Delaware Court of Chancery Rejects Challenges to Sale of Company by Private Equity Controller, Assesses Transaction Under Business Judgment Rule Standard

Background

Authentix provides “authentication technologies” designed to prevent fraud and counterfeiting by applying tracers to products. Carlyle U.S. Growth Fund III, L.P. (“CUSGF III”) acquired Authentix common and preferred stock between 2008 and 2013, and as of the sale date, owned (via Carlyle U.S. Growth Fund III Authentix Holdings, L.P. (“CUSGF Holdings”)) 70% of the Company’s preferred stock and 52% of its common stock. Authentix’ board during the relevant period consisted of its Chairman and CEO, Bernard Bailey, who originally had been appointed to the Board by Carlyle; Stephen Bailey, a Carlyle Partner and Managing Director who was CUSGF’s designee to the Board; Michael Gozycki, a Carlyle Managing Director who was CUSGF Holdings’ board designee; Paul Vigano, who served as the representative of J.H. Whitney & Co., a private equity firm that owned 25% and 16% of Authentix’ preferred and common stock, respectively, at the time of sale; and Lee Barberito, who was a designee of plaintiff Manti Holdings, LLC, which was an early investor in the Company. The Court found that a majority of the board lacked independence from Carlyle: S. Bailey and Gozycki faced “inherent conflicts of interest” if “Carlyle’s interests diverged from the common stockholders with respect to the sale,” and B. Bailey lacked independence from Carlyle given his senior corporate officer role.

CUSGF III’s partnership agreement provided for a fund life of ten years, “although that term has been extended after the sale of Authentix.” While the original fund term expired in 2017, “that did not impose a contractual obligation to exit any particular investment at that time.” The ten-year term, along with fund life extensions, are common provisions in private equity fund documents. The Board commenced a “wide-ranging sales process in 2016, culminating” in the sale to BWE in September 2017. Plaintiff, minority shareholders in the Company, claimed that “Carlyle is a controller; Carlyle’s business model required it to sell Authentix in 2017, regardless of price; accordingly, it caused Authentix’ board to run a sales process that was unfair to the stockholders, but from which Carlyle extracted a unique benefit, a timely exit from Authentix for Carlyle’s investors’ interest in the private equity fund.” As a result, plaintiffs asserted, entire fairness applies.

Following trial, the Court found for defendants, concluding that business judgment rule, not entire fairness, was the appropriate standard of review. The Court’s opinion contains instructive guidance regarding the impact, if any, of ordinary course private equity fund arrangements on whether a private equity controlling stockholder is conflicted; the benefits of an appropriate sales process with respect to whether entire fairness is implicated; and the limited utility of certain expert and other evidence.

Takeaways

Ordinary course private equity fund structures and compensation arrangements will not, in and of themselves, result in a finding that the fund sought a “non-ratable” benefit distinct from other stockholders. A non-ratable benefit is a unique benefit to a controlling stockholder in connection with a challenged transaction even where the controller receives the same transaction consideration as minority stockholders. A controller’s attempt to obtain such consideration implicates the entire fairness standard, i.e., in that event the controller is competing with the common stockholders.

Ten-Year Term: First, according to plaintiffs, Carlyle benefitted because CUSGF III’s ten-year term was expiring in 2017 and Carlyle, propelled by the resulting “liquidity-driven conflict,” compelled a fire sale of the Company “to meet investor expectations.” Plaintiffs asserted that “it was crystal-clear that if Authentix had put off the sale until 2018, the stockholders would have received more than twice the consideration paid by BWE.” The Court recognized that, if plaintiffs established that Carlyle determined it needed to sell immediately, “consequences (and price) be damned, that would create a conflicted controller transaction, and Carlyle would be liable, absent entire fairness.” But neither the contractual arrangements governing the fund nor the evidence introduced at trial supported such a finding.

As for the fund’s ten-year term, the Court found that ten years “is the lifecycle typical of most private equity firms,” encompassing periods of fund raising, investing in and working to create value in the companies in which the fund invests, and finally “looking for exit opportunities and to monetize its investments.” The Court acknowledged that a “preference to exit around the ten-year mark exists because when a fund reaches the end of its term, it can no longer obtain additional capital from its investors, and thus, cannot make further investments in portfolio companies.” The Court observed, however, that a “fund can continue to hold and manage its remaining portfolio companies after its term ends,” or, alternatively, the general partner can “seek an extension of the fund life” from investors, in which case it could continue to make investments in portfolio companies. Therefore, CUSGF III’s ten-year term “did not impose a deadline for selling its portfolio of companies,” and Carlyle “has had funds where they continued to hold investments after term expiration.” In this case, CUSGF III’s investors also approved a two-year extension of the fund’s term. As a result, the Court found that the “factual record does not demonstrate that Defendants were operating under such time pressure . . . to sell Authentix so that they were willing to do a fire sale of the Company, accepting far less than the fair value of their shares in return for an immediate sale.”

