Tag: Regulatory

Russia and the WTO: The Private Equity Outlook

Posted on by Nikolai Karetnyi

Russia’s ascension into the World Trade Organization signaled an expected, but nonetheless major, opening of the Russian economy. Russian membership in the WTO will dramatically lower tariffs for both Russian exports and imports into Russia. These developments, coupled with Russia’s growing middle class, global engagement through the 2014 Winter Olympics and 2018 World Cup, and market reforms, seemingly transform Russia into a hotspot for private equity investment.[1] However, the actual picture is far from rosy. Despite ending its holdout as the last G20 nation not in the WTO, Russia will continue to challenge private equity investors through both structural and legal barriers.

Many forecast the effects of Russian membership to be similar to those of China’s. After joining in 2001, China’s exports rapidly grew and its economy adjusted to meet the rising global demand for cheap Chinese exports. But simply put, Russia is not China. Though Russia’s economy is also based on exports, these exports are often commodities rather than cheap products buoyed by low wage costs. Additionally, state ownership and interventionism remains the norm in the attractive commodity sectors, meaning that Russia will be slower to adapt new reforms to compensate for the opening of its markets. [2]

This is particularly significant for private equity companies aiming to invest in Russia. While barriers to foreign investment in the crown jewels of the Russian economy (oil and gas companies) are unlikely to be removed, more foreign investment could flow into Russia’s manufacturing sector. Between 2007 and 2011, the manufacturing sector accounted for 51% of investment projects and 92% of job creation. Other similar sectors, such as the industrial and food sectors, also attracted a high number of projects and significant foreign investors. With newfound access to European markets, these sectors should experience an influx of private equity investment in the near future. [3]

Despite Russia’s economic structural limitations, private equity investors remain confident in Russia’s future growth. [4] The main reason for this confidence is Russia’s growing domestic market. Due to rising wealth levels, about 25% of Russia’s population now calls itself middle class. [5] This is a stark contrast to the oligarch-driven wealth gap that typified Russian society in the 1990’s and early 2000’s. Russian companies, already experiencing a trade surplus, will look to capitalize on the growing middle class rather than exporting to new markets. However, the specter of European competition in Russia’s markets will necessitate expansion and an influx of both domestic and foreign private equity.

While economic forces have seemingly aligned to attract investors, Russia’s culture of bureaucratization and corruption continues to ward off private equity. Additionally, the politicization of Russia’s economy also creates a major barrier for American companies. Currently, the US and Russia do not have normal trade relations due to the Jackson-Vanik Amendment, thus the US is precluded from using WTO mechanism to challenge Russia’s higher tariffs on American goods. Strict government regulation of foreign investment and corruption at all administrative levels further complicates private equity investment in Russian companies. However, investors who have already successfully navigated these barriers remain confident in future growth. For new investors, the risks may be justified by the increasing rewards of Russian companies expanding inward to a robust domestic market.

[1] Positive Outlook for Russian Investment as it Joins WTO , Ernst & Young Emerging Markets Center (Sep. 7, 2012), http://emergingmarkets.ey.com/positive-outlook-for-russian-inward-investment-as-it-joins-wto/

[2] Matthew Philips, Don’t Get Too Excited About Russia’s WTO Deal, Bloomberg Businessweek (Aug. 22, 2012), http://www.businessweek.com/articles/2012-08-22/dont-get-too-excited-about-russias-wto-deal

[3] See note 1, supra.

[4] Lena Smirova, Russia Climbs Up Investment and Business Climate Rankings, The Moscow Times (October 25, 2012), http://indrus.in/articles/2012/10/25/russia_climbs_up_investment_and_business_climate_rankings_18629.html

[5] See note 1, supra.

Minority Shareholder Freeze Outs

Posted on by Aaron Schneff

Issues surrounding arbitration are now front and center in the business and legal worlds. In January 2012, news concerning Carlyle Group’s initial public offering surfaced when it proposed “the most shareholder-unfriendly corporate governance structure in modern history.” [1] In its proposal, Carlyle required that public shareholders arbitrate all claims against the company. Moreover, the arbitration must be confidential and precludes class-action lawsuits.[2] With the Supreme Court practically removing all barriers to arbitration in cases like AT&T Mobility v. Concepcion[3] orCompuCredit v. Greenwood, [4] Carlyle’s proposed governance structure seems poised to withstand legal challenge.

But Carlyle goes beyond merely requiring disputes to be arbitrated. Additionally, many Carlyle shareholders will have no ability to elect directors. If public shareholders hold less than ten percent of the company, Carlyle reserves the right to summarily repurchase all of those shares. [5] Perhaps most interestingly, Carlyle has supplanted fiduciary duties with a partnership agreement that grants the board to act in its sole discretion without good faith. A committee of independent directors appointed by Carlyle deals with conflicts of interest.

However, minority shareholder freeze out is not an entirely new concept in the private equity sphere. Other public private equity firms including Apollo Global Management, the Blackstone Group, and Kohlberg Kravis Roberts contain similar corporate governance structures. [6] Some commentators view these provisions as designed to “eliminate any ability of shareholders to sue the board for even the most egregious acts.” [7]

The first challenge the Carlyle Group will face is the approval from the Securities and Exchange Commission. The question will likely center on whether a public company can force arbitration in cases involving federal securities law. In support of its proposed corporate governance structure, Carlyle will find solace in recent Supreme Court decisions like AT&T Mobility and CompuCredit.

Arguments favoring the arbitration clause focus on the division between the company and shareholder interest. Some commentators believe that shareholder interests and incentives tend to be short term, while companies should be run by boards of directors who are incentivized to focus on the company’s long-term interests.[8] By limiting shareholder rights, the board of directors can avoid the pitfall of focusing on short-term profits.

