WSJ Deal Journal reports some important movement on the antitrust and private equity front.  Specifically, Judge Richard Jones (W.D. Washington) granted the defendants’ motion to dismiss in Pennsylvania Avenue Funds v. Borey, dismissing the plaintiffs’ allegations that two private equity firms had violated the Sherman Act by bidding jointly on the target company (Watchguard Technologies) in order to “artificially fix the price … or rig the tender offer bids for WatchGuard shares” after initially submitting independent bids.

Wilson Sonsini, who argued the successful motion, has posted an informative Client Alert summarizing the highlights of the decision.  Apparently, the Court rejected the per se characterization of joint bidding because it recognized the potential for joint bidding to increase rather than suppress competition in some circumstances.  The court found that the bidding arrangement could not survive a motion to dismiss on the alternative rule of reason characterization because ”dozens of other suitors who expressed interest in WatchGuard refused to make bids. . . . The result was a contest for corporate control in which it appeared that there were only two bidders, but the appearance is a mirage. An acquiror who believed that WatchGuard was worth more than [the] bid could have made a topping bid. The agreement between [the funds] would have had no effect on such a bid. Moreover, had WatchGuard’s shareholders believed that the [] bid was too low, they retained power to reject the merger by voting it down.”  Finally, it is worth noting that Judge Jones did find that the bidding arrangement was not impliedly immune from the antitrust laws because of overlapping securities regulations.

Private equity deals have been the subject of a good deal of speculation in antitrust circles in the past several years as bidding arrangements are the subject of pending litigation and have come under the scrutiny of the Department of Justice.  Its just one decision, but this one seems pretty dismal for plaintiffs in these private equity collusion suits.  Judge Jones’ decision seems to suggest that in the post-Twombly world, and with the market definition problems inherent in a rule of reason type case in the “market for corporate control,” plaintiffs are going to have a difficult time surviving the pleading stage without a plausible story that a specific “club deal” is tainted by collusion with a tangible impact on acquisition price.   I just don’t know if that kind of evidence is out there.  Its certainly tough to get without the benefit of discovery.  Anyway, I thought that the “club deal” collusion story was about facilitating tacit or explicit collusion on a series of deals (you don’t bid here, I won’t bid there).  That might be much harder to identify in practice.

But this is not the last of these suits.  It will be interesting to see how the plaintiffs antitrust bar adjusts to this ruling in future cases.

See here.

I leave tomorrow for Tulane’s Annual Corporate Law Institute.  This conference is viewed by many as the top annual deal conference, so I am expecting great things (this will be my first time attending the conference).  Indeed, the speaker line-up is incredible.  Chief of OMA at the SEC, Chief Justice of the Del. Supreme Court, Vice Chancellor Strine, Richard Breeden, Justice Jack Jacobs, a medley of deal lawyers from super firms, Patrick McGurn from ISS… the list goes on.

While the topics are hot (exec. comp., SOX, shareholder activism), what will be most interesting to me is the interplay between the practicioners, the jurists, and the regulators.  I have worked for all three at different times, and the differences in perspective I noted were. . . vast.  This should be a fun conference.

(I participated in a recent Going-Private conference where the organizers - Frank Aquila and Nancy Wojitas - similarly did an incredible job with respect to representation.  For example, there was a hugely successful s/h-plaintiffs’ attorney sitting on a panel with corporate counsel.  And both parties were candid about where they stood on going-private transactions.  It was fascinating.)

 I will try to take bloggable notes.  And I hope those of you reading who are also going to the conference will introduce yourselves to me (either at the conference or via an advance e-mail at nowickie[insert “@” sign]wlu.edu)!

This recent article in the NYT (log in required) caught my eye. It discusses the growing market for temporary financial services to companies. Since SOX this market has grown by 68% to $8.9 billion, and is expected to grow another 10% this year. The companies looking for temporary help include nonprofits, public corporations, and start-ups.

While the post-SOX boom suggests that public companies are the largest user of these services, the article also notes that start-ups have been renting CFOs for the past fifteen years. This practice makes a lot of sense from the entrepreneur’s perspective. Start-ups are short of cash and may be unable to keep a permanent finance person on staff. But when it comes time to solicit angel or venture capital funding, bringing in an expert can help entrepreneurs with financial projections in a business plan and during negotiations over valuation, all at an hourly rate. This hire-as-needed model works well for lawyers – why not for finance types? The article was quite rosy on the idea, but I wonder if there are any downsides? Perhaps liability concerns for the temp (the article mentions the possible need for a D&O policy)?

