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Focus: Private Equity – November 2006

Can deals be too 'clubby'?

In brief: The US Department of Justice has begun an investigation into the conduct of private equity firms in the United States and whether their participation in 'club' deals is potentially anti-competitive. Partner Carolyn Oddie (view CV) discusses the key aspects of these investigations and the implications for Australian consortium participants.

• Background
• What's the issue in Australia?
• Are firms really competitors?
• Exercising care
• Sharing confidential information between 'club' members
• Arrangements with lenders
• Key things to remember

Background

In October, reports started filtering through that the US Department of Justice (DOJ) had begun an informal investigation into the conduct of private equity firms in the United States. Apparently, letters sent to a number of private equity firms sought information and documents in connection with deals and business practices conducted by these firms in recent years. 

Antitrust investigations stemming from the DOJ have recently shaken up other industries such as the insurance industry and resulted in similar examinations being conducted by regulatory bodies such as the Australian Competition & Consumer Commission (ACCC) and Australian Securities & Investments Commission (ASIC). 

Last week a class action was filed against 13 private equity firms which have been accused of rigging the market to take companies private. The action claims that as a result of 'club' deals, the target is prevented from running a fully competitive auction designed to maximise value for stockholders. The claim states that as a result, investors in the target are deprived of the full economic value of their holdings and 'squeezed out' at artificially low valuations.

These developments confirm that just because, 'that's the way things have always been done', does not mean that conduct is beyond scrutiny. 

The DOJ appears to be focusing on the behaviour of private equity firms that form, or participate in, a consortium to bid for a specific asset.  The speculation is that private equity 'club' deals can raise a number of potentially anti-competitive issues, and the DOJ is investigating:

• whether the formation of the consortium removes the competitive tension in a bid process, and as a result, the consortium is able to acquire the asset for a lower price than if a number of bidders were competing for it on an individual basis;
• exclusive arrangements with major industry lenders, effectively precluding other bidders from obtaining the finance necessary to make a competing bid; and
• whether firms operate according to an unwritten rule or 'gentlemen's agreement' that once a firm enters into a formal agreement with the target company, another firm will not make a competing bid for that asset.

The issues raised by the DOJ's investigation and the institution of the class action are a timely reminder for private equity firms in Australia to be on the alert for trade practices issues. 

What's the issue in Australia?

In Australia, anti-competitive behaviour is governed predominantly by the Trade Practices Act 1974 (Cth) (the TPA). Competition law issues can arise at various stages of private equity club deals and other consortium arrangements, including in the discussions leading up to the formation of the consortium, in the break up of assets, in the consortium arrangements themselves, and in contracts with third parties, such as financiers. 

Early discussions between firms about the possibility of entering into a consortium are always sensitive. Competitors or potential competitors for an asset need to avoid any allegations that as a result of sharing sensitive information, preparing for a bid or discussing a break-up of assets, they have entered into a contract, arrangement or understanding that:

• involves price fixing;
• amounts to an exclusionary provision (or boycott); or
• has the purpose or effect of substantially lessening competition in a market. 

These issues are always difficult in the context of competitor collaborations.  Most consortium participants consider it essential to the success of a venture that each party commit to the consortium and not seek to undermine it. In this context, the balance between pro-competitive consortia which can increase the number of bidders for an asset, and anti-competitive behaviour such as taking out an existing rival bidder, is a fine one. The difficulty is that consortia involving competitors or potential competitors risk breaching the per se prohibitions against price fixing and exclusionary provisions. There are specific exemptions for joint ventures and collective acquisitions in the TPA but these exceptions are quite technical and it is important to seek advice before relying on them. 

Are firms really competitors?

The issue for private equity 'clubs' is determining whether the firms in a consortium are 'competitors' or 'potential competitors' in the relevant sense. There is a real legal question as to whether two bidders competing for a target are 'competitors' or 'potential competitors' in a market for goods or services.  Whether they are 'potential competitors' may depend on whether they have already launched separate bids or not, and whether individually they could even if they wanted to.  However, from a risk perspective it is safer to assume that they may be regarded as competitors in the relevant sense and seek advice.

Price fixing is absolutely prohibited by the TPA (section 45A). Price fixing is an arrangement which involves 'fixing, controlling or maintaining' of a price by competitors. It can apply to an acquisition as much as a supply. The classic case in relation to 'control' of the price when tendering is an agreement between bidders to pay an unsuccessful tenderer's fee. 

Exclusionary provisions are also prohibited by the TPA (ss 4D and 45). An exclusionary provision or boycott is a provision of a contract, arrangement or understanding between persons, at least two of whom compete with each other, where a purpose of the provision is to prevent, restrict or limit the acquisition from, or supply of, goods or services to particular persons or classes of persons, or in particular circumstances or on particular conditions. An express agreement between 'competitors' (potentially two private equity groups) not to bid for a particular asset is the type of conduct which could be caught.

