Private Equity’s Backroom Dealings

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You don't really want to bid on HCA, do you? DO YOU? Photo: null/Johnny Greig/iStockphoto

If it weren't for the insane horse-race election hysteria, we'd probably be hearing a lot more about the massive private equity conspiracy lawsuit that has the potential to radically reshape the way private equity does buyouts and make some of the industry's wise old men look like colluding mobsters.

Essentially, eleven of the biggest firms in private equity are accused of conspiring to bring down prices on a bunch of huge club deals — the ones where a bunch of firms pool their money to buy a company — back when huge club deals were a thing. The lawsuit was filed in 2007, but yesterday an unredacted complaint was unsealed. It shows industry titans e-mailing each other various embarassing hints that it would be best for all parties if a particular deal did not turn into a bidding war. Blackstone president Tony James once e-mailed KKR partner George Roberts: “Together we can be unstoppable but in opposition we can cost each other a lot of money.” (In the full complaint, we also learn that another KKR partner, Henry Kravis, really likes exclamation points.)

DealBook does an admirable job of explaining the concept of collusion between private equity firms. Here's an even simpler way to think about it, if you're so inclined:

Say you really like antique pocket watches. Like, really like antique pocket watches. And the way you collect them is by going to auctions and estate sales and bidding on them. You usually get a decent price, because there are a lot of antique pocket watches to go around and fairly limited demand for them.

Now imagine there are three other guys who also really, really are into antique pocket watches, who start going to all the same auctions as you and bidding against you and driving up the price. This would be a bummer, no? So now, even if you're still outbidding these guys, your new price is $300 per watch as opposed to the $50 you used to pay. They're paying more, too, on the auctions they win.

So, after ten or twenty bidding wars like this, you'd be running out of money, and you might invite these guys out for a post-auction coffee and tell them, "Look, dudes. We all like pocket watches. I get it. But there are a lot of watches in the world, and there's no reason for us to be shredding each other on every single one of them. So how about this? I'll send you guys my auction schedule, you send me yours. If you feel like showing up to all the same ones as me and paying $300 a watch, then by all means go ahead. But if there are some watches you're not all that excited about, and others you really can't live without ... [here's where you'd wink] ... then let's make some sort of arrangement."

You might also propose a sharing arrangement, in which all four of you would buy pocket watches together, each chipping in some money and agreeing not to make solo bids for any of them. This would have the same effect of depressing prices, but with the patina of cooperation.

These two scenarios, give or take a fiduciary duty here or there, are a rough sketch of what's happening with the private equity lawsuit. Firms like KKR and Blackstone appear to have formed club deals with the understanding that doing so would keep bids low, and suggested to rivals that everyone could be happier if these club deals didn't turn into huge, competitive affairs. On one deal, the $32.1 billion buyout of HCA, the hospital chain whose acquisition was led by KKR and Merrill Lynch, the suggestion was fairly blunt:

K.K.R. expressly asked its competitors to “step down on HCA” and not bid on the company, according to an e-mail that was unsealed and written by Daniel Akerson, then a partner at Carlyle and now the chief executive of General Motors.

The problem is that when you ask competitors to "step down" on private equity deals, as opposed to pocket watch auctions, you make shareholders of acquired companies mad that they didn't get the prices they felt they deserved. And, more to the point, you risk running afoul of antitrust laws.

Private equity firms are, of course, saying that the "scratch my back, I'll scratch yours" nature of club deal participation is just business as usual, and Fortune's Dan Primack points out that there were fierce bidding wars during the time covered by the suit, even between some of the alleged colluders. But it's long been an industry secret that club-deal collusion happens. (Way back in 2005, a "legendary private equity investor" told Andrew Ross Sorkin as much, right before saying, "Please don't quote me by name.") And if there were explicit agreements not to bid on certain deals in order to keep prices low, no matter how informal, it could constitute illegal anti-competitive behavior.

What a jury would make of all this, especially after an election in which private equity's avarice has been on constant display, is anyone's guess. But we'll probably never find out. Private equity's notorious aversion to the spotlight means that reaching an out-of-court settlement is one deal they'll be almost certain to make.