Another advantage is that arbitration clauses reduce transaction costs. When private equity firms primarily operate through acquiring companies, shareholder litigation significantly increases the cost of doing business. According to a report released by Cornerstone Research in cooperation with Stanford Law School, 91% of acquisitions valued over $100 million in 2011 were subject to shareholder litigation. [9] According to the same study, the number of lawsuits per deal averaged 5.1. [10] Of the 565 legal challenges to acquisitions in 2010-2011, 27% were voluntarily dismissed, 4% were dismissed by the court with prejudice, and 69% settled. [11] With the cost of legal representation on the rise, the increase of lawsuits per deal becomes increasingly burdensome for publicly traded private equity firms.

While it is unclear whether firms can require arbitration for claims of federal security violations, the Supreme Court’s decision in CompuCredit seems to support the use of arbitration in any setting not directly prohibiting it. Further, the use of arbitration clauses may be necessary to support the central business model of publicly traded private equity firms. Finally, the market is the best place to regulate corporate governance structures: if investors are not satisfied with shareholder rights, they can simply choose not to invest. As long as adequate disclosure is provided to potential shareholders, arbitration provisions like that proposed by Carlyle Group should be held valid.

[1] Steven Davidoff, Carlyle Readies an Unfriendly I.P.O. for Shareholders, DealBook (Jan. 18, 2012), http://dealbook.nytimes.com/2012/01/18/carlyle-readies-an-unfriendly-i-p-o-for-shareholders/

[2] Id.

[3] AT&T Mobility LLC., v. Concepcion, 131 S.Ct. 1740 (2012) (Under Federal Arbitration Act, California must enforce mandatory arbitration clause that precludes class-action arbitration)

[4] Compucredit Co. v. Greenwood, 132 S.Ct. 665 (2012) (holding where federal statute is silent on arbitration, Federal Arbitration Act requires arbitration agreement to be enforced according to terms)

[5] Id.

[6] Id.

[7] Steven Davidoff, Carlyle Readies an Unfriendly I.P.O. for Shareholders, DealBook (Jan. 18, 2012), http://dealbook.nytimes.com/2012/01/18/carlyle-readies-an-unfriendly-i-p-o-for-shareholders/

[8] Id.

[9] John Gould, Developments in M&A Shareholder Litigation, Harvard Law School Forum on Corporate Governance and Financial Regulation (Mar. 4, 2012), http://blogs.law.harvard.edu/corpgov/2012/03/04/developments-in-ma-shareholder-litigation/

[10] Id.

[11] Id.

Growing Singapore’s Venture Capital Industry

Posted on by Aaron Berman

What is the state of venture capital and entrepreneurship in Singapore? For six years in a row, the World Bank has named Singapore the friendliest country in which to conduct business.[1] Its business friendly laws, well educated population, and easy to absorb culture have combined to make Singapore one of Asia’s financial and commercial centers. [2] The amount of venture capital funding for small medium sized enterprises, however, lags behind that of other countries. Recently, Singapore has attempted to rectify the situation by encouraging technology startups and venture capital.

Is the problem the people, or a lack of financing? According to one survey, conducted by the Zoltan Acs of George Mason University and Erkko Autio of the Imperial College Business School, it is not necessarily the people; Singapore has a population with entrepreneurial spirit and aspirations, but lacks access to venture capital finance.[3] In 2011, there were less than twenty venture capital funds focused on investing in Singapore based businesses. [4]

Over the past year, the Singaporean government has attempted to bolster venture capital investment in Singapore. One way in which it is doing this is to increase the amount of funding available from the government itself. In 2011, the government had around $300 million of funding available to startups. Recently this year, Singapore’s National Research Foundation, a governmental department, announced that it would make approximately S$4 billion in additional funding available for startups.[5] It is, however, currently unclear exactly how, when and to whom the funds will be dispersed.

The Singapore government has also increased other resources available to startups. For example, the Singaporean government is providing startups with office facilities, training, and mentoring.[6] Additionally, the government has a tech incubator, and various incentive programs such as a three-year tax exemption and joint funding options. [7] Finally, the number of contracts between government research departments and entrepreneurs has tripled over the past year. [8]

There is one catch with these programs; in order to gain access to many of these government programs, a startup company must be at least partially owned by a Singaporean person or business entity.[9] Thus, foreigners looking to start companies in Singapore must either find a Singaporean cofounder, or give equity to Singaporean VCs or government funds. [10] Very new startups will also struggle to bring foreigners to Singapore, as the government’s visa program imposes minimum paid-in-capital and local hiring requirements. [11]

Investment activity is not entirely government driven, however. [12] Singapore is a large financial center and, in 2011, its private equity and venture capital sector has an estimated $26.5 billion in total assets under management. [13] Of that total, a 2011 PriceWaterhouseCoopers survey found that $500 million was invested in venture capital deals with startups inside Singapore. [14]

The private venture capital industry appears to be growing since that survey. The Singapore Venture Capital and Private Equity Association’s membership is increasing every year.[15] Recently, Facebook co-founder Eduardo Saverin gave up his American citizenship, and moved to Singapore to invest in startups. [16]

Singapore makes for an attractive destination for investors due to low corporate and personal tax rates, highly educated population, its business friendly government, and position as a regional hub for conducting business in other Southeast Asian countries. [17]

Despite these advantages, however, Singapore remains a small country of only five million people, limiting the growth opportunities for domestic companies, and making its domestic market unique in ways that may not translate easily to other places. [18] Overcoming the limitations of the domestic market for goods and services is one of the key challenges for startups seeking to attract capital; startups must be able to show how they will reach markets outside of Singapore.[19]

[1] Anthony Kuhn, Singapore’s Rising Tech Industry Draws Expat Innovators and Investors National Public Radio, (Sept. 17, 2012), http://www.capradio.org/news/npr/story?storyid=161267393.

[2] http://www.ivcpost.com/articles/5939/20120928/economist-reviews-asias-tech-start-up-environments.htm; http://news.asiaone.com/print/A1Business/General%2BNews/Story/A1Story20120928-374378.html

[3] Jo-Ann Huang, Venture Capital Industry Needs More Support, Channel News Asia (Mar. 23, 2011), http://www.channelnewsasia.com/stories/singaporebusinessnews/view/1118413/1/.html

[4] Id.

