FIRST Newsletter
November 2006
Been There, Seen It, Done It: A market practice investigation emerges in the
private equity sector
This month we examine several breaking issues involving the
private equity sector, including collusion, the legitimacy of buying
consortiums or clubs, and whether the size of the deals translate
into increased vulnerability to insider trading. We also look at
several old-fashioned frauds that have recently surfaced in the
sector.
Private equity investments have been the darling of the financial
services industry as the deals have gotten larger along with
potential returns on investments. The sector experienced a bit of a
renaissance after it came under attack in the late 1980s; at the time
private equity firms were characterized as “vultures” who would
take a company private, leverage it up with debt in order to finance
the transaction and then split it apart for reasons having to do more
with servicing the debt than strategy. It is the sector that inspired
the book “Barbarians at The Gate,” which explores the
management buyout of RJR Nabisco in 1988.
The private equity sector has taken on a new flavor recently that is
leading to regulatory concerns for collusion and insider trading. The
RJR Nabisco transaction was arranged by a single private equity
firm, Kohlberg Kravis Roberts (KKR); it was the largest transaction of
its kind until the recently announced HCA buyout and the largest
private transaction of all time completed by a single firm. The HCA
transaction involves a consortium of firms, as most recent LBO
transactions do, and it is aspects of the club model that are leading
to regulatory scrutiny.
The recent attention on the private equity sector, which generated
approximately USD $130 billion in profits last year, is unusual. It is a
sector that even more than hedge funds has been able to fly
beneath the radar. Private equity funds, like hedge funds, are lightly
regulated and have experienced exponential growth during the past
five years; along with the aggressive growth of the sector has been
the call for increased regulation, which is expected to be
heightened by the present investigations into collusion and insider
trading.
The emerging cases very much resemble recent market practice
events involving market timing, sales practices, and research
analyst conflicts of interest. The buy-out firms have not been
accused of meeting in secret rooms and devising schemes to keep
prices within certain levels. Instead, at this early stage of the
investigation, it appears that the regulators are looking at standard
market practices within the sector or the way the firms conduct
their business.
Of course, Wall Street and large financial institutions have been
there before: they recently survived market practice investigations
into market timing, late trading, research analyst conflict of interest,
laddering of IPO share allocations, and contingent commissions. As
a result, we believe the industry is better equipped to cope with the
regulatory spotlight that is coming, or has come, their way.
Lessons learned from previous market practice investigations
discussed over the years in this newsletter include cooperation
(and contrition) with the regulators, transparency, timely
compliance with requests for information and pro-active ferreting
out of any potential conflicts-of-interest, or appearances of conflictof-interest.
KOHLBERG KRAVIS ROBERTS, SILVER LAKE
PARTNERS, CARLYLE GROUP (EXCERPT OF EVENTS #6791,
6792, 6793)
The US Department of Justice’s (DOJ) New York office announced
in mid-October 2006 that it had sent letters seeking information
related to market practices from several top-tier private equity
firms, including Kohlberg Kravis Roberts (KKR), Silver Lake Partners,
and the Carlyle Group. The letters request information on private
equity auctions that date back to 2003. At issue in this case is
whether consortiums of private equity firms, or buying clubs, that
participate in large financing transactions represent any form of
collusion. The DOJ expressed concern that alleged collusive
behavior has worked either intentionally or unintentionally to keep
down the price of acquired assets.
The US Department of Justice’s primary concern is for private
equity transactions involving management buyouts; in these
instances, from the beginning, the management can work closely
This monthly publication is produced by the FIRST database research group and provides an overview of cases from the FIRST database. The
events described are extracted from the text of the complete cases and are just a small sampling of what is entered into the database.
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FIRST Newsletter
with a consortium of companies in order to avoid an open bidding
auction. This keeps the acquisition price low for both the
management and the buyout firm, but can also create possible
conflict of interest. If a management favors one bidder or
consortium over another, the competing buyout firm or “club” may
not want to move forward without management support. This
behavior can keep asset prices lower than they would be if there
was a free and open auction process.
The concern with group deals or “buying clubs” goes beyond
simple collusion; the investigation is looking at what happens during
the bidding process and the combination of firms that originally bid
against each other. For instance, Blackstone competed against
Goldman Sachs’ private equity group and Apollo Management in its
$4.35 billion bid for Nalco. But once the auction process was
completed and Blackstone emerged as the winner, the firm invited
both Goldman Sachs and Apollo to participate in the financing
consortium as “equal partners.”
