Friday Letter: Minority Issues

Control empowers those agents of change that transformational investors like private equity firms expect to deploy. In comparison, minority positions run the risk of depriving new owners of the means to put theory into practice. And in the meantime your portfolio company can fly into the ground.

The dangers of the minority stake have been colourfully illustrated by the shenanigans surrounding the tempestuous relationship between Washington DC-headquartered buyout house The Carlyle Group and French paper products manufacturer Otor, in which Carlyle invested €45 million for a 20 percent stake in February 2000.

The initial deal might have been euphemistically termed ‘opportunistic’ given that the target company had made losses in the two preceding years. Presumably in acknowledgement of this poor trading record, the shareholder agreement included provisions for Carlyle to assume majority control of the business should Otor fail to meet certain specified profitability targets. The incumbent management (who remained with the firm after the deal) acquiesced. But two years later, in March 2002, when Carlyle claimed that these targets had not been met Otor’s founding managers pushed back – and thus began a tortuous legal process.

Taking its case to a Paris arbitration panel, Carlyle might have hoped for a swift judgement. If so, it was forced to think again. Earlier this month – more than three years after the opening submissions – Carlyle finally emerged triumphant. Ruling in favour of the US investor, the court instructed Otor to convert bonds held by Carlyle into shares, handing it ownership of around 80 percent of the company.

Blair Thompson, a lawyer at London-based law firm SJ Berwin, is not surprised by the length of time taken reaching judgement. “Such cases will always be heavily disputed because you will have one party saying ‘you didn’t perform’ and the other saying ‘the problems at the company were not our fault’. It all comes down to how tight was the initial agreement, but the agreements are not uniform: there will be very different performance stipulations depending on, for example, what type of deal it is, what sector the business operates in and who is the private equity firm.” And hence there’s plenty of room for very different interpretations of the wording. And the possibility of very big legal bills as a result.

Perhaps all that time spent waiting for a decision would not have been so bad if it hadn’t been for the extraordinary battle between Carlyle and the Otor founding management team of Jean-Yves Bacques and Michele Bouvier that was being conducted as a highly colourful backdrop to proceedings. The rancour involved made it clear that there had been a profound breakdown in the relationship between the two sides.  

Fortunately, says Thompson, spectacular fallouts like this are likely to be few and far between. “You can sometimes get situations where the performance conditions are heavily negotiated at the time of the investment and then post-deal it all blows up into a real dispute. But you only find yourself in court if there’s been a fundamental breakdown of understanding and the two parties are moving in completely opposite directions.”

In the case of Carlyle/Otor, it seems that is precisely what happened. Perhaps there are lessons to be taken on board, the first of which might be for buyers to make sure they rigorously undertake an aspect of pre-deal due diligence that can often be overlooked: stress testing the management. The second is to make sure that the language of shareholder agreements signed at the time of a deal is as tight as it possibly can be, and binds management to very specific targets – ones with hard numbers and unambiguous criteria and modes of calculation.

Perhaps the most important lesson of all though is to take minority stakes only in exceptional circumstances. Being a control freak may not be a glowing endorsement of an individual, but it’s a healthy attribute for a buyout firm who intends to transform an acquisition.