The risk also rises

When pondering the important topics of due diligence and risk management, most GPs think first of this: how do I avoid getting sued or fined? Litigation, especially in the US, is expensive even if you win. This can take away from returns and also presents reputation risk, whether deserved or not..

We asked three astute litigation specialists to predict where the most lawsuit danger resides for general partners as they enter a possibly painful and protracted post-boom era.

Three lawyers, eleven risk picks

2. Angry public LPs
As the case of Connecticut vs. Forstmann Little demonstrated, a failed investment mixed with a public institution can equal trouble for a GP. States that invest directly in funds, and entities such as state pension funds, pose their own risks, Becker says. They often face political pressure to enter into litigation when a fund has garnered negative PR or lost a lot of money. He cites the collapse of hedge fund manager Amaranth Advisors in 2006, after which the San Diego County Employees Retirement Association sued the fund manager for securities fraud.

“Private limited partners will sue if they think they'll get money, but there's not the political overlay that you get with public entities,” Becker says.

Short of not taking public investors' money, there is little a firm can do to mediate this risk. A GP's best bet is to do sufficient reputational due diligence. An LP who has been investing in private equity for a long time and understands the industry is a better bet than one new to private equity, and a GP should always be wary of which politicians, regulators or attorneys general might want to intervene on behalf of the LP if an investment fares poorly.

3. Aggrieved ex-employees
Another result of a market downturn could be “trimming the ranks” of the general partnership. When a partner in the management company is let go, the firm should tread carefully, Becker says.

“You have a lot of the employment issues that you would have in any entity, but particularly given the amounts of money involved [in the private equity industry], really what the funds have to do is make sure they turn very square corners in terms of how they get rid of excess general partners, making sure that they comply with all the rights of those partners and do it in a way that will look good if there's ever litigation involved,” he recommends. “A lot of the people who might be terminated have a substantial amount of money at hand to bring litigation if they want to.”

There is little a firm can do to protect against this risk on the back end. A firm's best course of action is to make sure that the formation documents of the management company, or whatever contract the firm may have with a new partner, clearly specify termination rights.

4. Post-IPO flops
A fourth type of litigation risk arises when a private equity-backed company goes public, then files for bankruptcy shortly afterward. The failure of former Thomas H. Lee Partners portfolio company Refco is a prime example of this. TH Lee Partners is still fighting lawsuits stemming from the loss, as well as waging its own lawsuits against Refco's management.

“Particularly when you have a public bankruptcy trustee out there looking to collect money, they'll be very creative in terms of looking for theories of liability in order to go after the deep pockets of the fund,” Becker says. “They might claim that the fund breached its fiduciary duties, knew there were financial problems at the company or knew the company had inadequate capital to keep going.”

The best way a firm can guard against this outcome is simply to make absolutely sure the portfolio can stand on its own, even in a downturn, after going public. This might mean taking smaller dividends or lightening the company's debt burden in the months preceding the IPO. Of course, some problems, like fraud on the part of the company's top management, are hard to guard against.

1. LBO non-completes
As the tumult surrounding buyouts like Clear Channel, Sallie Mae, Harman Industries and several others demonstrate, the nervousness of buyers and/or lenders has been a major driver of litigation in private equity in recent months.

“When deals were entered into in a very different economic climate but haven't closed yet, the targets for the acquisition are taking a very hard line in terms of sticking to the deal,” says Larry Byrne, a partner in Linklaters' litigation practice.

The best way to avoid these costly and usually highly public lawsuits, Byrne advises, is to make sure that the material adverse change clauses and other provisions relating to the terms of the deal are clearly worded and unequivocal.

“I think all the funds are already giving much greater scrutiny to key provisions of the deal documents,” he says. “Not just the MAC clauses but other change-in-condition type clauses, form selection venue and choice of law clauses.”

2. Regulatory crackdowns
“In a difficult economic climate, there are lots of deals turning in unknown directions, and lots of firms suffering very badly,” Byrne says. “You can expect increased regulation of the activities of the parties in the financial markets, including private equity funds.”

Massive losses at many alternative investment firms have drawn calls for reform and increased oversight, and not just from burned investors. JPMorgan CEO Jamie Dimon recently called on the Securities and Exchange Commission to investigate the circumstances leading up to the collapse of Bear Stearns. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke are pushing for a ramping up of government regulation of financial institutions as well. The UK's Financial Services Authority is also rethinking its role. Although few proposals mention private equity in particular, a new regulation issued generally for all financial institutions might make an especially bad fit for private equity firms.

Massive losses at many alternative investment firms have drawn calls for reform and increased oversight, and not just from burned investors. JPMorgan CEO Jamie Dimon recently called on the Securities and Exchange Commission to investigate the circumstances leading up to the collapse of Bear Stearns. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke are pushing for a ramping up of government regulation of financial institutions as well. The UK's Financial Services Authority is also rethinking its role. Although few proposals mention private equity in particular, a new regulation issued generally for all financial institutions might make an especially bad fit for private equity firms.

