The End of Private Equity?
If directors can be held liable for selling a company in a leveraged buyout that leads to bankruptcy, private equity firms could lose their power and influence.
If you were a director or an officer of a public company over the last 35 years and were tasked with choosing a buyer for your company, it was a pretty easy decision: You sold to the highest bidder. Ever since the Delaware Supreme Court decided Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. in 1986, boards of directors figured that, when cashing out the existing shareholders of a public company, sell to the highest bidder and your fiduciary duty will be fulfilled, no questions asked.
However, Judge Jed S. Rakoff in the Southern District of New York could change the Revlon standard in a way that would make directors liable for a decision to sell their company to a buyer who intends to load up the company with debt, thereafter putting the company into a precarious financial situation. If Rakoff’s thinking prevails — still a big “if” — when directors sell a company to a private equity firm in a highly leveraged transaction and that heavy debt load results in a subsequent bankruptcy, the directors of the selling company can be held liable for selling the company to a leveraged-buyout firm in the first place, even if it offered the highest price at the time of the sale.
If directors can be held liable for selling a company in a leveraged buyout that later goes belly-up, the whole private equity bonanza of the past half-century could come to a grinding halt. In fact, the mere threat of that liability could lead to material changes in the way these deals get done — using less leverage, paying lower prices, extracting fewer fees or ginning up fewer so-called dividend recaps — and could mean a diminution of the power and influence of private-equity firms worldwide.
Private equity has become a huge business in the United States and beyond. According to management consultants Bain & Co., there is now nearly $3 trillion of cash in the coffers of private equity firms looking for a place to be invested. An entire ecosystem has evolved around leveraged buyouts. Wall Street banks earn billions in fees annually from raising debt and equity for private equity firms and for providing them with M&A advice as the firms go about buying and selling companies. Private equity moguls have become some of the wealthiest Americans, not only as a result of the lucrative fee structures the industry has long enjoyed but also because many of the biggest private equity firms themselves have tapped the public equity markets through IPOs. For instance, Steve Schwarzman, the co-founder of the Blackstone Group, with more than $620 billion of assets under management, is worth around $28 billion these days, and Blackstone itself is valued at $110 billion in the public markets. Henry Kravis and George Roberts, the first cousins who co-founded KKR, are worth around $10 billion each. KKR is worth around $47 billion. The list goes on.
Suffice it to say that these guys are rich and powerful and used to getting their way. They don’t want anything to change about how they do business; to date, they have been extraordinarily successful at fighting off attempts to change the structure of their industry.
Enter Rakoff. His little-noticed December 2020 ruling came in an ongoing case involving the failed 2014 leveraged buyout of Jones Group, a publicly traded apparel and footwear company, with brands such as Nine West, Anne Klein, Stuart Weitzman and Gloria Vanderbilt. Rakoff opined that directors of a selling company may lose the benefit of the business judgment rule if it turned out they agreed to sell a company that later goes into bankruptcy and it can be shown that the directors knowingly sold the company to a buyer who intended to load the company up with debt or undertook other actions, such as stripping out valuable assets, that might be reasonably expected to lead to a subsequent bankruptcy filing.
That is obviously a very different standard than simply selling a company to the highest bidder. If Rakoff’s thinking prevails — the ruling was part of a motion to dismiss and a full trial before a jury still awaits — directors would have to think twice, or more, before selling a company to a buyout firm that intends to load the company up with a lot of debt, or take other actions, such as stripping out valuable assets, that could reasonably be expected to lead to a bankruptcy filing unless things go swimmingly.
The Jones Group buyout went awry pretty quickly. In December 2013, the Jones board of directors voted to sell the company for $2.2 billion, including the assumption of $1 billion of existing debt, to Sycamore Partners, a private equity firm focused on investing in retail businesses. But before the deal closed the following April, Sycamore changed the acquisition materially, lowering its equity investment from $395 million to $120 million and borrowing $350 million more than anticipated. These moves saddled the newly renamed Nine West Holdings with $1.55 billion in borrowings and added onto the already poorly performing company debt equal to nearly eight times its EBITDA, well beyond what Citigroup, Jones Group’s investment banker, told the Jones board would be a reasonable amount of debt. Sycamore also hived off two of the most valuable divisions, Stuart Weitzman and Kurt Geiger, into a different Sycamore affiliate at a valuation significantly below their fair market value.