Whilst the regulators argue that banding together to place group
bids may limit the price paid for assets, the private equity industry
counters that club deals are necessary due to the large size of
some transactions; they argue that no single firm will be able to
garner financing on its own once these deals reach the $20 billion
price level. And deals that are consummated without auctions are
raising the largest level of scrutiny, including the pending $33 billion
management buyout of HCA Inc by KKR, Bain Capital, and Merrill
Lynch private equity (see below).
Neither the DOJ nor the firms named in the investigation have
commented publicly on the matter. One unnamed individual told the
Financial Times (10/13/2006) that the investigation concentrates on
“what deals did we do, who did we work with (and) when did we
find out about them.” Another unidentified senior person with a
buyout firm commented, “there are times when we team up but that
doesn’t mean we are price-fixing.” Another unidentified source
added that clients sometimes ask for buyout firms to team up.
Carlyle, Texas Pacific Group, KKR, and Blackstone are believed to
be in the process of joining forces as an organized trade group in
order to represent the buyout sector more consistently, and perhaps
to respond to the current investigation with a single industry voice.
The issue of whether private equity firms are working together in
“club” arrangements in order to control price bidding wars, or to
purposely keep asset prices low, is contentious. KKR conducted the
largest leverage buyout in history when it took RJR private in 1988
for $25 billion. The private transaction was heavily contested and
KKR ended up paying double RJR’s initial valuation by the time the
auction process was concluded. In contrast, the largest deals today
are in the range of $15 billion and involve a consortium of firms
working together.
November 2006
There are several sub-categories of private equity, including
management buyouts and private equity financing transactions.
Management buyouts in particular are believed to be a concern to
regulators given their proclivity to possible conflict of interest. A
firm’s management has a fiduciary duty to get the best possible
price for the company when they are seeking financing; if they are
also negotiating to become the new owners of the firm, they may be
working at cross purposes because it is in their personal interest to
get the lowest possible price.
Ultimately, antitrust experts claim that it will be hard to make a case
of collusion stick against the firms without evidence that they
specifically gathered together in an effort to establish uniform asset
pricing, as other industries have done (see example event #6664).
The question that remains to be answered during this early stage of
the investigation is when does a consortium of buyout firms become
vehicles of antitrust cartels?
MERRILL LYNCH, BAIN CAPITAL, KOHLBERG KRAVIS
ROBERTS (EXCERPT OF EVENTS #6829, 6830, 6831)
The US Securities and Exchange Commission (SEC) announced in
July 2006 that it was examining possible insider trades associated
with the buyout of hospital chain HCA. According to the SEC, the
trading volume in call option trades rose nine times in the days
before HCA announced a $33 billion management buyout by a private
equity consortium led by Kohlberg Kravis Roberts (KKR), Bain
Capital, Merrill Lynch Global Private Equity, and HCA founder
Thomas Frist Jr.
In addition to alleged unusual call option trading patterns, the SEC is
also looking at unusual price spikes in HCA bonds and credit default
swaps in the weeks before the public disclosure of buyout
negotiations in the Wall Street Journal on July 19, 2006. According to
one unidentified credit derivatives trader, some of the price spikes
can be attributed to the general impression in the markets that HCA
was a candidate for a private buyout.
HCA announced the takeover officially on July 24, 2006, less than a
week after the Wall Street Journal first reported the pending private
buyout. The SEC is allegedly investigating evidence based on
unusual movements during the weeks prior to the Wall Street
Journal’s published story on July 19, 2006 that discussed HCA’s
ongoing buyout negotiations. These anomalies include unusual
volume in trading of HCA stock options, larger-than-average price
moves on HCA debt, and a dramatic rise in the cost of HCA credit
coverage as reflected in the price for HCA credit default swaps.
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FIRST Newsletter
The rise in price for HCA credit default swaps is outside the bounds
of the current regulatory investigation into insider trading, but
nonetheless it is interesting and may indicate that insider information
was floating through the markets ahead of public disclosure of the
HCA’s leveraged buyout. For instance, during the month of June 2006
an investor needed to pay around $130,000 for credit default
protection from a default of $10 million in HCA bonds over five years.
In the days before news of the possible deal was disclosed in the
Wall Street Journal, credit default protection against a possible HCA
bond default cost approximately $170,000. After the deal was publicly
disclosed the price of HCA credit protection rose to $400,000.
The rise in the cost of HCA credit protection is especially significant
because a buyout would result in a “leveraging up” in debt for HCA
and hence, the possibility of a default would increase. This was
confirmed by several ratings agency statements indicating a
lowering of HCA’s debt rating after completion of the transaction.
