Private Equity under Investigation
Justice Department Doesn’t Understand How the Industry Works
by Josh Lerner
Fifty-three years ago, Judge Harold Medina dismissed charges brought by the Justice Department against seventeen leading investment banks. A case built up over a decade of investigations and almost three years of trial collapsed when the government was unable to show that the industry’s collaborative practices constituted an anticompetitive conspiracy. The judge observed that activities the government depicted as nefarious were “nothing more nor less than a gradual, natural, and normal growth or evolution by which an ancient form has been adapted to the needs of those engaged in raising capital.”
Now modern-day trustbusters have again launched an investigation into collusion in financial services, this time focusing on private-equity firms. The Justice Department is concerned that private-equity firms are teaming up to bid in auctions of companies going private rather than jointly underwriting public corporate offerings. Nor is this unique to the United States. Britain’s Financial Services Authority has an-nounced that it is increasing its scrutiny of private-equity firms. Among the problems or risks attributed to private equity are conflicts of interest, a reduction of the efficiency of capital markets, the opaqueness of the groups’ operations, and the abuse of inside information.
It is hard not to feel that history is repeating itself. For not only is this investigation sure to fatten the profit pools of dozens of securities-law firms, but the fundamental errors that Judge Medina flagged a half-century ago seem destined to be repeated.
Far from being a static industry with ossified giants, private equity features brutal competition and enormous dynamism. Groups that were dominant just a few years ago, such as Hicks, Muse, Tate & Furst and Forstmann Little & Co., have dramatically downsized or announced their intention to cease operations after experiencing investment missteps and succession problems. Meanwhile, new organizations have amassed enormous sums of capital in short periods. Even a quick glance at the annual market shares of private-equity groups reveals wild fluctuations. As Judge Medina stated when reviewing the changing rankings of underwriters a half-century ago, “The only pattern is no pattern.”
Thus, the reality of the market seems dramatically different from the typical setting where trustbusters are mandated to work. Moreover, the behavior in the Justice Department’s crosshairs — deal sharing — is an important aspect of this competition that benefits us all.
To understand the benefits of deal sharing, it is helpful to look at private equity’s older sibling, venture capital. VC syndication has been the norm here for many decades, and the impact of such syndication has been extensively studied. From this research, several clear conclusions emerge. First, deal sharing helps investors make better investment decisions. Potential investors in young or restructuring firms frequently face a mass of confusing, even contradictory information. Syndication allows venture investors to get a valuable “second opinion” about potential additions to their portfolio. Second, it helps companies’ managements. Venture and buyout investors work closely with the managers of the companies in which they invest. Syndication frequently results in representatives of two or more venture funds serving on boards. Frequently, these individuals have complementary skills, such as knowledge of the underlying technology and the market. Finally, deal sharing helps limit risk. Private-placement memoranda limit the amount of capital that funds can put into any one deal. Syndication allows venture groups to undertake transactions that otherwise they would need to pass on, due to concerns about lack of diversification.
Are there costs of syndication? Undoubtedly. When venture groups team up, it may “soften the competition.” In many technologies and regions, there are only a handful of leading groups. When two of these work together, the valuation at which the company will be financed may fall. But on the basis of extensive evidence, the benefits to society from widespread venture syndication appear to substantially outweigh the costs.
The venture-capital experience suggests that “clubbing” will have many benefits to the private-equity groups themselves and to society as a whole, and that to proscribe it based on fears of anticompetitive consequences would be a substantial mistake. Of course, if firms engage in price-fixing or market division, the Justice Department has every reason to step in. The worry, though, is that the antitrust enforcers will again mistake competition for collusion because they don’t understand the complexities and nuances of this business.
Unfortunately, the history of antitrust enforcement is littered with examples of government actions that, however well intentioned, blocked firms for many years from taking actions that would have benefited them and society as a whole.
Even if the antitrust threat dissipates, there is a broader lesson here. When one considers private equity’s substantial successes in this decade, it is clear that the industry thrives on its extraordinary flexibility and ability to take risks. The recent actions of private-equity groups that are likely to have the broadest societal impact were initially fraught with challenges. For instance, many private-equity groups had failed in earlier efforts to internationalize, but funds have recently enjoyed great success in Europe and Asia. Similarly, buyouts of high-tech firms were supposed to be too risky, yet recent transactions have proved the received wisdom to be false.
Private equity is a dynamic industry, at whose heart is the taking of calculated risks based on limited information. Washington must understand that the many benefits private equity provides by facilitating economic growth are unlikely to be sustained if the heavy hand of government intrudes, whether through litigation or regulation.
— Josh Lerner is the Jacob H. Schiff Professor of Investment Banking and the author of Venture Capital and Private Equity: A Casebook.