Choice of entity is a standard topic in courses on small or start-up businesses. The usual materials cover the basic tax, liability, and governance issues relevant to the choice. These materials are fine for pointing students toward the LLC or S corporation forms for the typical small business, or “lifestyle” firm, as both forms enjoy limited liability and flow-through taxation. (Although my one quibble here is that insufficient attention is devoted to the ultimate choice between LLCs and S corps, where items such as the LLC self-employment tax can be relevant.) The general advice doesn’t hold, however, for start-ups seeking or potentially seeking venture capital.

In this paper, Vic Fleischer explains why start-ups are a different animal, and why they actually prefer C corps despite double taxation and the inability of shareholders to use significant corporate losses during the early years (think R&D expenses). The most interesting reason, to me, requires looking to the ultimate investors in venture capital funds. The VC funds are limited partnerships, so any gains/losses that flow through the start-up to the VC fund also flow through the VC fund to the fund’s limited partners. The majority of limited partners are tax-exempt entities such as pension funds, endowments, and foundations. These investors don’t care about flow-through losses, because they have no tax liability to offset. Also, they try to avoid flow-through gains, which are unrelated business taxable income (UBTI) that, because these entities are tax-exempt, can trigger an audit. Therefore, these investors prefer start-ups to be C corps, venture capitalists will aim to please these favored investors, and start-ups will aim to please the venture capitalists.

On another note, I think Vic’s article is instructive on the craft of writing. It’s tempting to find irrational reasons for start-ups to form C corps (we’ll never have losses!), and as Joseph Bankman documented in The Structure of Silicon Valley Start-Ups, 41 UCLA L Rev 1737 (1994), a “gambler’s mentality” probably does have something to do with it. But when sophisticated players like venture capitalists are involved, I tend to favor rational over irrational explanations for behavior. In fact, I’m taking this approach in a new paper to explain the puzzling behavior of angel investors (no draft yet, although blogged about at Conglomerate).

Thanks to everyone at TOTM for having me.  I’m a big fan of this blog, and look forward to visiting here for a short time.

I was intrigued by a recent article in the Wall Street Journal on venture debt, or the practice of lending to start-ups as opposed to the standard practice of investing for equity.  According to the article, debt made up 7% (or nearly $2 billion) of the money invested in venture-backed companies last year, up from 2% the year before.  The article also shows that venture debt was nearly $4 billion at the height of the venture capital market in 2000.

Venture debt is interesting — and puzzling.  Investments in start-ups are risky, plagued by extreme levels of uncertainty, information asymmetries, and agency costs.  A VC fund invests in a number of start-ups in the hopes that its portfolio will contain the next Google or eBay, to offset the inevitable duds.  VC-fund investors expect a better-than-market rate of return, and most profits come from the IPOs of a small number of highly successful start-ups (like Google and eBay).  The VC model works because of the potential for a huge upside.  Can venture debt work, when by definition it does not offer this huge upside?

Perhaps.  While the start-up is solvent, venture debt commands a high interest rate (double digits, according to the WSJ article).  The article also mentions that lenders get warrants, convertible into equity, which allows them to share (to some extent) in a huge upside.  Also, if the start-up liquidates, debt has first priority over the preferred stock of VCs.  Therefore, venture debt makes sense by offering some upside, although of a different makeup, and by limiting the downside.  But venture debt also presents problems.  First, the typical high-tech start-up must spend available cash on R&D and other growth activities, not interest payments.  Venture debt is unlikely to be the “patient capital” that start-ups need for long-term success.  Second, and perhaps more importantly, venture debt is likely to complicate a start-up’s chances with VCs.  VCs fund relatively few companies.  If a start-up comes with venture debt, I can’t imagine it’s very attractive to the VCs, whose money would go to pay off the debt during solvency, and who would now be second in liquidation preference during insolvency.  Unless the amount of venture debt is sufficient to eliminate the need for venture capital – and by current levels it is nowhere close – do start-ups carrying venture debt really have a chance for long-term success?  Venture debt may make sense for some companies, but in general it seems like a bad idea.

