Tuesday, May 21, 2013

A Peek into the Back Alley of Private Equity


A Peek into the Back Alley of Private Equity

Lawsuits are often how we get to see the back alley of the money management business.  The mid-size buyout firm Castle Harlan is involved in two such matters.  Full disclosure: I conducted due diligence on the firm and recommended making an investment in one of their funds in 2002 to the North Carolina State Treasurer.  In one case, Castle Harlan is accused of improperly flipping an industrial company, hours after acquiring it.  The PE firm acquired Norcast Wear Solutions, a Canadian company, from the Swiss firm Pala Investments for $190 million.  Seven hours later it sold Norcast to Bradken Ltd of Australia for a $27 million profit.  Pala alleges that Castle Harlan committed fraud in misrepresenting its interest in acquiring Norcast.[1]
 
Double Off-Sites (2010)
In a separate matter, shareholders of Morton’s Steakhouse allege that the directors of the restaurant chain sold the company too cheaply to Tilman Fertitta, the CEO of Landry’s Inc.[2] At the time of the sale, Castle Harlan still owned about 27% of the company, after taking the company public in February 2006 at $17 per share.  Morton’s didn’t fare too well as a public company, and Mr. Fertitta acquired the company for $6.90 per share in 2012.  A quick and irrelevant aside: as I was looking into this deal, I discovered a survey showing that Morton’s is the favorite location for people having affairs.[3]  It’s probably the restaurant’s proximity to hotels and not its mega-sized portions that draw in unfaithful patrons.

Among other charges, investors allege that Castle Harlan improperly pressured the board of directors to accept Mr. Fertitta’s bid.[4]  Having already gotten much of their capital out of the Morton’s investment, the shareholders allege that Castle Harlan had an incentive to look out for their own interests to the detriment of the public shareholders. 

As of now, there are only hints about what actually happened in the Norcast transaction and the sale of Morton’s Steakhouse.   Whether Castle Harlan’s actions were improper or not, these deal illustrate how private equity will use its sharp elbows to make money.  The Norcast flip is every private equity firm’s dream deal.  Imagine making $27 million in seven hours: the internal rate of return is astronomical.  While this is an extreme case, in many instances private equity and real estate funds line up buyers for a business before they’ve acquired the asset.  Usually, they’re acquiring a conglomerate and immediately set out to sell the unwanted pieces. 

In the Norcast situation, you’re left with the very unsettling feeling that Castle-Harlan and Bradken colluded to deprive Pala of a fair price.  Had Bradken been competing with Castle Harlan for Norcast, the bidding would have produced a higher price for Pala.

The sale of Morton’s captures the inherent conflict between the private equity owners and public shareholders after an IPO.  I’ve written about this conflict before in “The Most Favored Passenger: Private Equity [January 11, 2013].”  The post highlighted Norwegian Cruise Lines special compensation arrangement that will pay management special bonuses for helping to facilitate the sale of Apollo Global Management’s remaining stake in the company. 

By the time a company goes public, the private equity owners are often getting antsy about getting money back to their investors.  The PE fund that made the original investment is probably approaching the end of its legal life.  In addition, the PE firm is trying to raise a new fund, and is feeling extreme pressure to demonstrate that it is winding up old investments.  Obviously, the public shareholders don’t share these concerns. 

Very often the board of directors consist of folks nominated by the private equity firm, and they may also sit on other boards controlled by the PE sponsor.   While they are supposed to look out for the interests of all investors, they have a variety of reasons to be beholden to private equity.

In due course, we’ll find out if Castle Harlan is liable in either of these situations.  Nonetheless there’s an ugly alleyway behind the private equity façade that we’re not supposed to see.


[4] Curiously, Castle Harlan had already been indirectly involved in the sale a restaurant chain to Mr. Fertitta.  The PE firm owned a 40% stake in McCormick and Schmick, which it took public in 2004 at $12 per share.  In a couple of secondary offerings Castle Harlan exited M&S completely in 2006 netting about $77 million.  A few years later, Mr. Fertitta acquired a 10% stake in M&S, and eventually bought the reminder of the company for $8.75 per share in late 2011.   While C-H was involved in this sale, it’s interesting that Mr. Fertitta and his company, Landry, were able to acquire two restaurant businesses after they did poorly as public companies.  Also of note, C-H first acquired M&S in 1994 and sold it to Apple South in 1998, before acquiring it again several years later.

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