Particular risks arise if there are arrangements (even if only a nod or a wink) between consortium members which result in members:

• agreeing not to bid against each other or the consortium for a particular asset or tender, or any other assets or tenders;
• agreeing not to bid for other assets or tenders or in some other way 'share' the market; or
• bidding against each other in such a way that results in bid rigging in terms of price or targets. This could include agreeing they will all bid, but only one will place a bid which would be acceptable.

In circumstances where there is a relationship between the parties in a consortium that may be regarded as a genuine joint venture, the impact of the new joint venture defence to price fixing and exclusionary provisions will need to be considered.  This provides a defence if the exclusionary provision or price fixing arrangement is for the purposes of a joint venture and does not have the purpose or likely effect of substantially lessening competition. The onus is on the defendant to show that the defence applies to the particular arrangements and the ACCC is likely to push for the defence to be interpreted narrowly. The defence, which will apply retrospectively, is likely to be available from 1 January 2007.

Exercising care

A contract arrangement or understanding between competitors although not illegal per se as an exclusionary provision or price fixing, can also be caught if it has the purpose or effect of substantially lessening competition in the market. 

One issue that the DOJ appears to be probing is whether the formation of a consortium removes the competitive tension in a bid process, and as a result, the consortium can acquire the asset at a depressed price. This is also a central issue in the class action where it is alleged that investors in the target are deprived of the full economic value of their holdings and 'squeezed out' at artificially low valuations.  The consortium agreement in these circumstances may be illegal if it has the purpose or effect of substantially lessening competition in the market.

There are a number of arguments why this conduct would not breach the TPA. The ACCC would have to overcome some difficult issues in defining the relevant market when firms operate in an international sphere. It is unlikely that there would be a market for the privatisation of a particular asset alone except in unusual circumstances. In addition, the market in which private equity firms operate is highly competitive.  Obviously the greater the size and number of participants in the consortium the greater the risk.

Sharing confidential information between 'club' members

In the past, the ACCC has been concerned that joint bids may involve the inappropriate exchange of confidential information. This sort of exchange can give rise to an inference that price fixing or market sharing conduct has occurred. The class action complains of inappropriate exchange of information on bids and potential bids.

When joint bids or consortium arrangements involve ongoing competitors, it is important to limit commercial-in-confidence information that is shared to the extent possible. In some instances, this has involved establishing 'ring fencing' arrangements. This is an additional issue for private equity firms to be wary of in times of heightened awareness of insider trading concerns.

Arrangements with lenders

The DOJ appears to be concerned that some consortia are entering into exclusive arrangements with major industry lenders, effectively precluding other bidders from obtaining the finance necessary to make a competing bid.

Arrangements of this kind are exclusive dealing arrangements which are prohibited by the TPA if they have the purpose or effect of substantially lessening competition in the market.

If a consortium was to sign up exclusive arrangements with the majority of major industry lenders this could have a foreclosure effect and prevent other consortia competing to acquire a particular asset by limiting competitors' financing options. If however, the arrangement was only signed with one lender, it is unlikely that it would have the effect of substantially lessening competition in the market for the provision of debt financing in Australia.  This is particularly the case when there is the possibility of obtaining finance from overseas in circumstances where the Australian market is really part of a global market.

In addition, a firm with a substantial degree of market power engaging in a widespread campaign of exclusive dealing could be exposed to challenge on the grounds that the purpose of the exclusive arrangements was to damage a competitor or deter competitive conduct.

Key things to remember

The main things to remember when becoming involved in a consortium bid are:

• be aware that agreeing with the consortium members not to bid against each other for a particular asset can raise issues;
• retaining the right to bid individually reduces risk;
• think carefully before exchanging sensitive commercial-in-confidence information with a competitor and where possible, consider limiting access to an appropriate pool of people;
• make your own independent decisions about whether or not to make a competing bid at any stage and do not enter into arrangements about this with another firm without seeking advice first; and
• when forming financing consortia exercise caution in setting the terms.

For further information, please contact:

• Carolyn OddiePartner, Sydney
  Ph: +61 2 9230 4203
  Carolyn.Oddie@aar.com.au
• Jon WebsterPartner, Melbourne
  Ph: +61 3 9613 8832
  Jon.Webster@aar.com.au
• David WengerPartner, Sydney
  Ph: +61 2 9230 4680
  David.Wenger@aar.com.au
• Peter JamesPartner, Brisbane
  Ph: +61 7 3334 3360
  Peter.James@aar.com.au
• David BrewsterPartner, Melbourne
  Ph: +61 3 9613 8707
  David.Brewster@aar.com.au

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