Private equity moved from the boardroom to the courtroom in June, as Forstmann Little & Co. began defending itself against civil charges brought by the State of Connecticut.
The case-filed in February 2002-accuses the New York-based buyout shop of breaching its fiduciary responsibility to limited partner Connecticut, which had invested $198 million in a pair of funds managed by Forstmann Little. Connecticut also claims contract clause and securities law violations, and has publicly stated that it was hoping for restitution in excess of its original investment.
The case is being closely watched by the private equity community. A finding against Forstmann could embolden LPs in other firms to pursue litigation, particularly if the claim of breach of fiduciary responsibility is confirmed, says Carl Metzger, a partner with Testa, Hurwitz & Thibeault, which is not a party in the lawsuit. On the other hand, if Forstmann prevails, it will reinforce the idea that private equity is a high-risk asset class, and that losses are not grounds for lawsuits, Metzger says.
As Connecticut State Attorney General Richard Blumenthal said at the time: “We want more than the $100 million-plus they wasted and wiped out. We want to make Forstmann the poster child for fair-dealing in the investment community.” Forstmann responded, issuing a statement reaffirming its commitment to fiduciary responsibility, and argued that the bursting of the telecom bubble, not fund mismanagement, caused LP losses.
Most legal experts believed that the case would settle out of court because both sides had a lot to lose from a public showdown. If it loses, Forstmann could have a stain on its reputation and become the target of copycat lawsuits. Connecticut has its own fiduciary responsibility to worry about, as its pension system could be viewed as litigation-happy, thus making it an unattractive limited partner in future funds.
“Most civil cases don’t go to trial, so the odds against this happening were pretty good,” Metzger says. “One of the differences here, however, is that the alleged damages are so high and the parties’ versions of events couldn’t be more different.”
He adds that a settlement could still occur up until a jury verdict, but sources say that neither side is known for its accommodating style.
“Teddy [Forstmann] hates to admit when he’s wrong, which is part of the reason he’s in this mess,” says a money manager familiar with Forstmann. “Blumenthal and [State Treasurer Denise] Nappier have dealt with these sorts of things aggressively in the past, and won.”
The case largely revolves around Forstmann’s continuing attempts to save telecom services provider McLeodUSA Inc., which filed for bankruptcy protection before reorganizing itself in late 2002. Forstmann became involved with McLeod in 1999, when it invested $1 billion worth of convertible preferred stock for a 12% ownership. At the time, telecom was as cool as the Internet and McLeod’s common stock was trading at more than $30 per share.
By the summer of 2001, everything changed. Rather than succumb to market pressures, Forstmann insisted that it could resuscitate a telecom portfolio that also included a sizable bet in XO Communications Inc. As McLeod’s stock dropped, Forstmann suspended coupon payments and pumped an additional $100 million into the company for a 20% position. The buyout firm made similar moves with XO, which is when the state began to get concerned.
Soon after the fall of 2001, McLeod began finalizing plans for bankruptcy. As part of the Chapter 11 plan, Forstmann invested an additional $175 million for a majority ownership stake.
Connecticut claims this final infusion allegedly did not involve any Forstmann funds in which it was an LP. The pre-bankruptcy deals, however, had used Connecticut funds, and the Constitution State argued that this fund-jumping arrangement resulted in an improper wipeout of at least half its original McLeod investments (via Forstmann).
Such losses are particularly difficult for Connecticut to swallow, because Forstmann funds do not follow the industry standard of aggregated returns. Instead, it pays carried interest back to its limited partners on a deal-by-deal basis.
This means that while both GPs and LPs are paid proportional carry on successful investments, an LP takes more proportional loss on bad investments than does the GP. Aggregated returns -added up wins and losses that are divvied up proportionally-were established at most firms 10 to 15 years ago in response to growing pressure from public pension funds. Kohlberg, Kravis, Roberts & Co., for example, instituted aggregated returns on its 1996 fund and has maintained them ever since.