[5] Singapore Offers $4bn Funding to Startups , PRWeb (Sept. 10, 2012), http://www.prweb.com/releases/SingaporeStartup/4bnFunding/prweb9884734.htm

[6] Eileen Elliott, Economist Reviews Asia’s Tech Start-Up Environments, International Venture Capital and Private Equity News (Sept. 28, 2012), http://www.ivcpost.com/articles/5939/20120928/economist-reviews-asias-tech-start-up-environments.htm.

[7] Jacky Yap, A Taiwanese Opinion on Singapore for Foreign Startups, E27 (Oct. 3, 2012), http://e27.sg/2012/10/03/a-taiwanese-opinion-on-singapore-for-foreign-startups/

[8] Singapore Offers $4bn Funding to Startups , PRWeb (Sept. 10, 2012), http://www.prweb.com/releases/SingaporeStartup/4bnFunding/prweb9884734.htm

[9] Jacky Yap, A Taiwanese Opinion on Singapore for Foreign Startups, E27 (Oct. 3, 2012), http://e27.sg/2012/10/03/a-taiwanese-opinion-on-singapore-for-foreign-startups/

[10] Id.

[11] Id.

[12] Bernard Leong, A Map on Venture Capital in Singapore, SGE (Mar. 5, 2009), http://sgentrepreneurs.com/2009/03/05/a-map-on-venture-capital-in-singapore/

[13] Nisha Ramchandani, S’Pore a Magnet for PE and VC Firms, AsiaOne (Oct. 1, 2012), http://news.asiaone.com/print/A1Business/General%2BNews/Story/A1Story20120928-374378.html

[14] Id.

[15] Singapore Offers $4bn Funding to Startups , PRWeb (Sept. 10, 2012), http://www.prweb.com/releases/SingaporeStartup/4bnFunding/prweb9884734.htm

[16] Anthony Kuhn, Singapore’s Rising Tech Industry Draws Expat Innovators and Investors National Public Radio, (Sept. 17, 2012), http://www.capradio.org/news/npr/story?storyid=161267393.

[17] Id .

[18] Id., Jo-Ann Huang, Venture Capital Industry Needs More Support, Channel News Asia (Mar. 23, 2011), http://www.channelnewsasia.com/stories/singaporebusinessnews/view/1118413/1/.html

[19] Id.

Re-defining the Line between Public and Private

Posted on by Zach Paterick

In his new article, Revisiting “Truth in Securities Revisited”: Abolishing IPOs and Harnessing Private Markets in the Public Good, Adam Pritchard argues that the current transition between private and public company status is awkward and inefficient.[1] Pritchard suggests that these inefficiencies can be reduced through the implementation of a two-tier market system for transitioning from private to public status.[2] In this blog, I analyze the implications of Pritchard’s suggested system on the Private Equity Community.

Background

Pritchard argues that the separate enactment of the Securities Act and the Exchange Act created a mismatched dividing line between public and private status.[3] The Securities Act draws the line in a manner that focuses explicitly on investor protection, while the dividing line under the Exchange Act reflects the attempt to balance investor protection, interests in capital formation, and practical ease of application.[4] Congress has shifted the point at which companies must go public through the JOBS Act, which gave the SEC new authority to exempt offerings from the requirements for registered offerings and authorized the SEC to adopt less demanding periodic disclosure from companies who benefit from this new offering exemption.[5] Pritchard contends that the JOBS Act reforms have the potential to create a lower tier of public companies and to blur the line between private and public companies.[6]

The Two-Tier System

Pritchard offers a different solution; one he believes unifies the public/private dividing line under the Securities Act and Exchange Act. Pritchard’s solution involves a two-tier market for both primary and secondary transactions, where the primary market would be limited to accredited investors, while the public market would be accessible to all.[7] Under this regime, all public offerings would be seasoned offerings with a price informed both by full disclosure and a pre-existing trading market. Issuers would be able to choose whether to sell in the primary or secondary market and companies would become eligible for the primary market after reaching a certain quantitative benchmark (he suggests $75 million in market capitalization, the threshold currently used by the SEC for shelf registration).[8]

Under this system, issuers below the quantitative benchmark would be limited to selling their securities to accredited investors. However, contrary to the current system, those securities could not be freely resold after a minimum holding period, but would instead be sold to other accredited investors on an established secondary market (similar to SecondMarket or SharesPost except expanding eligible purchasers from Qualified Institutional Buyers to all accredited investors).[9]

Elevation to the public market would be completely voluntary.[10] Issuers unable or unwilling to meet the obligations associated with access to the public market would be allowed to remain private. Once a company chose to go public, a seasoning period would follow with the filing of requisite 10-Q’s during which the shares would continue to be traded in the private market.[11] This seasoning period would allow the trading price in the public market to be informed by the prior trading in the private market as well as the new information required to initiate the “going public” process.[12] Only after the company graduated to having its shares traded in the public market would the company be free to sell equity to public investors.[13] This two-tier system relies on the pricing efficiency of the markets.

Impact on Private Equity

Pritchard’s suggested model would impact the private equity market in multiple dimensions. First, companies looking for late stage investment to expand their brand could continue to seek private capital, without having to cross the public divide. Consequently, the amount of firms seeking private equity would likely expand, creating more opportunities for private investment.

Additionally, Pritchard’s plan would essentially create a liquid market for private equity investors. While similar markets already exist, see SecondMarket and SharesPost, these markets are limited to “qualified institutional buyers” (investors with more than $100 million under management). Pritchard’s secondary markets would include accredited investors, individuals with at least $200,000 in annual income or $1 million in assets. This increased participation in the secondary market would allow the market to establish a trading price.

Lastly, Pritchard’s plan would eliminate the need for marketers to create demand when a firm decides to go public. Instead, the secondary market, supplemented by the required filings to go public, would establish a trading price. The underpricing dilemma of IPOs would essentially disappear. Thus, private equity holders participating in the company’s transition from private to public would receive greater returns.