Henry Manne is back with another article in the WSJ.  This time Manne goes toe-to-toe with the “corporate democrats.”
Profs Ribstein (”Shareholder democracy is just one of the burdens that public corporations have to bear these days”)  and Bainbridge (”it’s a brilliant spanking of the shareholder activists, which I highly commend to your attention”) have already chimed in on this one.  Still, it is worth posting a few key paragraphs:

The hidden agenda of many corporate democrats is even more apparent when they argue that large corporations are indeed like small republics and should, therefore, like all governments, be democratized or constitutionalized. This is usually no more than an assertion that the large size of an otherwise private enterprise is sufficient to convert what would otherwise be a private ordering into something suffused with a public interest — in other words, an argument for more socialism. The very success of a private concern becomes the reason for destroying its privateness — a neat rhetorical trick if it was not so patently absurd.

Sometimes this argument is made a bit more logical by saying that large size necessarily means that external costs will be visited on the rest of society. This is the basis for the currently popular claim that so-called “stakeholders” should have a real voice in how the corporation conducts its affairs. But even if there are occasional costly externalities associated with corporate activities, rearranging corporate governance, which is obviously functioning adequately for investors now, is an irresponsible and costly way to solve that real political problem.

We need corporate activists today more than ever, but we need them to lobby and argue for repeal of our many costly and ill-serving bits of corporate regulation. They might start with Sarbanes-Oxley, then go back in time to cover the Williams Act and state anti-takeover provisions, the Investment Company Act of 1940, the Securities and Exchange Act of 1934 and the Securities Act of 1933. I know this is pie-in-the-sky idealism, but it does not change the fact that, on balance, the world would be a far better place without these laws or anything like them.

I don’t have anything to add to this other than a recommendation to go read it in full.

I’d like to thank everyone at Truth on the Market for allowing me the opportunity to guest-blog over the past two weeks. I’ve really enjoyed the chance to share some of my thoughts and contribute in some way to this wonderful forum.

Before departing, I wanted to tie-up a loose end that I left dangling in my earlier post on private equity regulation (I’m sure folks have been up nights awaiting resolution of this issue). As my prior post discussed, I generally find little merit in the recent calls for subjecting the private equity industry to greater regulatory oversight. (You can read my prior post here). I suggested, however, that there are some market imperfections in the private equity industry that may merit some reform. What are these market imperfections? In general, they are the information asymmetries that result from the challenge of valuing privately-held corporations. (more…)

With all of the discussion of late about the compliance costs of Sarbanes-Oxley, I thought I’d address a hypothesis that has been bandied around with increasing frequency about the relationship between SOX, going-private transactions, and private equity.

One might think that in the private equity world, there is a “perfect storm� of sorts for a robust going-private market.  As I have noted before, buyout funds have raised record amounts of cash in the last few years which they will need to deploy in a relatively short period of time (a fund generally seeks to invest most of its capital in its first 4-5 years).  The downside is that a significant increase in the amount of private equity capital does not necessarily translate into a concomitant rise in going-private transactions, as the supply of buy-out “candidates� should remain the same (all other things being equal).  In fact, all of this private equity money could actually create a private equity “bubble� in which “too much money is chasing too few deals�  (also known as the “LP-overhang� problem). 

But now enter Sarbanes-Oxley into the mix.  As a number of studies suggest (see, e.g., here, here, here, and here), the significant compliance costs of SOX (especially Section 404) may very well be creating a greater supply of companies interested in going private than in the past.  The result of these two developments?  You guessed it:  private equity firms should be funding many of these going-private transactions.  Indeed, there is no shortage of press accounts (see, e.g., here, here, here) suggesting that this is exactly what is happening. 

In actuality, I think the relationship between private equity, SOX and firms’ going-private decisions is much more complicated that these accounts suggest.  For starters, just because a firm is “taken private� by a buyout shop does not mean the firm is no longer subject to SOX.  Consider, for instance, the following quote in a recent Business Week article that advances the hypothesis at issue:

At the same time that some companies may be looking to go private to avoid regulation, private equity firms are on an acquisition tear. In recent years, private equity firms have taken many previously-public companies private, including well-known names such as Hertz, Neiman Marcus, Metro-Goldwyn-Mayer, and Toys ‘R’ Us. These deals totaled more than $22 billion. Overall, private equity firms have spent more than $130 billion this year to date for the acquisition of public companies. With an additional $100 billion believed to be available to these firms, a lot more buying is likely.