At least one LP has asked Forstmann to suspend its practice as a goodwill gesture reminiscent of how VC firms accelerated claw-back provisions or reduced fund sizes. Forstmann, however, has argued that the deal-by-deal structure better aligns LP and GP interests. The firm did discontinue management fees charged on lost investments in XO.
When the six-person jury trial began June 1 in Rockville, Conn., the charges still included a breach of fiduciary responsibility and contract clause violations. Superior Court Judge Samuel Sferrazza had previously thrown out the securities law violations-considered to be among the most serious charges-but denied a defense motion to dismiss the entire case. The judge also ruled against a defense request to disallow the introduction of fund placement memoranda that included certain spending restrictions contained in side letter agreements. But he did prevent the admittance of a Power Point file used during Forstmann’s fund-raising presentation.
After opening statements, the prosecution called Ted Forstmann as its first witness. He acknowledged that the McLeod investment had not gone according to plan, but said that it eventually would make money for investors. He also said that his firm had followed the letter of its LP agreements, and that any internal disagreements over the McLeod investments were the normal course of business for a private equity partnership.
Future witnesses are expected to include other Forstmann executives and Connecticut Treasurer Nappier. The trial is expected to last around one month prior to jury deliberations, assuming no settlement is reached.
Sources say that a ruling for Connecticut could prompt similar lawsuits against the firm, and cause some public pensions-and some private ones-to be precluded from investing in future Forstmann vehicles. This assumes, of course, that there will be future Forstmann funds. Ted Forstmann is rumored to be contemplating retirement, and it is unclear whether or not his younger partners would want to maintain the Forstmann Little name in his absence.
– Dan Primack
CalPERS Loses Chief, Posts Gain
Rick Hayes, an advocate for public LPs, early last month tendered his resignation as head of private equity investments for the California Public Employees’ Retirement System (CalPERS) to become a managing partner at Oak Hill Capital Management (see story, page tk). Hayes joined CalPERS in 1998. In 2000, he was elected chairman of the Institutional Limited Partners Association (ILPA). As head of ILPA, he ruffled feathers in 2002 by advocating that VCs adopt a cash in/cash out standard for calculating private equity returns. Prior to joining CalPERS, Hayes was an operating executive at AT&T Wireless Service, and previously he helped manage a $1 billion international venture capital and buyout fund for Bank of America.
Hayes’ departure from CalPERS comes as the pension fund separately released investment performance data for the one-year period ending March 31, 2004. The entire system experienced a 29.6% return, which puts its standing assets at $165.8 billion. The system’s alternative investment management program – which includes venture capital, buyouts and other private equity investments – grew by 3.8%, CalPERS reported.
– Lawrence Aragon./Carolina Braunschweig
Penn. Foes Have Day in Court
An attorney representing Pennsylvania Auditor General Robert Casey Jr. argued in front of the Pennsylvania Commonwealth Court in early June that Casey has the right to conduct a performance audit of the state’s two large public-employee pension funds.
Casey has been fighting for more than a year to audit the performance of Pennsylvania Public School Employees’ Retirement System (PSERS) and State Employees’ Retirement System (SERS), which manage a combined $61 billion in assets.
Attorneys for the pension funds and the auditor general have argued in front of the Commonwealth Court over who has a right to audit PSERS and SERS. While the court did not set a date for when it would issue a ruling, participants said they expect the court to rule before the end of the summer.
Casey’s attempt to audit the funds stems from the retirement systems’ use of 150 outside consultants and investment advisors. The tally for those services added up to more than $250 million. Meanwhile, the funds, which represent more than 500,000 workers and retirees, has lost about $20 billion over the last two years.
The losses led to the PSERS board voting to raise its subsidy from individual school districts to make up for the deficit. The increase may lead to higher property taxes in some Pennsylvania school districts.
Casey and the overseers of the funds, as well as their political allies, have accused one another of using the audit issue to pursue political objectives. State Treasurer Barbara Hafer, who is chair of PSERS and sits on the SERS board. Her term as treasurer expires in January. Casey is running to take her place in the next election. Casey and Hafer, as well as other state leaders, have accepted campaign contributions from pension fund money managers.
