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According to the Oct. 10 Wall Street Journal, the Department of Justice has begun an antitrust investigation into potentially anti-competitive conduct by several leading private equity firms. Although the companies under investigation and the Antitrust Division are not saying much, the subjects of the probe apparently include the Carlyle Group, Clayton, Dubilier & Rice Inc., Kohlberg Kravis Roberts & Co., Silver Lake Partners, and Merrill Lynch Global Private Equity. Each reportedly received a letter requesting the voluntary production of information relating to one or more specific transactions that have taken place since 2003. The focus of the investigation appears to be on potential collusion among firms that have pooled resources in attempted takeovers of large public companies — a practice known as “club deals.” The alleged competitive harm involves prices paid to shareholders for certain transactions, which might have been higher absent the coordinated efforts of the private equity firms. On Nov. 15 a private lawsuit was filed, seeking class action status to represent these shareholders. Six additional private equity firms were sued in the private action. In the end, the government’s investigation probably will not result in prosecutions, and the private actions are likely to be dismissed or settled. And although no industry enjoys being under the Justice Department’s scrutiny or sued for treble damages, the current inquiries actually may benefit private equity firms in the long run. Private equity firms create separate funds to purchase one or more public companies. The investors in such funds traditionally have been large pension funds, university endowments, and wealthy families. The funds’ financial return comes from a variety of fees imposed on the acquired companies, dividends, and any profits when the companies are taken public again, usually in an initial public offering. Until recently, the largest private equity deal ever done was KKR’s $25 billion purchase of RJR Nabisco in 1988. For years, most of the private equity deals were much smaller, as were the funds themselves. Rapid changes are under way, however, and several firms are increasing the size of their funds to $20 billion and beyond. This has quickened the pace of large takeovers to the point where 15 of the 20 largest private equity buyouts have occurred in the past 18 months. In 2006 alone, we have seen several megatakeover offers, such as the $33 billion proposed acquisition of HCA Inc., the $26 billion potential buyout of Harrah’s Entertainment, and the $22 billion bid for Kinder Morgan. Private equity deals now account for nearly one-fifth of all major mergers and acquisitions. Yet it is the advent of club deals — acquisitions funded by multiple private equity firms working together — which suggest that even bigger privatizations are ahead. Indeed, companies as large as Home Depot, Dell, and Texas Instruments have been rumored to be possible targets for club deals. The ability to pool resources, share risk, borrow on favorable and flexible terms, and leverage assets have combined to bring about a trend that some have referred to as the “LBOing of Western civilization.” In the first 10 months of 2006, 21 club deals have been announced worldwide with a total value of $176.5 billion. This is up nearly 80 percent from all of 2005. AUTOMATICALLY ILLEGAL? In 1990, Federated Department Stores was put into play and two rival bidders quickly emerged — R.H. Macy & Co. and Campeau Corp. The rival bidders submitted several bids, each one higher than the previous bid, until it dawned on the management of both companies that competitive bidding was not in their mutual economic interest. The companies then agreed that Macy’s would withdraw its bid and allow Campeau to acquire Federated. A former shareholder of Federated brought suit on behalf of himself and other similarly situated shareholders. He argued that if it hadn’t been for the undisputed agreement between Macy’s and Campeau, the price for Federated would have been higher. He also alleged that the agreement represented naked bid rigging, which would be unlawful under Section 1 of the Sherman Act if it had occurred in any other industry. After careful consideration, the U.S. Court of Appeals for the 2nd Circuit decided that, because Macy’s and Campeau had publicly disclosed their agreement in filings with the Securities and Exchange Commission and because the relevant SEC regulations contemplated joint bids, the securities laws should trump the antitrust laws under the facts presented in the Federated takeover. Thus, joint bids are lawful as long as they are publicly disclosed, there are no fraudulent misrepresentations in connection with the bid, and the bidding takes place in the context of a tender offer, which the SEC specifically regulates. The ruling of the 2nd Circuit in the Federated matter is a rather narrow one, and no decision suggests that a “secret deal” among multiple bidders to suppress the price of a target company is lawful simply because securities are involved. So, if the private equity firms in club deals have been operating clandestinely in deciding what price to offer for a target company or who will participate in a joint bid, are they necessarily in trouble? There are many good and valid reasons for private equity firms to pool resources (both capital and human), to share risk, and to jointly pursue acquisition targets. Price suppression, while theoretically possible in a particular instance, is pretty far down the list of reasons to coordinate on a bid. Why? Well, among other reasons, there is an enormous amount of capital available for private equity deals (six times as much this year as in 2001) and a growing number of firms in the field. To suggest that a handful of firms in this highly competitive industry might be able to, or would attempt to, artificially suppress the fair market value of a large, publicly held company is not likely. Moreover, the board of directors of a sophisticated public company is undoubtedly going to seek alternative bids and a fairness opinion before simply turning over the company to a particular club of private equity owners. Club deals have been around in a variety of forms for years and are not inherently suspect. For example, venture capital firms frequently collaborate and pool funds to help startup companies. Banks have been doing “syndicated” loans in a number of situations, and rarely has anyone complained that they are fixing interest rates or terms and conditions in loan documents. Oil companies also join together to lease and develop offshore oil wells to spread the risk. All of these activities have generally been considered output-enhancing and, therefore, pro-competition. Another reason the Justice Department’s private equity investigation is likely to founder is that these are very sophisticated firms that employ high-priced legal talent to ensure that they comply with the antitrust laws. It is hard to imagine that investment bankers smart enough to negotiate a complex $20 billion transaction are going to be so stupid as to engage in blatantly unlawful conduct and to leave behind the type of paper trail (e-mails, for example) that would be necessary for successful prosecutions. The Justice Department has looked at Wall Street before and come away empty-handed because of a failure to locate the type of evidence (a proverbial smoking gun) required for a successful prosecution. For example, in 2001, the Antitrust Division closed a lengthy investigation into whether various firms had conspired to fix underwriting commissions in connection with the issuance of new securities. Several years earlier, the department had examined an alleged conspiracy to jointly set trading costs on Nasdaq. Although a civil consent order was signed, there were no fines or admissions of wrongdoing. A WIN-WIN OUTCOME Private equity firms appear to be playing a useful role in corporate restructurings. Taking a large public company private and away from the relentless focus on quarter-to-quarter earnings may enable such an enterprise to reach its full potential. The capital markets are highly efficient, and if the private equity model (even with the club variation) succeeds where other ownership structures have failed, everyone may be better off. The Justice Department is likely to take a close look at some large club deals to try to understand how the joint bidding process operates. The Antitrust Division is reportedly giving particularly close scrutiny to the privatization of Hertz Global Holdings Inc. after its auction last year by Ford Motor Co. Assuming, as I do, that the Justice Department will find that the private equity firms involved in that transaction and others acted properly, you can expect to hear little more about this investigation, though it will undoubtedly linger for a year or more. Over the long run, private equity firms will benefit from competing on a level playing field and from greater public scrutiny of their industry. The last thing these firms need is some future scandal that might cause the capital upon which they are so dependent to dry up. Although the bankers currently taking remedial antitrust classes would probably prefer to be working on their next transaction, the applicable antitrust principles here are fairly easy to explain and should not impede their deal-making. As with any competitive activity, the presence of an honest referee — here, the Justice Department — can only improve the sportsmanship.
Sean F.X. Boland is a partner in the D.C. office of Howrey and co-chairman of the firm’s antitrust practice group.

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