HCA’s privatization is considered one of the largest private equity
transactions on record. The HCA deal marginally eclipses KKR’s
takeover of RJR Nabisco in 1988. In order to finance the transaction,
the buying consortium has put together a $21.3 billion debt-financing
package that the Daily Deal (10/9/2006) says “appears to be pushing
both the bond and loan markets to their natural limits.” The
consortium, including Bain Capital, KKR, and Merrill Lynch, will tap
into four sources of financing: US nonbank loan investors, banks,
European nonbank loan investors, and high-yield bond investors.
The investigation has taken on a political flavor. HCA was founded by
the family of Senator Bill Frist who is majority leader for the US
Senate. Frist is currently under investigation for allegedly selling his
shares in HCA ahead of the buyout announcement. He has
contended all along that he had no advance knowledge of the
private transaction and dispensed of the stock in order to avoid the
appearance of conflict of interest. Frist’s sale of the stock, which
was through the auspices of a blind trust, occurred at a time that it
was trading at a 52-week high and when other insiders were selling
off shares.
The fear among regulators and others is that large buyout
consortiums increase the chances for the misuse of public
information, and more specifically, insider trading. According to
Marc Powers, a former SEC enforcement lawyer, “the more people
involved in a transaction, the more important it is to ensure that all
participants understand their obligations not to tip people off.”
It is certainly more difficult to control the use of privileged
information when a group of acquirers are involved in a private
equity deal. Some transactions involve as many as seven private
equity firms with the associated increase in bankers, lawyers, and
other service providers. For instance, in more traditional mergers
there is often just one investment banker working on each side of
November 2006
the transaction and less opportunity for insider trading based upon
non-public information. In addition, while traditional mergers may be
consummated in a period of weeks or a few months, a buyout, which
may include complicated debt financing arrangements, can take
significantly longer. The increased length in time also increases the
risk that insider information can be abused.
HCA’s buyout proposal is awaiting final shareholder approval at a
meeting scheduled for November 16, 2006 and the transaction is
expected to close before the end of the year.
MADISON DEARBORN (EXCERPT OF EVENT #6821)
The Securities and Exchange Commission announced on June 22,
2006 that it had charged Justin Huscher, a former managing director
with Madison Dearborn Partners, with insider trading related to the
acquisition of Unisource Energy Corp. The SEC contends that
Huscher made a trading profit in excess of $54,000 as a result of
information he gleaned from a friend regarding the pending
acquisition of Unisource by a JP Morgan-led consortium. Huscher
agreed to a civil injunction for violations of federal securities laws
and to pay more than $108,000 in disgorgement and civil penalties.
He also agreed to a bar from association with any investment
adviser, with a right to reapply after four years.
The SEC contends in its complaint filed against Huscher that he first
found out about the pending acquisition of Unisource Energy Corp
when a friend and business associate contacted him in the summer
of 2002. The individual, who was employed by JP Morgan Securities,
inquired about the possibility of Huscher’s firm participating in a
consortium to acquire Unisource Energy. At the time Huscher was a
managing director with private equity firm Madison Dearborn
Partners. According to the complaint, Huscher expressed interest in
exploring the possibility of participating in a JP Morgan-led buying
club for Unisource. He agreed to keep any information pending the
sale of the energy company in the strictest confidence and
acknowledged that he had been privy to non-public information.
Madison Dearborn decided in October 2002 to drop out of the
investor consortium that JP Morgan was assembling in its bid for
Unisource. In November 2003, Huscher’s friend at JP Morgan
disclosed that the acquisition would be completed in a few days.
According to the SEC’s complaint, Huscher proceeded to purchase
8,000 shares of Unisource stock through personal brokerage
accounts. He purchased the stock at prices ranging from $19.45 to
$19.55 per share. By the time the acquisition was consummated on
November 24, 2004 Unisource’s stock rose by 26% or $24.49 per
share, and Huscher had made a profit in the shares he had acquired
a few days earlier of $54,692.
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FIRST Newsletter
Huscher served as a senior investment manger at First Chicago
Venture Capital from 1990 through 1993. He then joined Dearborn,
which was spun-off from First Chicago. He was employed as a
managing director with Dearborn until his departure in 2004. He also
served on several boards of directors, including those associated
with Williams Energy Partners and Jefferson Smurfit.
AA CAPITAL (EXCERPT OF EVENT #6797)
The Securities and Exchange Commission (SEC) announced on
September 8, 2006 that it had issued a restraining order against AA
Capital Partners Inc and its founder and president, John A.
Orecchio. The SEC alleged that AA Capital Partners was running a
Ponzoi scheme and misappropriating client assets. This case is
unusual because it is rare that a private equity fund is caught in this
type of alleged securities fraud. In order to further protect investors’
assets, the SEC closed down the investment firm and froze all its
funds.