This sounds like a pretty impressive connection between private equity, SOX and buyouts.  The problem, however, is that these major buyouts did not necessarily make the companies immune from SOX.  Only MGM is now truly a “private company� and no longer required by law to comply with the statute.  Hertz, Neiman Marcus and Toys ‘R’ Us are all still subject to Section 12 of the Securities and Exchange Act of 1934, meaning that they must not only file their regular ’34 Act reports but must still comply with all of the costly SOX requirements.   Why?  Because each firm issued hundreds of millions of dollars of public debt to finance the buyout (they aren’t called “leveraged� buyouts for nothing).  Thus, it is only going to be buyouts that retire all publicly-traded securities that might have been driven by a desire to avoid SOX.  This will exclude any LBO utilizing publicly-traded debt instruments, which means it will exclude most medium and large-scale buyouts.  Because these transactions require the lions’ share of private equity capital, most private equity dollars will not be devoted towards helping firms escape SOX.

This still leaves buyouts of smaller companies, which are arguably the most adversely affected by the compliance costs of SOX and so should be the most willing to seek out private equity money.  But this leads to the second problem with the hypothesis: even if a company truly “goes private� with private equity dollars, it still can’t ignore SOX.   At some point, the buyout firm will need to liquidate its investment, which will require the firm to either (a) push the company towards an IPO, (b) push the company towards a cash acquisition, or (c) push the company towards an acquisition for publicly-traded securities.  In scenario (a), the company will obviously need to be in compliance with SOX before consummating an IPO.  Likewise with an acquisition by a public company in scenarios (b) or (c), certifiable SOX compliance by the target will almost certainly be a key aspect of the transaction.  Of course, a company might let SOX compliance slide a little during its life as a private company, but the smart money will recognize the benefits of being “SOX-ready� well in advance of an anticipated liquidity event.  It is for this reason that the National Venture Capital Association has noted to the SEC that “for many private companies with no immediate plan for offering stock to the public, SOX-compliance is still a necessity.�  (The full text of the NVCA’s comment letter to the SEC can be found here). 

I don’t mean to suggest that there is no connection between SOX, going-private transactions, and private equity.  I simply mean to emphasize that to the extent there is a relationship, it is not necessarily as direct as it might appear.   

Thanks to everyone here at Truth on the Market for inviting me to guest-blog for the next couple of weeks. As I mentioned during my stint on the Conglomerate, one of my primary areas of research is private equity, so as before, I’ll be focusing a fair amount on developments in the exciting world of buyouts and venture capital.

To begin, I’d like to comment on yesterday’s story in the Financial Times regarding the formation of a “trade body� to represent the interests of the world’s largest buyout firms. The initiative appears to be in the early phases of development and is being spearheaded by four of the major players in the industry— Blackstone, Carlyle, KKR, and Texas Pacific Group. As the story notes, the move appears to be in response to growing concern among public policymakers and journalists about the growth of private equity and a sense that increased regulation of the industry may be a distinct possibility.

The notion that private equity should be subjected to greater regulatory oversight is hardly new. In fact, calls for increased regulation of the industry have been circulating for some time now. Recently, however, it seems the voices have gotten a lot louder. Hardly a week goes by without some reference to it (for last week’s reference, see here), and no less a bastion of capitalism than Forbes has contributed to the discussion in a rather scathing article on the subject last month (article here). Why all the fuss? Part of the clamor seems to echo the concerns voiced during the buyout frenzy of the 1980s that LBOs ultimately harm employees and communities through layoffs that often follow an LBO (this seems especially true of the criticisms voiced overseas in Germany and France). Other critics focus on the secretive nature of LBO firms and their proclivity for keeping their operations under the radar. For many, this is especially troubling considering how much money is being poured into private equity. As Forbes noted, “globally, 2,700 funds are raising half a trillion dollars in cash to invest; this will bankroll them for $2.5 trillion in deals, given their penchant for putting $4 (or more) of debt leverage atop every dollar they put up.� Add to this the occasional bad buyout deal (e.g., TH Lee’s Refco debacle) and the conclusion seems obvious: the industry needs more regulation to avert a catastrophic meltdown.