By way of additional support for such a conclusion, the Court found that: (i) as the Company’s largest stockholder, CUSGF III “had an inherent economic incentive to negotiate a transaction that would result in the largest return for all shareholders,” and the fact that a controller supports a sale does not demonstrate a willingness to accept less than fair value; (ii) the fund had independent motives to extend the term, including to continue investing in another portfolio company, such that the fund may have needed an extension for other investments; and (iii) investors approved extending the fund’s term, suggesting that they “were not exerting enormous pressure on Carlyle to liquidate CUSGF III sufficient for Carlyle to have an incentive to accept less than fair value for its investments, including Authentix.”

The Court cited favorably In re Morton’s Rest. Gp., Inc. S’holder Litig. for the similar proposition involving another commonplace private equity motivation – there, the Court found that a “private equity fund’s relatively common desire to raise a new fund was not an unusual crisis requiring a fire sale and that private equity funds are naturally disincentivized to hastily seek below-market merger consideration to avoid alienating past investors.” 74 A.3d 656 (Del. Ch. 2013).

Carried Interest Clawback: Second, plaintiffs argued that Carlyle received a unique benefit because the sale eliminated the potential for Carlyle, pursuant to the fund’s clawback provisions, to have to return to limited partners distributions it previously received associated with its Authentix investment. As the Court explained, for CUSGF III, “investment proceeds from portfolio companies are distributed in line with a distribution ‘waterfall’ set out in the Limited Partnership Agreement.” Upon exit, CUSGF III was required to first return 100% of invested capital (and provide a preferred 7% per annum cumulative compounded internal rate of return on the limited partners’ capital) to limited partners. Only then would carried interest distributions (i.e., Carlyle’s portion of the proceeds) be made from additional investment proceeds. These additional investment proceeds would be split between the relevant Carlyle entity and limited partners according to the specific terms of the waterfall. Significantly, investment proceeds “are distributed through the waterfall on an ongoing basis,” such that the “carried interest distributions may be (in fact, have been) made prior to the disposition of all portfolio companies.”

Hence, the clawback possibility: If, in a given period of time when it makes a distribution, Carlyle “receives more than its fair share of proceeds through the carried interest distributions, a clawback provision will trigger and require Carlyle and its deal team to return excess distributions to the limited partners of CUSGF III” for that period of time. However, the limited partners are only entitled to the preferred return on capital that is still deployed in the fund’s remaining portfolio companies. When remaining portfolio companies are sold and the capital is returned to the limited partners, the 7% preferred return ceases for that capital. Plaintiffs argued that Carlyle was “motivated to sell Authentix to cease the 7% preferred return and prevent clawback, as the proceeds from which Carlyle’s carried interest was computed would then cease to be diminished by the 7% preferred return.”

The Court disagreed that such an incentive existed so as to create a disabling conflict. It found no contemporaneous evidence establishing that the desire to eliminate the potential for a clawback “was a potent motivator that colored [Carlyle’s] judgment.” Moreover, the clawback provision “has an incentive structure that does not place pressure on Carlyle’s deal team members to sell portfolio companies at less than fair value in a fire sale.” There are two possibilities: If Authentix was growing faster in terms of proceeds than the 7% preferred return, then the fund would not be at risk of clawback “as there would be no shortfall in the preferred return for which carried interest distributions would need to account.” Alternatively, in a scenario characterized by declining proceeds, there is a clawback risk if Carlyle “could not meet the 7% preferred return on the investment capital still outstanding in Authentix prior to its sale.” In either case, Carlyle is incentivized to “hold onto portfolio companies that are growing in proceeds” and “sell portfolio companies that are more likely to decline than grow in proceeds, which returns capital to the limited partners and benefits all shareholders of the company through a sale prior to further decline.” As a result, according to the Court, the clawback incentive structure “is not indicative that Carlyle’s deal team conducted a fire sale to avoid a clawback, but instead implies that the Carlyle team was interested in selling Authentix because it may decline in value; and that it would be best for all shareholders, regardless of the clawback, to sell before the value further declined.”

An appropriate sales process can support the conclusion that a controller is not seeking and/or did not obtain a unique financial benefit. The Court found that the “comprehensive marketing and sales process of Authentix is evidence against liquidity pressure. The process took a full year.” The full board (including plaintiff Manti’s representative, Barberito) supported the decision to begin a sale process for Authentix and unanimously chose investment bank Robert W. Baird & Co. to run it after receiving presentations from five banks. The Board decided to launch a scoping (i.e., not broad) process in the fall of 2016 to evaluate whether buyers could appropriately value Authentix in light of the potential loss of one of the Company’s most significant contracts at this time. Baird assembled a list of potential buyers, with all Board members having an opportunity to provide feedback. Baird ultimately contacted 127 potential buyers, including 27 financial buyers, and disclosed to them the potential loss of a significant customer and Carlyle’s holding period, “which is standard information that potential buyers would want.” Eighteen potential buyers “attended fireside chat meetings, with four potential buyers submitting initial indications of interest, ranging in price from $120 million to $248 million. Authentix moved forward with due diligence with these four companies, during which two of these four dropped out of the process. A third, Innospec, maintained a “$177 million topline indication of interest, but specified that $100 million of its purchase price was contingent on obtaining three-year contracts” with specified customers. A fourth, Intertek, provided a $140 million indication of interest, with $55 million contingent on the Company renewing contracts with two customers on existing terms. Finally, BWE, after initially partnering with plaintiff Manti on an indication of interest at $107 million, decided to pursue its own deal and “put in its solo bid for $107 million.” BWE ultimately was successful in acquiring the Company following extensive negotiations, as described below.

Commenting on the sales process, the Court observed that there was no evidence that “Carlyle caused Authentix or Baird to fail to contact logical buyers, contact too few buyers, or refused to work with any particular buy.” As a result, according to the Court, “while it is not dispositive, the comprehensive sales process that took a full year is indicative that Carlyle was not driven by a liquidity pressure to sell off Authentix for less than fair value.” Instead, the evidence demonstrated that “Carlyle was interested in moving quickly because of the volatility of Authentix’ business rather than due to liquidity pressure because of the fund life.” While plaintiffs contended, based on the plaintiff-appointed director Barberito’s opinion at the time, that extending the sales process would have led to increased value, the Court stated: “To sell now or wait for a better opportunity later? Absent a showing of a conflicted transaction, this is the very stuff of which business judgment is made.”

The sale to BWE was arm’s length and Carlyle did not stand on both sides of the transaction, such that business judgment rule review could be appropriate. The Court found that the sale of the Company to BWE was arm’s length. In so finding, the Court assessed the “vigorous” negotiations that preceded the final transaction terms. Authentix was able “to negotiate Intertek up to a bid of $115 million,” and, in reaction, “BWE increased its indication of interest to $115 million.” After being granted exclusivity, however, and conducting additional due diligence, Intertek reduced its bid from $115 million to $85 million up-front cash plus $30 million contingent on Authentix securing certain contract renewals and achieving certain financial results. In light of Intertek’s reduced offer, Authentix returned to BWE, which submitted an updated indication of interest at $105 million. After conducting further diligence, BWE “concluded that the fair upfront price for Authentix was between $60 and $70 million, significantly lower than its” prior bids. Following extensive back and forth negotiations, the Board voted to approve a sale of the Company to BWE in exchange for upfront consideration of $77.5 million, up to $9.8 million in additional consideration depending on obtaining payment of a customer receivable, and an additional $7.5 million conditioned on Authentix achieving certain 2018 EBITDA metrics (which Authentix ultimately did not meet).

Expert industry testimony not tied to the facts of the case will be accorded little weight. Plaintiffs introduced expert testimony and passages from textbooks discussing the private equity industry generally, such as “limited partners always want to know where they stand vis-à-vis liquidity,” “not returning funds on a timely basis . . . can be a black mark . . . to secure commitments for a new PE fund,” and “a fund’s fixed life cycle generally privde [sic] some structure over the expected cadence of realizations to LPs.” Reacting to this evidence, the Court found to “prove a liquidity-driven conflict of a controller, it is not enough to show a general interest in investors that a fund adhere to a timeline; a plaintiff must show sufficient evidence ‘of a cash need’ that explains why ‘rational economic actors have chosen to short-change themselves.’” In short, “‘sweeping characterizations’ of the ‘industry writ large’ are insufficient,” and the “private equity lifecycle ‘is not so formulaic and structured that the cycle itself [can] support an inference of a liquidity-based conflict.’”

Carlyle’s receipt of consideration for its preferred stock is not a non-ratable benefit. The Court rejected plaintiffs’ argument that Carlyle’s receipt of consideration for its preferred stock was a non-ratable benefit triggering entire fairness review absent a showing that Carlyle had a unique liquidity need. Without such a showing, Carlyle’s interests “were aligned with the common shareholders as the largest common stockholder of Authentix,” and it “had the most to gain from a higher sale value from distributions for its common shares, as the distributions for the preferred shares would remain as approximately the first $70 million in consideration.”

*Anna Boos is a law clerk in our New York office.