AA Capital Partners managed approximately $194 million for six
pension funds primarily through private equity investments. AA
Capital also maintains trust accounts for advisory clients in the
range of approximately $68 million. When the SEC shut down AA
Capital it was concerned that the trust accounts, in addition to the
$194 million in pension fund assets, were at risk.
As an example of the alleged misdeeds, the SEC complaint cited the
withdrawal of at least $5.7 million from client accounts between
May 2004 and October 2005; these funds were allegedly sent to
Orecchio-controlled accounts that were used to finance a Michigan
horse farm and a company that manages a Detroit strip club.
The SEC complaint also alleges that under Orecchio’s direction, the
firm’s CFO was directed to withdraw additional funds related to
what was characterized as a “tax miscalculation.” In addition, the
firm is believed to have misappropriated at least $5 million to cover
operating expenses. The firm allegedly misrepresented these cash
withdrawals in client statements by labeling them “capital calls.”
November 2006
$5 million. According to the SEC, the firm spent more than $4.4
million on salaries in 2005, which was more than twice its revenue.
Orecchio alone was paid at least $1.1 million in wages during 2005.
AA Capital deployed a diverse investment strategy. Its private equity
investments included a Hawaii real estate time-share project, a
Chicago-based hip-hop music company, and a Biloxi, Mississippi
casino. The pension funds that entrusted their assets to AA Capital
included a Detroit-based carpenters’ fund, an Arkansas-Oklahoma
carpenters’ fund, and a Michigan teamsters’ pension fund.
The SEC claims it acted as fast as possible after uncovering the
alleged fraud due to the fact that it could “jeopardize the retirement
funds of union workers.” According to the regulator’s complaint, AA
Capital’s management team, including the Chairman and CFO,
suspended Orecchio from the firm on August 31, 2006 after it
learned of the SEC’s investigation into possible misappropriations.
Orecchio continues, however, to own 50% of the firm and the CFO
and Chairman remain in their management positions. The SEC
contends that thus far neither AA Capital nor Orecchio have repaid
the misappropriated funds to the firm’s clients.
The unusual characteristics of this case have surprised analysts
and experts who track the private equity sector. AA Capital was
considered a respectable firm. Dan Primack, the editor of Private
Equity Week, commented to the Chicago Tribune (9/28/2006): “The
big surprise is that AA Capital is, or was believed to be, a legitimate
firm. They’re not some scam pretending to be something they
weren’t, but legitimate pros with legitimate resumes who were
investing in legitimate funds.”
One unnamed industry insider told Investment Dealers Digest
(9/25/2006) that he believes “there have always been shenanigans”
in the private equity sector. He added, “when it was a smaller
industry, these shenanigans didn’t come to light. Now it’s an
enormous industry. There’s more money, more people and
consequently more light. Ten years ago, these things would have
been handled quietly.”
Orecchio is also accused of having charged excessive expenses to
the firm and using client assets to cover the cost. For example, from
January 2006 through early August 2006, Orecchio filed $4.3 million
in travel and entertainment expenses. This included $1 million in
political contributions, hundreds of thousands of dollars for private
jets, and $120,000 for Super Bowl tickets.
The SEC characterized the financials at AA Capital as “extremely
poor.” Its liabilities, according to the complaint, far exceed assets.
The firm’s 2005 revenues were $2,018,585 while its expenses totaled
$7,151,605. This left the firm with an operating deficit of more than
4
November 2006
FIRST Newsletter
EVENTS OF NOTE FROM THE FIRST DATABASE INVOLVING PRIVATE EQUITY AS A PRODUCT TYPE
Organization
Name
Date
Loss Amount
(USD)
Short Description
FIRST
Event ID
659,143,232
Telstra announced that its final bill for a failed investment with Pacific Century
Cyberworks (PCCW) in Reach could be upwards of AUD $1 billion. Telstra and
PCCW formed the joint venture in 2001, with the goal of providing
telecommunications services in Asia through an undersea cable network.
4865
300,000,000
Citigroup has filed a lawsuit against a former fund manager in Brazil, seeking USD
$300 million in damages for alleged fraud and deception. Citigroup claimed that the
fund manager, who was the general partner of its USD $700 million Brazilian
private equity fund, attempted to sell shares of two wireless companies without
authorization, conducted business on his own behalf, and obstructed auditors.
5573
100,000,000
Zurich Financial Services cancelled a planned $1.1 billion sale of Universal
Underwriters, its U.S. automotive insurance subsidiary, to private equity firm
Hellman & Friedman LLC on January 16, 2005 after Kansas insurance regulators
discovered that the insurer had overcharged customers by applying incorrect
pricing models.
