Harry CampbellHere’s one way to gain an edge in deal-making: hire the former chief executive of the company you want to buy to advise you.
What may seem to be a real advantage, however, can turn out to be a problem, as demonstrated in recent litigation arising from the $3.7 billion buyout of the industrial machinery maker Gardner Denver.
In that deal, the private equity firm Kohlberg Kravis Roberts & Company had hired the company’s former chief executive, Barry Pennypacker, as an adviser within months of his resignation. The use of a former top executive raises many of the same questions that occur when a management-led buyout is on the table. Does a former insider’s special knowledge and relationships give the bidder an unfair advantage to the detriment of other potential bidders — and to shareholders?
The question is whether K.K.R. and Mr. Pennypacker crossed the line.
After about five years as chief executive of Gardner Denver, Mr. Pennypacker resigned in July 2012. His reasons are still unclear, but it appears that the resignation came over management of the company and disputes with the board. Mr. Pennypacker was succeeded on an interim basis by Gardner’s chief financial officer, Michael M. Larsen. Mr. Pennypacker’s departure was clearly a blow to the company. Gardner’s shares fell 8.6 percent the next day.
To would-be acquirers, his exit was also blood in the water. Within two weeks, SPX, a competitor of Gardner’s, submitted a preliminary proposal to acquire the company. Only a few days later, ValueAct Capital, the holder of about 5 percent of Gardner, sent a letter to the company agitating for a sale. Shortly thereafter, another company also reported interest in an acquisition. Mr. Larsen, who became the permanent leader, and the Gardner board, working with Goldman Sachs, then vigorously explored a possible sale.
But the swirl of activity also attracted Mr. Pennypacker, who saw his own opportunity. He enlisted the aid of UBS and began shopping his expertise to private equity firms.
Kohlberg Kravis and its industrials team bit and hired Mr. Pennypacker.
This is a common practice on Wall Street these days. Private equity firms hire industry veterans to advise them not just on operating the companies in their portfolios, but on potential acquisitions. Deals also remain scarce, which means the potential increase for these advisers to nudge private equity buyers toward their own former companies. Blackstone’s new technology team, for example, is headed up by a former executive of Dell. Not surprising, Blackstone initially took a big interest in possibly bidding for the PC maker, though it eventually decided against making an offer.
In the case of Gardner Denver, nearly all of private equity firms that participated in the bidding had hired former employees of Gardner or one of its competitors to advise them, according to a person close to the deal.
And while former chief executives have been known to bid for their companies, most recently in the case of Best Buy, this appears to be one of the few cases where a private equity firm hired a former chief so soon after his resignation.
The practice may not be rare, but hiring former executives raises alarm bells at target companies. In some ways, hiring a former executive to advise on a takeover bid is a form of a management buyout, with all the potential conflicts and dangers that entails, including the potential misuse of confidential information.
All told, the hiring of former executives has the potential for real problems as the information these managers have can give a big advantage to a bidder, all at the expense of shareholders of the target company.
But like management-led buyouts, there are procedures in place that bidders and targets try to use to wall off the conflicts of interest.
As you would expect from a well-lawyered place like Kohlberg Kravis, the private equity firm did appear to adopt these procedures. As part of its relationship with Mr. Pennypacker, the firm demanded that he sign an agreement to ensure that he did not divulge confidential information about Gardner.
It is here where the trouble started. In October, according to court filings, Mr. Pennypacker’s counsel inadvertently sent a draft of this agreement to Mr. Pennypacker’s old e-mail address at Gardner Denver. Oops. Alerted of his involvement, the company jumped in to make sure that Mr. Pennypacker did not share any confidential information.
What happened next is the subject of dispute. As is almost always the case in a buyout these days, there was shareholder class-action litigation brought in a Delaware court to challenge the acquisition. At first, this suit appeared to be a run-of-the-mill case that would quickly settle. But when the plaintiffs’ lawyers began discovery, they uncovered details of Mr. Pennypacker’s involvement. In court filings, the plaintiffs claimed that despite safeguards, Mr. Pennypacker had still provided confidential information to the private equity firm.
Kohlberg Kravis had a number of defenses. First, while a mistakenly sent e-mail was probably not the best way to alert Gardner, Gardner eventually signed off on the relationship between the private equity firm and its former chief executive. And Kohlberg Kravis had its own procedures in place that were intended to prevent Mr. Pennypacker from disclosing inside information.
The private equity firm strongly denies that any confidential information was shared, stating in a filing with the court that “Mr. Pennypacker repeatedly made clear that he was aware of his confidentiality obligation, that he honored it, and that he based his conversations with K.K.R. on public information.” According to a person close to the firm, Mr. Pennypacker will not be Gardner’s chief executive once it goes private.
(On Tuesday, about 97 percent of the shares voted approved the merger.)
Possible conflicts of interest were also raised by lawyers representing Gardner’s shareholders in a related motion before the Delaware Chancery Court. The parties settled part of the litigation, resulting in the disclosure to shareholders of Mr. Pennypacker’s involvement. But the plaintiffs may decide to amend their complaint to pursue a claim related to Mr. Pennypacker’s relationship with Gardner’s suitor.
If the plaintiffs do actually pursue these claims, the facts of what actually happened between Mr. Pennypacker and his new employer will be sorted out. The plaintiffs’ lawyers do point to many conversations in their court briefs, but they have not pinpointed any smoking gun, namely specific confidential information that Mr. Pennypacker provided to Kohlberg Kravis.
Still, even if Kohlberg Kravis and Mr. Pennypacker did nothing wrong legally, you cannot help feeling squeamish in a way similar to when someone leaving a government post immediately cashes in on a big, lucrative private sector job. Even though almost every private equity firm does it and it can be legal, you cannot help but wonder whether something is off. The reason is that it is hard to see how confidential information held by the former executive cannot taint the process.
Despite these misgivings, given the viciously competitive market for deals, this practice is likely to continue to be common.
For boards of target companies, this is all a warning to be careful. It may behoove them to ask who is advising their buyer. It may well be a familiar face.