In summary, Pritchard’s two-tier market plan would create new opportunities for private equity investment, create a liquid trading platform, and help ensure that investors exiting the market when a firm elects to go public receive proper returns. Such a market system would be advantageous to private equity investors; it should be given serious consideration.

________________________________________
[1] Adam C. Pritchard, Revisiting “Truth in Securities Revisited”: Abolishing IPOs and Harnessing Private Markets in the Public Good (University of Michigan Law & Econ Research, Paper No. 12-010, 2012), available at http://ssrn.com/abstract=2103246 .

[2] See id. at 5.

[3] Id. at 3.

[4] Id.

[5] See Revisiting “Truth in Securities Revisited” at 4.

[6] Id.

[7] See id. at 30.

[8] See id.

[9] See id. at 31.

[10] Id. at 33.

[11] Id.

[12] Id. at 34.

[13] See id.

Regulatory Oversight in Private Equity

Posted on by Kail Jethmalani

Late last year, the Securities and Exchange Commission (SEC) announced an informal inquiry [1] into private equity funds. This investigation has at least three goals: (1) understanding alleged systemic risks posed by private equity funds; [2] (2) ascertaining whether valuation, due diligence, and related compliance controls are in place and adequate; [3] and (3) rooting out potential fraud. [4] However, some commentators have expressed the belief that the SEC is concerned with the valuation and compliance processes in place at smaller funds and so called “zombie”[5] funds, as opposed to the major players. [6] Indeed, neither the Blackstone Group nor KKR—both major players and publically traded—received the SEC’s first wave of informal inquiry requests in February, [7] and it is unclear if they have since received a request in a subsequent wave. Comments by the Bruce Karpati of the SEC’s enforcement division confirm this narrow view: “[the agency] is looking at zombielike funds that have potentially stale valuations.” [8]

The SEC’s espoused goals thus seem inconsistent: in contrast to large funds, small funds or zombie funds are unlikely to cause the systemic risks that would warrant investigation. Although valuations for zombie funds might raise concerns of fraud, [9] systemic fraud in private equity valuations seems unlikely due to countervailing incentives: private equity funds might want to overvalue assets to attract new investors, [10] but they want to maximize the difference between purchase and sale price [11] which could incentivize undervaluing assets. Reputation, which directly affects investor confidence, is another check on fraud. [12] Additionally, private equity investments involve sophisticated investors, [13] and as a matter of policy the SEC limits oversight of sophisticated investors. Increased regulatory oversight chips away at the notion that sophisticated investors can and should bear the economic risks of their investments themselves.

Therefore, to even investigate zombie funds is a marked policy shift for the SEC. By subjecting zombie funds to regulatory oversight, as opposed to leaving them to private resolution, the SEC has imposed not-insignificant regulatory compliance costs onto all private equity funds. [14] Simply put, the industry-wide costs imposed by the SEC’s new regulatory scheme could substantially outweigh the costs [15] associated with private resolution of zombie funds. Although investors might face significant losses through private resolution, private equity is a field for sophisticated investors that are capable of bearing investment risk. Consider a hypothetical pension fund that has invested into what has become a zombie fund. The fund must only take steps to leave the investment and absorb the associated losses. [16] In contrast, the SEC must first identify the zombie fund by reviewing valuation and compliance procedures, likely a costly and inefficient endeavor. Every private equity fund subject to SEC oversight must thus bear the cost of regulatory compliance, rather than limiting the costs to investors in zombie funds. A more efficient solution might be to work directly with aggrieved investors to investigate only particular funds. Upon receiving a complaint from an investor, the SEC can launch a targeted investigation that does not impose unnecessary costs onto the industry. The SEC already maintains a complaint reporting system, and expanding that system to include zombie funds is potentially a better use of the Commission’s finite resources.

Further, some commentators also question whether the SEC should devote any resources to valuation methods. [17] Conventional wisdom holds that valuing a private entity is an art, not a science; there is inherent uncertainty in valuation. [18] Industry groups argue that valuations are not as important to private equity funds as they are to other alternative investments. [19] Hedge funds, for example, charge fees based on changes in valuation, whereas the majority of fees due to private equity firms are based on the difference between the entrance and exit prices. [20] Although the SEC contends that smaller private equity funds might be incentivized to overvalue assets to attract greater investment and management fees, [21] they also face the countervailing incentive to minimize their asset valuation to maximize the delta between entrance and exit price. As previously noted, the private equity industry serves sophisticated investors capable of bearing investment risk, and the SEC’s resources might be better used to protect lay investors rather than to regulating an uncertain-by-nature practice.

This is not to suggest that greater regulatory oversight does not lead to benefits for the firms themselves. For example, some small and midmarket funds have retained outside firms to analyze and test their compliance practices, with the goal of understanding vulnerabilities. [22] Funds have already seen benefits from these reviews, by discovering that their internal controls with regard to data security were not up to SEC standards. [23] Nevertheless, these benefits must be weighed against the broad inefficiencies imposed by the regulatory scheme. Small and midmarket funds must already consider how to efficiently use their relatively limited resources. Rather than imposing costs across the industry, a much narrower regulatory scheme implemented through the existing complaint system is more likely to limit costs. Risk aversion will still lead to the creation of elaborate compliance schemes and mock reviews given that many compliance groups have “little or no experience with an SEC inquiry[,]” [24] or may not understand how to handle an SEC investigation. However, because fewer funds will be in the spotlight at any given time through the use of the complaint system—there at least 200 zombie funds, compared to more than 10,000 private equity funds generally— [25] it will be easier to contain industry-wide costs.

______________________________________________________

[1] Letter from Securities and Exchange Commission to Certain Private Equity Funds (Dec. 8, 2011), available at http://online.wsj.com/public/resources/documents/SECInquiry.pdf.

