Litigation, especially in the US, is expensive even if you win. This can take away from returns and also presents reputational risk, whether deserved or not. Following conversations with multiple litigation specialists and fund managers, PE Manager locates where some of the most lawsuit danger resides for general partners in today’s litigious culture.
1. VALUATION POLICIES
Fund managers rightfully argue that valuing illiquid assets is a blend of art and science. Nonetheless investors want fair value estimates to be as objective and transparent as possible in order to accurately evaluate the risk and return in their own portfolio. If a fund manager’s valuation policy isn’t rigorous or transparent enough, limited partners may be forced to bring claims (such as breach of fiduciary duty) to avoid exposing themselves to litigation risk from their own ultimate beneficiaries, says Jonathan Sablone, chair of the private funds dispute practice at law firm Nixon Peabody. “This is especially true of LPs with their own fiduciary duties such as pension funds or endowments.”
2. SPLIT INVESTMENTS
Another LP-related risk comes when a private equity firm uses multiple funds under its umbrella to purchase an asset. It’s not uncommon for fund managers to diversify risk by spreading exposure to an investment across funds if it makes sense for their investors, but LPs need to be assured the investment was allocated fairly. Without an objective and documented policy for dividing investments across funds, LPs may take a firm to court for allegedly cheating their fund from more exposure to a hot deal, or conversely, putting too much ownership of a dud investment in their fund without an objective reason for doing so.
To demonstrate the point, Michael Brodsky, who provides dispute consulting services as a director at Big Four audit and accounting firm Deloitte, says for example a GP may neglect underperforming fund A to give attention to well performing fund B. “To achieve a higher carry payout, a GP may house most of a promising investment in Fund B, which can run against the grain of their investment policy and open themselves to litigation risk from investors in Fund A.”
Stephen Baldini, head of law firm Akin Gump’s litigation practice, says some private equity firms discuss split investments with their LP advisory committees in order to avoid this kind of litigation risk.
“Doing so shows the LPs consented to the allocation percentages, an approval that would also show regulators the process took into account potential conflict of interest issues,” says Baldini.
But a word of caution: GPs using this solution should be mindful of the advisory board’s composition. If a few major investors have the most influence on the advisory committee, and stand to gain the most if a hot investment is given to a fund they have more exposure to, smaller investors may still feel aggrieved.
3. LEGACY OWNERS
Some deals are structured so that a buyer will hold some portion of payment until an acquired company achieves certain performance benchmarks or operating metrics. Known in Wall Street parlance as “schmuck insurance”, an earn-out also allows sellers to preserve a fraction of their stakes in a company to avoid feeling embarrassed if the new owner flips the company for a much higher price. Structuring an earn-out is complicated, and with legal complexities comes litigation risk.
Buyers, for example, can be sued by sellers if the latter believes resources were being shifted around to prevent a company from hitting certain benchmarks, which if met would have resulted in the buyer making additional payments to the seller.
Sablone, who has litigated many earn-out disputes, says an unjustified reallocation of resources by the buyer could give rise to “claims for breach of the implied covenant of good faith and fair dealing, bad faith allegations and general breach of contract claims”.
Reallocating resources following an earn-out agreement in fact was the basis of a high-profile lawsuit (dismissed in late 2011) against media powerhouse Viacom, which in 2006 purchased video game maker Harmonix for $175 million. It was alleged by Harmonix’s former owners that after Viacom and Harmonix merged, they purposefully renegotiated a third-party distribution contract in order to reduce earn-out payments owed to selling stockholders. Legal experts advise sellers to negotiate having a board observer sit on the target company, or retain full access to a company’s financials post-transaction, to help keep buyers honest in relation to earn-out payments.
4. CLUB DEALS
Another significant litigation threat, specifically for firms that club together to make an investment, is being sued for anticompetitive behavior.
An ongoing private equity bid-rigging case against some of the world’s most well-known private equity firms is evidence of the risk. Emails and other forms of communication from industry luminaries such as The Blackstone Group’s Tony James and Kohlberg Kravis Roberts co-founder George Roberts were examined in court after investors alleged an overarching collusion conspiracy made during the mega buyout period between 2003 and 2007. Baldini says GPs should be conscious of how correspondence across firms could be interpreted by a jury during club deals. And as long as the firms involved don’t have an agreement or understanding with respect to the purpose of their investment or how they intend to vote their shares, then they probably can’t be proven to have acted as a group, say legal experts.
Even if regulators and investors take no issue with a club deal, litigation risk still exists from other GPs in the consortium. Private equity firms that share a portfolio company may have different takes on exit strategy, portfolio management and dividend recapitalizations, to name a few examples where disputes could arise. Baldini says all members of the consortium should involve their legal advisors earlier in the due diligence process to try and foresee where conflicts could erupt down the road.
If you do not receive this within five minutes, please try to sign in again. If the problem persists, please email: