In the early 1980s, William Simon, a former secretary of the Treasury, and Ray Chambers, a former investment banker in New Jersey, made a fortune buying Gibson Greetings Inc. using very little of their own money and then selling it. Each man reaped a windfall of $70 million from an initial investment of $330,000. Ever since, the alchemy of leveraged buyouts has been dazzling.
Practitioners of leveraged buyouts, who refer to themselves as part of the “private equity” industry, are among the richest Americans. They use a whole lot of borrowed money and as little equity as possible to buy companies they perceive to be undervalued or poorly managed. They hope to flip them at a big profit a few years later.
The formula’s success has been stunning. Private equity firms, once quaint partnerships, are now publicly traded behemoths. Steve Schwarzman, a co-founder of the powerful Blackstone Group with more than $600 billion under management, is worth roughly $23 billion. Leon Black, a co-founder of Apollo Global Management, is worth about $10 billion.
But now the party could be ending. In a little-noticed December ruling in a case involving a failed 2014 leveraged buyout, Jed S. Rakoff, a federal judge in the Southern District of New York, threw some sand into the otherwise well-lubricated gears of what has been a 40-year financial bonanza. It’s about time we started asking tough questions about the ramifications of loading up companies with huge amounts of debt they will surely have difficulty repaying.
Judge Rakoff’s decision stemmed from the fallout from a years-old private equity deal in the retail industry. In July 2012, the directors of Jones Group — then a publicly traded apparel and footwear company, with brands such as Nine West, Anne Klein, Stuart Weitzman and Gloria Vanderbilt — hired investment bankers at Citigroup to try to sell the company, which had been struggling financially. 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.
But before the deal closed the following April, Sycamore changed it, lowering its equity investment to $120 million from $395 million, and borrowed $350 million more than anticipated. These moves saddled the newly renamed Nine West Holdings with $1.55 billion in borrowings and foisted onto the already poorly performing company debt equal to nearly eight times its EBITDA, or earnings before interest, taxes, depreciation and amortization, and well beyond what Citigroup recommended to the Jones board.
At that time, the board could have exercised its right to bow out of the deal, since Sycamore had changed the terms of it by greatly increasing the debt on the company while also decreasing its equity investment. But the board continued with the sale despite the increased risk.
Predictably enough, Nine West filed for bankruptcy in 2018. As part of its reorganization plan, the company settled its claims against Sycamore but not those against the former Jones Group officers and directors. That’s what led to the lawsuit against them, essentially for failing to anticipate that selling the company to Sycamore in such a convoluted and leveraged deal might lead to bankruptcy court.
In his decision in that lawsuit, Judge Rakoff, who has long been critical of bad behavior on Wall Street, wrote that the former directors and officers of Jones Group could be held liable for approving the sale of the company, since it later went bankrupt. In other words, Judge Rakoff said in his ruling, officers and directors had better think twice before agreeing to sell a company to a buyout firm. What had for decades been considered a virtue — selling a company for a market-clearing price to the benefit of existing shareholders — might have become a vice. Judge Rakoff’s decision “has the potential of really blowing up,” said Brian Quinn, a law professor at Boston College.
Of course, it’s hard to know if Judge Rakoff’s ruling will become a new precedent. The judge wrote that former Jones Group directors made “no investigation whatsoever into the propriety” of either the huge debt Sycamore had piled onto the company or its squirrelly deal to split two of its most valuable divisions, Stuart Weitzman and Kurt Geiger, into a different Sycamore affiliate at a valuation significantly below their fair market value. Judge Rakoff called the Jones board “reckless” and said it could not take cover behind the business judgment rule, which usually protects directors from being held accountable for past business decisions so long as they were made in “good faith.”
The ruling has the potential to hold accountable those responsible for allowing otherwise solvent companies to be sold into circumstances that would soon enough cause their bankruptcy. There’s still a trial in the offing, but many law firms that specialize in bankruptcies immediately understood the ruling for what it is: a shot across the bow of the buyout juggernaut. In a message to its clients, Ropes & Gray wrote that the Nine West decision “should be viewed as a serious warning for corporate decision makers” and that even though the directors of the selling company were no longer involved, they “cannot ignore” what a company’s balance sheet looks like after it is sold to a new buyer “without also risking their protections under business judgment rule.”
In the wake of Judge Rakoff’s ruling, Big Law quickly sought to warn clients that officers and directors of companies needed to be more vigilant about who they agree to sell a company to and what the buyer plans to do with it. The days of just selling a company to the highest bidder regardless of the consequences — the legal standard on Wall Street since the Delaware Supreme Court decided the so-called Revlon case in 1986 — might just be over.
At least in public, private-equity practitioners seem to be unmoved by Judge Rakoff’s ruling. A spokesman for Steve Schwarzman at Blackstone told me the buyout billionaire did not have a “point of view” on the Nine West decision. John Finley, Blackstone’s general counsel, declined to comment after reading it.
And Judge Rakoff’s bombshell hasn’t put a damper on the private-equity industry — yet. In January, BC Partners, a British buyout firm that has raised more than $30 billion of equity capital, borrowed $480 million in bank debt and took out another $70 million line of credit to complete the buyout of Women’s Care Enterprises, a Florida health care provider. The borrowings represented “adjusted” debt equal to nine times the company’s EBITDA, according to the S&P Global ratings agency.
But the directors of companies being sold to buyout firms would be foolish not to take Judge Rakoff’s ruling to heart. In its note to clients, Ropes & Gray may have said it best: “Caveat Venditor: Sellers (and their Directors) Beware.”
William D. Cohan (@WilliamCohan) is a former investment banker, a special correspondent for Vanity Fair and the author of several books about Wall Street.
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