[2] Shaun Gittleman, U.S. SEC Set to Monitor Private Equity Funds, Official Says, Reuters (May 8, 2012), http://blogs.reuters.com/financial-regulatory-forum/2012/05/08/u-s-sec-set-to-monitor-private-equity-funds-official-says/ (due to new regulations implemented under Dodd-Frank, private fund advisers must report potentially systemic risks through the SEC and Commodity Futures Trading Commission).

[3] Carlo V. di Florio, Director, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission, Address at the Private Equity International Private Fund Compliance Forum (May 2, 2012), available at http://www.sec.gov/news/speech/2012/spch050212cvd.htm.

[4] Id .

[5] Zombie funds are those where investors must continue to pay management fees, even though the funds are inactive or not actively managed. Often, the zombie fund’s assets are difficult to value or sell. Thus, investors are locked into these funds—which continue to accrue management fees—without the prospect of future payoff. According to one estimate, as much as $100 billion is tied up in zombie funds, and investors stand to lose substantially if they try to sell their stake: private markets value those investments at 30-40% of the stated value. See David P. Abel, Investors Beware of Zombie Funds, Motley Rice Blog (June 7, 2012),http://blog.motleyrice.com/investors-beware-of-zombie-funds/; see also Susan Pulliam and Jean Eaglesham, Investor Hazard: ‘Zombie Funds’, Wall St. J. (May 31, 2012), http://online.wsj.com/article/SB10001424052702304444604577339843949806370.html .

[6] See Dan Loeser, SEC Investigates Private Equity Valuation Methods, Colum. Bus. L. Rev. (Feb. 27, 2012), http://cblr.columbia.edu/archives/11980.

[7] Joshua Gallu and Cristina Alesci, SEC Review of Private Equity Said to Focus on Smaller Firms, Bloomberg Bus. Wk. (Feb. 14, 2012), http://www.businessweek.com/news/2012-02-14/sec-review-of-private-equity-said-to-focus-on-smaller-firms.html .

[8] Pulliam & Eaglesham, supra note 5.

[9] Abel, supra note 5 (there is “concern about the possibility of private equity firms manipulating the value of investments to prop up these zombies.”)

[10] See Gallu & Alesci, supra note 6; see also Jonathan E. Green and Lindsay S. Moilanen, SEC Scrutiny Focuses on Asset Valuation and Private Equity Funds, Inv. Funds Group Newsletter (Kaye Scholer, New York, N.Y.), Summer 2012, at 8, available at http://www.kayescholer.com/news/client_alerts/Investment-Funds-Newsletter-Summer2012/_res/id=sa_File1/Investment-Funds-Group-Newsletter-Summer2012.pdf .
[11] See Loeser, supra note 6.

[12] Id.

[13] See Gallu & Alesci, supra note 7; see also Loeser, supra note 5.

[14] See Loeser, supra note 6.

[15] Which are perhaps more accurately characterized as investment losses.

[16] Private resolution is likely to lead to losses upon exiting the investment. See Abel, supra note 5 for a description of some potential private remedies.

[17] See, e.g. , Loeser, supra note 6 (discussing the inefficiencies arising from greater SEC oversight in the context of the Commission’s already overextended resources).

[18] Id . (citing European Private Equity and Venture Capital Ass’n, Int’l Private Equity and Venture Capital Valuation Guidelines (2006)).

[19] Gregory Zuckerman, How Scared Should Private Equity Be Under SEC Microscope?, Wall St. J. (Feb. 27, 2012), http://blogs.wsj.com/deals/2012/02/27/how-scared-should-private-equity-be-under-sec-microscope/ .

[20] Id . Note, however, that private equity funds do derive some fees from fund valuation (typically 2%) but receive far greater fees from profits or “carry” (typically 20%). This fee arrangement is commonly referred to as “2 and 20.”

[21] See supra note 10.

[22] Laura Kreutzer, PE Firms Learn to Live with Dodd-Frank, Dow Jones Private Equity Analyst (Aug. 27, 2012), available at http://pevc.dowjones.com/article?an=DJFPEA0020120827e88refmxe&from=alert&pid=22

[23] Id .

[24] Id.

[25] Pulliam & Eaglesham, supra note 5.

Health Care and Venture Capital: An Uncertain Outlook

Posted on by Sumit Gupta

When most people hear “health care” today, their minds automatically pivot to the national health care debate dominating the election season. Many venture capitalists, however, are thinking about their next target in the broad health care and biotechnology industry. Investment in the sector, which includes companies developing “medical devices, diagnostic [platforms], technology based healthcare services, life science tools,”1 and pharmaceuticals, has been on the rise. In 2011, venture capital investment in biotechnology reached $4.82 billion, with medical devices and healthcare services financings realizing gains of 17% and 41%, respectively, year-over-year. 2

What’s behind the uptick in a sector “long shunned by venture-capital investors?”3 Two key explanations are optimism over “new U.S. laws that could speed up drug approval in key areas”4 and the increasing role of software in health care. The current regulatory climate makes it a difficult and lengthy process to receive FDA approval for pharmaceuticals and medical devices.5 As the founder of a short-lived medical device startup, I can attest to the difficulties that FDA approval can bring a similarly-based business – our startup’s projections, for example, indicated that simply becoming eligible for 510(k) clearance (which is necessary to market certain categories of medical devices in the United States) would cost $20 million and take at least 5 years. The FDA has since established the Center Science Council to improve the predictability of its decision-making on new innovations,6 and the response from venture capitalists has been cautiously positive.7

Entrepreneurs remain hopeful, as increased software penetration, beyond electronic medical records, exposes new opportunities in the field. Venture firms have begun “broadening the types of businesses they consider part of the life-sciences field”8 to include those creating software solutions to many of healthcare’s most pressing problems. These firms aren’t comparable to those such as Google or Facebook when they were still startups, but that’s a good thing – venture capitalists such as Kevin Kinsella of Avalon Ventures recognize that “every therapeutic idea or product is a big idea”9 and has a better chance of disrupting a field still relatively foreign to the Internet. Cyrus Massoumi, founder of ZocDoc, a startup which allows users to find and book appointments online, finds the current financing landscape superior to that of years prior. In 2007, the reaction to ZocDoc’s pitch was “less, ‘Good idea,’ and more, ‘Good god, you’re crazy.’”10 In the five years since, Massoumi and his team have raised $95 million, culminating in a $75 million Series C last year with DST Global and Goldman Sachs.11