Last December, the Commonwealth Court turned down the pension funds’ attempt to have the suit thrown out of court. In the same ruling, the court rejected Casey’s call for monetary damages against pension board members.
PSERS manages approximately $40 billion and invests in Adams Street Partners, Spectrum Equity Investors, TA Associates, Madison Dearborn Partners and Landmark Partners.
SERS manages approximately $22.1 billion and its portfolio includes Apax Partners, New Enterprise Associates, Summit Partners, Blackstone Capital Partners, Lexington Partners and HarbourVest Partners.
Empire State Looks to Double Down on PE
The New York City Comptroller’s Office, which manages the City’s pension funds, plans to double its private equity portfolio over the next three to five years. Worth $2.2 billion today, the retirement system’s private equity investments could total $4.1 billion once the pension fund reaches its 5% target allocation.
In late May, the Comptroller’s Office announced it issued requests for proposals, seeking a new private equity consultant to guide that effort.
The New York City Comptroller’s officer oversees 10 retirement funds worth $82 billion altogether, but only five of those invest in private equity. The system’s new private equity consultant will advise an investment strategy, sub-asset allocation and industry best practices, as well as identify and evaluate new investment opportunities and analyze market conditions.
La Jolla, Calif.-based Pacific Corporate Group has had the contract for six years. They’re expected to compete along with other investment advisors and consultants for the new contract, says Gavinn Boyce, a spokesman for the New York City Comptroller.
Proposals are due June 8. The contract will be awarded in July.
– Carolina Braunschweig
Intersouth’s Russell Goes To Quellos
Sallie Shuping Russell in June returned to the limited partner ranks as a managing director with The Quellos Group, after a three-year flirtation with direct VC investing at Intersouth Partners.
The move was warmly received by many in the institutional investor community, who remember Russell from her time with Duke Investment Management Co., McMillion Eubanks Capital Management and Cambridge Associates.
“Sallie is a really good person and has a good eye for this type of investing,” says an endowment portfolio manager who preferred to remain anonymous. “I don’t think that she would have left for just any opportunity, and this one makes sense because she’s going somewhere that also has her former partner at Duke, Gene McDonald.”
Russell originally joined Intersouth as a general partner in March 2001, after having co-founded Duke Management Co. and serving as that group’s vice president and director of private investments.
Much of her work at Intersouth dealt with client relations, but she did lead several investments in the life sciences sector. Soon after going part-time last year, Russell was contacted by McDonald, who had left Duke to launch a private markets platform for hedge fund-of-funds manager The Quellos Group.
“This really is about me wanting the opportunity to build a team with Gene, because I know what he’s capable of doing,” Russell says. “I’m at the point where I’m looking at what I want to be doing for the next 15 years, and while I really enjoyed my time at Intersouth and learned a lot, I think that this new role fits me very well.”
Quellos already has raised more than $400 million in fund-of-fund capital, and Russell is expected to help with future offerings. She will maintain her financial interest in Intersouth’s current fund, and plans to stay involved with her portfolio companies over the next several months. Intersouth puts two investment professionals on each deal, and Russell’s two remaining board seats will be taken by “second chair” Chris Hegele.
– Dan Primack
SERS Ups Its PE Allotment
The $24.7 billion Pennsylvania State Employees’ Retirement System (SERS) added $130 million worth of commitments to its private equity portfolio, part of an effort to boost the portfolio’s size by 4% over the next four years.
At their monthly meeting last week, trustees of the pension fund committed $50 million to Oak Investment Partners 11th fund, a multi-stage investment vehicle whose size has not yet been disclosed by the Westport, Conn.-based firm. However, Oak’s two previous funds each topped $1 billion.
SERS also allocated $50 million to Bain Capital’s Bain Capital VIII, a Boston-based buyout fund slated to close with $8 billion. The pension fund said it would also invest $30 million in Gryphon Partners III, a buyouts focused fund being raised by San Francisco-based Gryphon Investors, whose size has not been disclosed.