As a result of these actions, the Jones board could have exercised its right to bow out of the deal, since Sycamore had changed the terms by greatly increasing the debt on the company while also decreasing its equity investment, and by seeking to pay less than fair market-value for the two divisions it sold to its affiliate. But the Jones board continued with the sale to Sycamore despite the increased risk that the deal structure added to the company’s financial outlook.
Nine West Holdings made its bankruptcy filing in 2018. As part of the confirmed plan of reorganization, Nine West settled its claims against Sycamore (for $120 million, among other remedies) but not those against the former Jones Group officers and directors, leading to the lawsuit in Rakoff’s federal court. The trustee of a litigation trust, established during the bankruptcy proceeding, argued that the directors and officers of Jones Group should have anticipated the company’s subsequent bankruptcy filing, given the convoluted and changing Sycamore capital structure. As a result, the trustee argued, the directors and officers should have halted the sale to Sycamore or demanded changes to Sycamore’s structure before completing the deal.
In his opinion, Rakoff called the Jones board of directors “reckless” and argued that it could not hide behind the business judgment rule for protection. He wrote that the board had done “no investigation whatsoever into the propriety” of the amount of leverage Sycamore proposed in the buyout of Jones Group and that as the case proceeded, perhaps the directors would be found liable for their poor judgment. (In his ruling, Rakoff was more lenient on the former officers of Jones Group, suggesting that there was very little they could have done to stop the Jones Group board of directors from selling the company.)
The facts surrounding the sale of Jones Group to Sycamore are unusual. Most buyouts do not contemplate stripping out valuable assets into a separate, affiliated company, and most private equity firms do not reduce the original amount of equity contemplated to be invested into the buyout by nearly 70%. As for the leverage Sycamore piled onto Jones Group (eight times EBITDA), that’s high, but with interest rates as low as or lower than they have ever been, and prices being paid for buyouts hovering in the range of 11 times EBITDA, it’s likely that leverage multiples will continue to rise, as long as banks and debt investors are desperate for higher yields, as of course they are.
The fallout from Rakoff’s ruling has been both predictable and surprising. What could easily have been anticipated is the uproar that has followed from board directors and the private equity industry decrying the suggestion that somehow a director of a selling company can be held responsible for what happens after a company is sold. A company, with or without lots of debt, can go into bankruptcy for any number of reasons, some of which it could be argued are unforeseeable and some of which seem inevitable, especially in hindsight. For instance, had a private equity firm closed on a chain of movie theaters in a leveraged buyout in February 2020, it’s unlikely the directors of the selling company could have reasonably been held liable for failing to anticipate the effects of the pandemic on the movie-theater industry.
On the other hand, the big Wall Street law firms that specialize in bankruptcy law immediately sounded the trumpet that Rakoff’s ruling — even at this preliminary juncture in the trustee’s lawsuit — could herald a material change in the buyout industry and could affect the future responsibilities of directors of a selling company. According to Weil Gotshal, which has one of the foremost bankruptcy practices in the United States, “If this decision is followed by other courts and, in particular, applied to Delaware companies, the job of being a director in the midst of deciding whether to approve an M&A transaction, particularly a leveraged buyout, will become more stressful. The key question, however, is how much?”
One thing seems clear in the wake of Rakoff’s ruling: Any board of directors that fails to make at least some documented effort to evaluate what a buyer intends to do with the company it is selling risks being held financially accountable for that omission. And that seems like a much-needed tweak to the process of selling a public company as well as a reasonable way to start to rein in the excesses of the private equity industry.
William D. Cohan is a business writer who appears regularly in The Atlantic, The Financial Times, The New York Times and Vanity Fair. He was a senior Wall Street merger and acquisition investment banker for 17 years at Lazard Frères & Co., Merrill Lynch and JPMorganChase. He is also a New York Times bestselling author of three nonfiction narratives about Wall Street.