While some parties are optimistic for biotech’s resurgence, “[p]ricing pressures, slower economic growth and greater regulatory scrutiny”12 continue to make investment difficult to come by. Ernst & Young’s global life sciences practice released a report two weeks ago finding capital harder to come by for younger companies in the sector.13 According to their numbers, venture capital investment in biotechnology remains substantially lower than the $5.40 billion peak reached in 2006-2007,14 and the situation may not be improving to the degree that 2011’s numbers suggest. The data available so far for 2012 support their pessimistic stance. In Q2 2012, biotech companies received $697 million, or 42% less money in deals than the same quarter a year prior, the lowest amount seen by the National Venture Capital Association “since the first quarter of 2003.”15 Most affected by these trends are the small, young startups hurting for cash, especially those on the software-side of things. While more established companies, such as Merck, who launched its own $250 million venture fund in 2011, “invest in [early-stage] innovation with a portion of the dollars they would have invested in their own R&D,”16 these dollars end up at companies immersed in the pharmaceutical sector – the bread and butter of companies like Merck. Nevertheless, the experience of ZocDoc and others in the field show that substantial venture money is still out there – only now it’s being packaged in smaller, but smarter, deals.17

__________________________________________
1ARBORETUM VENTURES, http://www.arboretumvc.com/about.php.
2 Sarah McBride, Venture firms see signs of rebirth in life sciences, REUTERS (Sep. 24, 2012, 2:42 PM), http://www.reuters.com/article/2012/09/24/us-venture-capital-life-sciences-idUSBRE88N0UG20120924.
3Id.
4 Id.
5 Kate Greenwood, Venture Capitalists Complain of ‘Regulatory Challenges,’ FDA Responds, HEALTH REFORM WATCH (Dec. 20, 2011), http://www.healthreformwatch.com/2011/12/20/venture-capitalists-complain-of-regulatory-challenges-fda-responds/ (“The venture capitalists blame ‘regulatory challenges,’ primarily ‘the hostile FDA.’”).
6 See CDRH Center Science Council FAQs, U.S. FOOD AND DRUG ADMINISTRATION (Mar. 31, 2011), http://www.fda.gov/AboutFDA/CentersOffices/OfficeofMedicalProductsandTobacco/CDRH/CDRHReports/ucm249249.htm.
7 See Greenwood, supra note 5.
8 McBride, supra note 2.
9 McBride, supra note 2.
10 Cyrus Massoumi, Healthcare Momentum: Our Shared Responsibility, THE HUFFINGTON POST (Oct. 4, 2012), http://www.huffingtonpost.com/cyrus-massoumi/appointment-booking-tech-startup_b_1939854.html.
11 ZocDoc, TECHCRUNCH, http://www.crunchbase.com/company/zocdoc.
12 Susan Kelly, Venture capital for medical technology harder to come by: report, REUTERS (Oct. 2, 2012, 1:23 AM), http://www.reuters.com/article/2012/10/02/us-medtech-investing-idUSBRE89104D20121002.
13 Id.
14 Id.
15 John Carroll, New biotech deals scrape record low as VC groups lose steam, FIERCEBIOTECH (July 19, 2012), http://www.fiercebiotech.com/story/new-biotech-deals-scrape-record-low-vc-groups-lose-steam/2012-07-19.
16 McBride, supra note 2.
17 See McBride, supra note 2.

JOBS Critics

Posted on by Luke Rachlin

As the JOBS Act awaited President Obama’s signature this week, critics, emboldened by accounting issues at the recently public Groupon, continued to take aim at provisions alleged to roll back crucial investor protections. Passed by strong majorities in both the House and Senate, the principle purpose of the JOBS Act is to promote capital raising among startups by easing their paths toward an IPO. Opponents of the Act, however, claim that its relaxed financial disclosure standards invite a reemergence of Enron-era accounting fraud.

Recent news on internet startup Groupon has stoked much of that criticism. Last Friday, in response to an auditor’s determination of a “material weakness in internal controls over financial reporting,” the company revised fourth-quarter earnings down by $14.3 million.1 Had the Act been in place, Groupon’s revisions would not have been a product of adjusted reporting requirements; the relevant JOBS provisions apply only to companies with less than $1 billion in annual revenue and $700 million in market cap, while Groupon earned 1.6 billion in 2011.2 Nonetheless, critics contend that events at Groupon highlight the risks associated with easing financial disclosure requirements, generally. Had the Act been law before Groupon went public last year, some point out, its annual revenue of less than $1 billion would have made it eligible for relaxed reporting requirements and the company’s questionable accounting methods may not have drawn the attention that they are getting now.3

Among the specific provisions targeted by the Act’s opponents is that which allows emerging companies on the verge of an IPO to have “private conversations with the S.E.C. about planned disclosures,” not to be made public until 21 days prior to an offering.4 Andrew Ross Sorkin of NYTimes Dealbook wrote recently that the provision, which allows companies to avoid “embarrassing public gaffes,” may benefit those seeking to go public who would otherwise be discouraged by accounting scrutiny, but is “awful for the investors, who rely on the transparency of the process.”5 Had the Act applied to Groupon’s public offering, Sorkin explained, “it is unlikely the public would have found out in time about a series of questionable accounting gimmicks and metrics that the company had hoped to employ to bolster its numbers investors.”6

The same day that Sorkin’s comments were published, The Wall Street Journal’s Michael Rapoport weighed in on the 21-day provision, characterizing it as permitting companies to “iron out disagreements with regulators behind closed doors before they go public.”7 This practice, Rapoport agreed, “might have prevented investors from finding out about Groupon’s early accounting questions until after they had been resolved.”8

Others, however, are less concerned. Joel Trotter, a Latham & Watkins attorney on the task force responsible for devising ways to make it easier for companies to file publicly, was quoted by Rapoport claiming that “three weeks is an extremely long time in assessing information relevant to an investment decision.”9 AOL Founder Steve Case has similarly responded that, while the bill is “not perfect,” it will ultimately “strike the right balance” between encouraging IPOs and maintaining appropriate disclosure standards.10

Opinions are clearly divided and the debate surrounding a 21-day notice provision barely scratches the surface of that division. If the last major adjustment to financial disclosure standards (See SOX 2002) provides any indication, it does not appear that the debate will be ending anytime soon.