To be sure, there are definitely some market imperfections in the private equity industry that should be addressed (more on these later). What concerns me with the current discourse is that the primary criticisms almost always boil down to the same thing: buyout firms are raising too much money (much of it from pension funds) to exist without meaningful regulation. The mere fact that buyout firms are raising record levels of funds, however, says little about why this might be a regulatory problem. Likewise, it says nothing about what regulatory response might be needed (if any). Is there a market failure that results in “too much� money going into private equity? If so, it seems we would be better off trying to isolate this problem at its source (e.g., perhaps we need to reexamine our prudent investor standard). Likewise, if there are problems with favored LBO techniques (e.g., dividend recapitalizations, etc.), why not address these transaction structures directly (just as Congress did in the 1980s with two-tiered tender offers)?

In short, before we talk about regulating private equity, we need a lot more precision in understanding exactly what (if any) problems are posed by the current private equity market and the best means to address them. Otherwise, I fear ending up with another set of hedge fund investment advisor regulations: regulations that give the appearance of providing oversight of a growing industry, but which are of questionable effectiveness.

Today’s W$J has an article on venture capital “pre-emptive financing,� a term I had not heard before. As the article describes:

Pre-emptive financing happens when a venture capitalist seeks out a promising start-up business and offers it money out of the blue, before the company tries to raise a second or third round of cash. If the offer is good enough, in theory, the venture investor will snag a piece of the company quickly, thus avoiding a costly bidding war that could erupt later once the company says publicly it is looking for cash and attracts several suitors.

The article gives the impression that pre-emptive financing is raining on Silicon Valley start-ups (it has a picture to this effect). But I wonder how widespread the phenomenon actually is. A quote from a general partner with IDG Ventures refers to “very high-quality opportunities.� And as I blogged about last October (here), many early-stage start-ups have struggled to get funding. So maybe its only high-quality later-stage start-ups that are seeing the rain.

According to this FT article, Stephen Schwarzman, the head of the buy-out firm Blackstone (a firm that will soon close on a record $13.5 billion buy-out fund), warned that prices being paid in buy-outs are in “nose bleed territory� and that “seeds of excess� are being sown.  As Schwarzman put it:  “[W]hen it ends, it always ends badly.  One of those signs is when the dummies can get money and that’s where we are now.�  This is consistent with the position I took in this post that market forces will prevent buy-out funds from continuing to reap easy profits.

According to this Business Week article, top managers are fleeing public companies for jobs with private equity funds to hunt for deals, head portfolio companies, or both.

The attractions are twofold: money and freedom. The pay can be outrageously good even at the entry levels; for CEOs, it can be spectacular. The flexibility is alluring, too. In private equity there’s less annoyance from the Sarbanes-Oxley Act, the controversial regulations passed in 2002 to police publicly held companies. And many private CEOs will avoid the Securities & Exchange Commission’s new proposal that would require the highest-paid executives at public companies to disclose their compensation in excruciating detail. (These rules and proposals still apply to companies that issue registered public debt.)

Regulatory issues aside, the fundamental nature of private-equity work is different. CEOs have a freer hand to do the tough but necessary things to repair companies for the long term, with less focus on quarterly results and placating public shareholders and more on meeting the strategic yardsticks of a multiyear turnaround effort.

Looks like we should add contributing to public company executive brain drain to the list of possible SOX and executive pay disclosure costs.

This article from CFO.com reports that VCs have been having trouble taking their portfolio companies public in the U.S. largely because SOX has made it too expensive for small companies and the Wall Street research settlement has resulted in much less analyst coverage of small public companies. Larry Ribstein also talks about this here. As a result, a couple of U.S. venture backed companies have recently gone public in London instead, and the London Stock Exchange’s Alternative Investment Market (AIM) is trying to capitalize on this potential trend. AIM representatives are in the U.S. pitching their market to VCs and emerging companies as an alternative to the U.S. IPO market. As noted by one attorney, “[t]o some extent, the AIM is replacing the Nasdaq as the international market for growth companies, and that, increasingly, is of interest to venture capitalists.â€? (more…)