“Now is a time when all of the funds should be increasing rather than decreasing their risk management through greater compliance, through strict enforcement of their own internal guidelines,” Byrne recommends. “It's much better to avoid getting involved in regulatory investigation, than getting involved and coming out of it clean after uncertainty and lots of legal fees and financial and reputational risk to the firms.”

3. Intra-consortium disputes
“Where financial institutions and other funds in the past would have been more likely to negotiate to work things out commercially, you can see a number of recent instances where people are going to the courts more quickly to sue to recover,” Byrne says.

As banks and private equity firms wrestle over debt financing, this risk has become quite apparent. In the highly publicized battle to close the Clear Channel buyout, Bain Capital and TH Lee Partners sued the bank consortium that had agreed to finance the deal when it attempted to walk away. UK firm Terra Firma Capital Partners has had to defend itself against two lawsuits filed by other financial institutions: the firm recently concluded a dispute with French bank Natixis over a refinancing package for its portfolio company Box Clever, and in June UBS sued Terra Firma over a debt syndication dispute.

1. LBO non-completes
As one can surmise from recent financial news headlines, the risk of litigation when any party tries to scrap a deal is a significant one. Lawsuits from scuttled deals abound: Fannie Mae's suit against JC Flowers, Harman International's suit against Kohlberg Kravis Roberts, Huntsman's suit against Apollo Management. The circumstances of each case differ widely, and many of them have been settled out of court, so it's difficult to draw generic conclusions about how to mitigate this risk, Dodds says.

“There's not a lot of guidance yet from the courts, but I think each case is so fact-dependent that you really can't generalize about the outcome,” he says. “I don't see how [this litigation trend] is not going to continue unless there are some pretty clear decisions, which seems unlikely to me simply because it always does come down to the language in the agreements as well as whether the facts bear out a claim that there was a material adverse change or triggered another out in the agreement.”

2. Disappointed buyers
Even after a deal closes, there is still the risk that the buyer will claim the sellers misrepresented the asset sold. For GPs looking to exit in a turbulent market, it's important to specify clearly in the sale agreement whether the buyer is entitled to any top-up payments or other penalties if the business doesn't perform as expected.

“Sometimes I think the deals are done so quickly that if there might be issues that no one wants to hold up the deal to really grapple with, the parties just kind of hope that it works out,” Dodds says.

These disputes have long been common in private equity, although Dodds notes that the industry has never been all that litigious in general. More companies fail in a downturn, so this type of lawsuit will almost certainly crop up. Sellers should take care to include language in the deal agreement that places the burden on the buyer to fully examine and understand the business before committing to the deal.

3. Angry public LPs
Like Becker, Dodds believes that the risk of being sued by investors, particularly public investors, has increased in recent years.

“Historically there hasn't been a lot of litigation in this area, partly because you usually have sophisticated investors, decent disclosure and a lot of discretion,” he says. “But we live in an environment where investors, especially those on the public side, are under a lot of stress and a lot of examination. Sometimes they're becoming more aggressive in pursuing claims.”

Some of this increasing litigiousness stems from the application of the Freedom of Information Act to the investments of public pension funds in several states in the early part of the decade, Dodds says. Once the nature of these investments and returns these LPs were getting from private equity became public information, the pressure to seek damages when those returns were poor increased.

4. Antitrust litigation
Another emerging litigation threat is the possibility that private equity firms could be sued on the grounds that clubbing together for deals is anticompetitive, Dodds says. Private equity firms Vector Capital and Francisco Partners were sued on these grounds in relation to the joint acquisition of Watchguard Technologies in 2006, after the two firms had made separate, individual bids for the company. The suit was dismissed this February, but in May Watchguard's shareholders submitted a new complaint accusing the firms of breach of fiduciary duty and insider trading.

“As deals were getting bigger, it just took more than one fund to finance the transactions,” he explains. “There were those who felt that they stepped over some line that hadn't been established yet. But thus far, courts have not found that there is any inherent violation when funds that pursue an investment jointly. If funds act in a manner to restrict competition through sham bids or concerted efforts to inhibit bids by other funds or tying up sources of financing, those may be problematic.”

There can also be antitrust issues when private equity firms purchase securities, he says. “If in the course of acquiring shares investors or funds are considered to be acting together as a group, that may trigger filing requirements under insider and proxy disclosure sections of the federal securities laws,” he cautions.

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, Dodds says. “That won't prevent someone from accusing you of doing that, especially if there is a pattern suggesting coordinated behavior but whether there was some sort of agreement is the core issue.”