_________________________________________
1. http://dealbook.nytimes.com/2012/04/02/jobs-act-jeopardizes-safety-net-for-investors/
2. http://online.wsj.com/article/SB10001424052702304023504577317932455874856.html?mod=googlenews_wsj
3. Id.
4. http://dealbook.nytimes.com/2012/04/02/jobs-act-jeopardizes-safety-net-for-investors/
5. Id.
6. Id.
7. http://online.wsj.com/article/SB10001424052702304023504577317932455874856.html?mod=googlenews_wsj
8. Id.
9. Id.
10. http://dealbook.nytimes.com/2012/04/02/jobs-act-jeopardizes-safety-net-for-investors/

LLC Fiduciary Duties in Delaware Private Equity and Venture Capital

Posted on by Justin Taylor

In its January 27th decision of Auriga Capital Corp. v. Gatz Properties, LLC, the Delaware Chancery Court put to rest any ambiguity in its reading of the Delaware LLC Act as it applies to establishing default fiduciary duties in the LLC context. (1) Although the topic had been addressed in a number of recent cases, none approached the depth and breadth of analysis exhibited by the Court in Auriga. (2) In his opinion, Chancellor Strine definitively establishes that a manager or member of an LLC owes the default duties of care and loyalty to all other members, unless an LLC agreement effectively expands, limits, or eliminates these duties.

Auriga Capital v. Gatz Properties

The dispute in Auriga centered on Gatz Properties, LLC’s management of property held by Peconic Bay, LLC. William Gatz, as the sole actor for Gatz Properties, formed Peconic Bay with Auriga Capital Corporation in order to develop land held by the Gatz family into a golf course. Peconic Bay then leased the golf course land from Gatz Properties. While the LLC Agreement required dual class majority approval for any “major decision affecting the company,” Gatz was effectively able to approve his own decisions as Manager without interference from minority members due to majority control of both the A and B Peconic share classes by Gatz Properties and the Gatz family.

Gatz made and approved such a “major decision” when he chose to perform a sale of Peconic, which ultimately led to a dispute with Auriga and other minority owners of Peconic Bay. In 2010, after the underperforming golf course operator with a sublease on the property chose to exercise its early termination option, Gatz turned away a serious bidder for Peconic Bay and orchestrated a sham auction. Gatz was the only bidder for the company, and purchased Peconic Bay at an unfairly low price. The minority members, whose invested capital amounted to $725,000, received a paltry $20,985 distribution from the sale. This led them to file suit and claim Gatz breached his fiduciary duties.

At trial, Gatz raised various defenses. However, of particular interest was his assertion that the LLC Agreement of Peconic Bay “displaced any role for the use of equitable principles in constraining the LLC’s manager,” and thus removed his actions from any fiduciary duty analysis. The Court rejected this argument, however, and affirmatively determined the existence of default restrictions on the actions of a managing member of an LLC beyond the requirements of good faith and fair dealing.

Existence of Default Duties

Like the Delaware General Corporation Law (“DGCL”), the LLC Act (the “Act”) does not plainly state the fiduciary duties of care and loyalty apply by default to managers and members of an LLC. However, unlike the DGCL, 6 Del. C. § 18-1104 of the Act provides an explicit default application of the “rules of law and equity.” Do those rules of law and equity include the duties of care and loyalty? Footnote 34 of Auriga explains they do.

That § 18-1101(c) provides for the contracting out or modification of fiduciary duties implies these duties exist by default. The Court goes on to explain that when §§ 1101(c) and 1104 are read together, these sections establish that when a manager or member would traditionally owe fiduciary duties, they are a fiduciary and are subject to the express right of the parties to contract out of those duties. So far as a manager or member would not owe fiduciary duties under traditional equitable principles, they do not owe any in the LLC context. This is not by operation of the Act, but by those same traditional equitable principles. The Act does not create a broader range of duties.

The Court also pointed to the 2004 amendment of the Act (in addition to the amendment of Delaware Revised Uniform Limited Partnership Act (“DRULPA”)) by the Delaware Legislature. The amendments were instigated by a Delaware Supreme Court holding in Gotham Partners L.P. v. Hallwood Realty Partners L.P, which questioned the extent to which default duties could be completely eliminated in the partnership context. (3) Both the Act and DRULPA were reworded to permit the complete elimination of fiduciary duties, as well as full contractual exculpation for breaches (through the introduction of §18-1101(e) for LLCs).

The Court in Auriga reasoned if the “equity backdrop” did not apply to LLCs then: 1) the amendment would have provided that members and managers owed no duties to the LLC other than those set forth by agreement or in the statute; 2) the General Assembly would have eliminated or modified the default application of the rules of law and equity in §18-1104; and 3) the General Assembly would not have provided for the elimination and exculpation of something if that something did not exist. These factors combined with the case law establishing the existence of default duties in the LLC setting and the policy concerns surrounding displacement of a widespread investor belief in the same, firmly established, in the Court’s mind, the alignment of those holdings and the legislature’s intent.