6187
51,000,000
Duke Street Capital, the London-based private equity company, lost $51 million
(66% stake) in the collapse of Austrian plastics manufacturer Steiner Industries.
Steiner became insolvent in May of 2000 in what Die Presse has described as “the
third-largest bankruptcy case in Austria since World War II.”
4593
28-Feb-05
23,169,828
DM Private Equity acquired Unwins in March 2005 for £32 million but the firm was
subsequently placed into administration on December 12, 2005, leading DM to
allege that it had been misled by accounting mistreatments and errors after a £13.2
million black hole was discovered.
6142
Thomas H. Lee
Partners/Merrill
Lynch
1-Jan-98
$16,400,000
(each)
Merrill Lynch and private equity firm Thomas H. Lee agreed in July 1998 to the
payment of $32.8 in order to settle charges that they had failed to fully disclose the
nature of their investments in jointly-managed ML-Lee Acquisition Fund I LP and
ML-Lee Acquisition Fund II LP.
4443,
4442
HSBC Holdings
Plc
30-Sept-05
6,800,000
HSBC was ordered to pay 7 billion won (US$6.8 million) in back capital gains taxes
by Korea's National Tax Service (NTS) for the sale of shares in a small Korean
company in 2002 and 2003.
6004
4,000,000
In an example of what can go wrong in the private equity market, British brokerage
Wood Gundy found itself in a dispute with an investment prospect in 1996. Wood
Gundy had invested about USD $4 million in private equity in publicly held Novatek.
However, Wood Gundy lost its investment when Novatek went bankrupt.
2694
3,250,000
Marshal Capital, a unit of Credit Suisse First Boston, lost $3.25 million in a cash
settlement to Log On America (LOA), for alleged stock price manipulation by short
selling the PIPE stock (private investment in public entities), in an effort to seize
control of the communications company.
4465
2,100,000
The CEO of private equity firm Chartwell Investments admitted to embezzling about
$2.1 million of the firm’s and investor’s money between April 16, 2001 and August
28, 2003. He was sentenced to five years in prison and started serving his term in
June 2005.
6825
Telstra
Corporation
Limited
Citigroup Inc.
Zurich
Financial
Services Group
Duke Street
Capital
DM Private
Equity Ltd.
Canadian
Imperial Bank
of Commerce
Credit Suisse
Group
Chartwell
Investments
18-Jun-06
31-Mar-05
31-Dec-04
31-May-00
1-Jan-96
1-Jan-00
28-Aug-03
5
FIRST Newsletter
November 2006
ALGO OPVANTAGE CONTENT UPDATE
ALGO OPVANTAGE CONTENT TRAINING UPDATE
We continue to move forward on the FIRST 4.x project, and client
feedback has been incorporated into the design. We are currently
finalizing business requirements with our development group. We
plan to introduce these changes to you in stages throughout the
course of 2007. As we have more information on how this project
will be phased out to you, we will let you know. Again, many
thanks for all your input!
Our team continues to provide online training sessions for FIRST
and if you are interested in attending or have new OR team
members who would benefit from this, please register for one of
the following sessions.
NORTH AMERICA
** Contact brunop@algorithmics.com for registration
• Wednesday, November 15th @ 3pm EST
• Tuesday, December 19th @ 3pm EST
FALL USER GROUP FEEDBACK
Our Fall User Group sessions are complete, with good turnout in
both New York City and London. Many thanks to the clients who
participated! One of the highlights of the sessions was a demo of
our proposed FIRST Version 4.x by our User Interface Team, Joe
DiVittorio and Karen Philp. If you were unable to attend either
session but are interested in a demo of the proposed Version 4.x,
please contact Laura Polak (laura.polak@algorithmics.com) by
November 15, 2006 who will be scheduling a web conference for
this purpose.
EUROPE
** Contact nbradley@algorithmics.com for registration
• Wednesday, November 15th @ 10am GMT / 11am CET
• Thursday, December 7th @ 10am GMT / 11am CET
ASIA / AUSTRALIA
** Contact eric.martinez@algorithmics.com for registration
• Thursday, November 16th @ 7pm EST / 11am GMT+11 (+ 1 day)
• Tuesday, December 19th @ 7pm EST / 11am GMT+11 (+ 1 day)
Algo OpVantage FIRST Database
For questions concerning sales and marketing, the Algo OpVantage FIRST database, or content on this newsletter please contact:
Penny Cagan, Head of Research/Managing Director, Algo OpVantage
Tel:
Email:
212-612-7853
penny.cagan@algorithmics.com
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