Club deals see silver liningin federal court ruling

SEATTLE — A federal court decision last month throwing out antitrust claims against two private equity firms that joined to buy a computer security company could give private equity firms at least moral support for future club deals.

But it's anyone's guess whether two new cases filed in Massachusetts against a who's who of the buyout world and a two-year-old U.S. Department of Justice investigation will give buyout firms additional comfort.

On Feb. 21, the U.S. District Court in Seattle dismissed antitrust allegations against Vector Capital Corp. and Francisco Partners, which teamed up to buy Watchguard Technologies Inc., a Seattle-based technology security company, after first competing for the company.

Two years ago, the explosion of super-sized buyouts brought with it an escalation of the so-called club deal, a consortium of private equity firms that joined together to buy a company. These club deals made buyouts of S&P 500-sized companies like Home Depot and Dell possible. However, in October 2006, the U.S. Department of Justice sent informal letters to Kohlberg Kravis Roberts & Co, Silver Lake Partners, The Carlyle Group, Clayton Dubilier & Rice and Merrill Lynch & Co. asking for information about these consortium-led deals. The Department of Justice expressed concern that the big buyout firms may be “colluding” to artificially reduce the prices of the companies they were aiming to buy. It could not be confirmed by press time whether the investigation is ongoing.

“This is the first decision on the merits since the issue broke,” said Robert Schlossberg, partner at Freshfields Bruckhaus Deringer, a Washington law firm not involved in the case. “The judge set out a standard that is favorable to buyers wanting to form a consortium.”

Although the decision is not binding outside the trial court's jurisdiction, it is the first opinion in a private equity consortium case and is likely to be cited in other cases, he said.

Institutional investors are far from uninterested bystanders. Although investors have no say in the deals their buyout managers strike or how they are structured, legal experts say the firms' limited partners could end up suffering for it. Investors could face the lion's share of any penalties and fines levied by the Department of Justice because they financially benefit from the purportedly wrongful behavior of their managers through their fund investments, according to an article in the Winter 2007 edition of law firm Nixon & Peabody's “Private Equity Newsletter.”

The Seattle class-action lawsuit was filed by Pennsylvania Avenues Funds, an alternative investment mutual fund that invested in Watchguard. It was not the first antitrust case brought since the issue broke two years ago when news surfaced about the Justice Department investigation.

A case filed in U.S. District Court in New York against 13 private equity firms, including Kohlberg Kravis Roberts & Co. and Blackstone Group LP, in June 2007 was dismissed without prejudice, which allows the plaintiffs to refile.

A U.S. Supreme Court decision toughening standards of proof in antitrust cases came down after the New York suit was filed that made it more difficult for plaintiffs' lawyers to state a claim.

In December, another case, which seeks class-action status, was filed in U.S. District Court in Boston against 30 large buyout firms and investment banks, including Bain Capital Partners LLC, the Blackstone Group LP and Goldman Sachs Group, alleging unlawful conspiracies to fix prices in seven leveraged buyouts by consortiums or clubs.

On Feb. 20, a second lawsuit was filed in the same court against 16 private equity funds for conspiracy to rig bids, restrict the supply of private equity financing, fix transaction prices and divide up the market for private equity services in leveraged buyouts. The second suit — also a purported class action — alleged in detail how investment banks participated as co-conspirators to rig the purchase price in at least seven leveraged buyouts, including the seven from the December suit. The two cases eventually may be consolidated said Craig Wildfang, partner, in the law firm Robins Kaplan Miller & Ciresi LLP, Minneapolis, who is plaintiffs' attorney in both cases.

The Seattle court's decision is likely to stand, for now. Plaintiffs intend to amend their complaint on other non-antitrust claims against the private equity firms and to appeal the antitrust ruling only if the rest of the case fails to provide a satisfactory outcome, said Jeffrey R. Krinsk, partner at Finkelstein & Krinsk LLP, San Diego, the lead counsel for Pennsylvania Avenue Funds.

In dismissing the antitrust claims with prejudice, the court ruled that two or more private equity firms combining in a buyout do not by itself show an illegal antitrust conspiracy, said Mr. Schlossberg of Freshfields Bruckhaus.

Instead, U.S. District Court Judge Richard A. Jones found there was plenty of competition based on the number other private equity firms that had requested information about the company even though most did not end up bidding.

The judge found sufficient competition even though the alleged facts of the case — that one of two bidders dropped out to join its former opponent to buy the company — could have given him pause, Mr. Schlossberg said. “What's helpful is that despite how that may look, you would still have to show the harm to competition.”

Even if the Massachusetts court agrees with its Washington state counterpart, the Department of Justice investigation and the subsequent court cases have already changed the behavior of some buyout firms, Mr. Schlossberg said. Some sellers are asking potential buyers to sign confidentiality agreements that now ban formations of consortiums without the seller's consent, he said.

“Sellers want to ensure there are enough horses in the race to generate a competitive outcome,” Mr. Schlossberg said.