Outcome of Auriga

The Court determined, and Gatz conceded, as an LLC manager without clear and unambiguous elimination or modification in the LLC Agreement, Gatz owed the other members of Peconic Bay the fiduciary duties of care and loyalty. The Court then determined that:

“Gatz breached his fiduciary duty of loyalty and his fiduciary duty of care by: (1) his bad faith and grossly negligent refusal to explore any strategic alternatives for Peconic Bay from the period 2004-2005 forward when he knew that American Golf would terminate its lease; (2) his bad faith refusal to consider RDC’s interest in a purchase of Peconic Bay or a forward lease; (3) his bad faith conduct in presenting the Minority Members with misleading information about RDC‟s interest and his own conduct in connection with his buyout offers in 2008; and (4) his bad faith and grossly negligent conduct in running a sham Auction process that delivered Peconic Bay to himself for $50,000. The results of this conduct left the Gatz family with fee simple ownership of the Property again, a Property that had been improved by millions of dollars of investments and now contained a clubhouse and first-class golf course. The Minority Members got $20,985.” (4)

Chancellor Strine awarded the minority members what they should have received in a fair auction: their initial investment of $725,000 and a 10% return. He deemed this “a modest remedy and the record could support a higher one.” Additionally, because the “record is regrettably replete with behavior by Gatz and his counsel that made this case unduly expensive for the Minority Members to pursue,” Strine required Gatz to pay one half of the minority’s attorneys’ fees and costs. If the manager or a member of an LLC wants a lesson on what not to do, this case is a very instructive read.

Key Takeaways for Private Equity and Venture Capital

In reflecting on Auriga, drafters and parties to LLC Agreements should find some comfort in the relative certainty the holding provides. In drafting their LLC Agreements for Management Company, General Partner, and Portfolio LLCs, parties should ensure their Agreements clearly and unambiguously reflect their intentions as to the types and extent of duties they intend to apply between members and management. Some key takeaways include:
• The traditional duties of loyalty and care apply by default to Delaware LLCs.
• A manager of a Delaware LLC is a fiduciary and subject to those default duties.
• Such duties may be altered or eliminated and liability exculpated by clear and explicit agreement under the LLC Agreement.
• Evaluation of fiduciary duty claims “cannot occur without a close examination of the LLC agreement itself.”
• The duties of good faith and fair dealing, as they exist independently from the duty of loyalty, apply to all LLCs and cannot be contracted around.
• LLC agreements in existing Private Equity and Venture Capital investments should be evaluated for clarity in any desired modification of fiduciary duties, with necessary amendments made to bring them in line with the intentions of the parties to the agreement in light of the Court’s clarifications.

1- Auriga Capital Corp. et al v. Gatz Properties, LLC et al, C.A. 4390-CS (Del. Ch. Jan. 27, 2012).
2- See Kelly v. Blum, 2010 WL 629850 (2010), Bay Ctr. Apartments, 2009 WL 1124451 (2009).
3- Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 817 A.2d 160 (Del. 2002).
4- Auriga, C.A. 4390-CS at 62.

Emerging Markets Provide Potential Gains and Headaches for Private Equity Firms

Posted on by Mark Franke

Dealbook reported this week that emerging market opportunities are beginning to bear fruit, noting that China boasts three of the largest markets for I.P.O.’s and the fastest growing markets for deals are Ukraine, Thailand, and Chile. Private equity firms like the Carlyle Group and Blackstone have committed significant capital to acquiring stakes in companies abroad and have set up offices in many emerging economic nations to capitalize on the shift of opportunity from the developed world to these untapped frontiers. Wall Street is responding to the sluggish growth at home by turning its eyes abroad, but these opportunities can bring headaches.

Putting aside the administrative costs and barriers to entry of working with foreign governments and in new, sometimes recalcitrant, markets, one major legal problem that arises when an American firm buys stakes in a foreign company is the need to comply with the Foreign Corrupt Practices Act (FCPA). Under this act, a U.S.-based company may not use bribes to “obtain or retain” business.

Private equity funds all offer substantially the same things: capital infusions and management expertise. While name recognition and a good track record may go a long way, the terms of the deals between companies and private equity firms are almost always on substantially similar terms, and the firms exert control over the companies in substantially similar ways—20% cut of the net profits as carried interest upon exit, preferred stock and management control by seeking board placements and various other mechanisms to mitigate downside exposure and maximize upside gains. Why should a company in a foreign jurisdiction respond to a bid from one private equity firm over another? In many cultures, gifts are an expected part of business transactions, and it is a natural impulse to try to grease the wheels of a negotiation. Indeed, a common practice on Wall Street in domestic deals is to do just that. A dinner here, a Broadway show there. Why not? Because the S.E.C. and D.O.J. say you can’t.

There are ways that skilled lawyers could exploit the margins of meaning in the language of the FCPA, contracting the scope of the word “bribe” so as not to capture the activity of their client. But this opportunity would only be meaningful in the context of defending an enforcement action, and private equity firms, like any rational actor, want to avoid litigation. It is risky business to depend on a creative argument from a verbal technician where the act may be questionable. The issue is not whether the act is an actual bribe, but whether the agencies will pursue an enforcement action. The agencies have lawyers too, and those lawyers spend their days scouring filings for suspicious activities and get paid to show how an act fits within the scope of the language. Moreover, beyond litigation costs, who wants to be on the S.E.C’s or D.O.J.’s bad side?

Consequently, when engaging in a deal abroad, especially in nations known for corruption, firms are having to spend more and more on FCPA compliance. While this is good news for law firms (FCPA compliance is a huge cash cow), the robust enforcement of the act is leading to astronomical costs that could arguably be stifling foreign investment. Certainly, American ideals require that firms act with integrity abroad, but with compliance costs going through the roof, at some point firms are likely to accept the cost of being on the bad side of U.S. Government and take the risk of losing a suit. In a world of rational economic actors, the loudest input in a firm’s decision is cost.

In the meantime, however, while costs of either option are comparable, firms will likely choose to comply. There is talk in Washington to make compliance less onerous, but with the election season in full swing, who knows when that will happen.