade group formed to lobby on the industry’s behalf (which may be viewed as an industry-wide reaction to the DOJ investigation). To date, it does not appear that the investigation or the threat of criminal or civil charges has deterred the formation of clubs.

Since word of the DOJ inquiry first surfaced, several private equity funds and hedge funds have continued to team up to acquire companies such as Reader’s Digest, Clear Channel Communications, Biomet, Inc., and Harrah’s in multibillion-dollar, go-private transactions announced in November and December 2006. It remains to be seen whether this trend will continue if the DOJ decides to pursue criminal or civil charges against any of the private equity funds or club participants that are the subject of the current inquiry.


  1. Murphy v. Kohlberg Kravis Roberts & Co., No. 06-13210 (S.D.N.Y. filed Nov. 15, 2006). Merrill Lynch & Co., Kohlberg Kravis Roberts & Company, the Carlyle Group, Silver Lake Partners, the Blackstone Group, Thomas H. Lee Partners, Apollo Management, Warburg Pincus, Clayton, Dubilier & Rice, Bain Capital, Texas Pacific Group, Madison Dearborn Partners, and Providence Equity Partners, Inc. have all been named in the lawsuit.
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The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

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