Friday Letter When is a flip too quick?

A dispute over a private equity firm selling a business within hours of buying it came to court in Australia this week. The outcome may be significant.  

In a week when political events in the United States have dominated headlines around the world, it's no surprise that the start of a federal court case in Australia on Wednesday went largely unnoticed by the world's press. But this is a case that could have some interesting ramifications for private equity – and not just in Australia.

It concerns a Canadian mining services company called Norcast Wear Solutions. In 2011, Norcast's private equity owner, the Swiss-headquartered group Pala, sold the business to US peer Castle Harlan for $190 million. Just seven hours later, Castle Harlan flipped the business to Australian listed business Bradken for A$202 million. Based on exchange rates at the time, that represented possibly the fastest $27 million profit in the history of the industry (imagine the IRR on that).

So, a triumph for Castle Harlan and its LPs? Not according to Pala. The firm is suing Bradken in Australia for at least $25 million in damages, claiming that the company engaged in ‘misleading and deceptive conduct’ and ‘bid rigging'. The latter is a relatively new addition to Australian law, and covers situations where companies in a position to compete against each other in a bidding process come to an arrangement not to do so. Pala's argument is that by using Castle Harlan effectively as an intermediary, Bradken was able to avoid paying the sort of premium that would normally have been expected of a trade buyer and thus – even if you take into account the money paid to Castle Harlan – get hold of Norcast on the cheap. (Pala is also pursuing legal action against Castle Harlan in the US, although the legal machinations aren't quite as advanced there).

Before the trial began, Pala was expecting the case to focus on whether a secret agreement existed between Castle Harlan and Bradken that was not disclosed to the vendor. In the absence of a smoking gun (a specific email detailing such an arrangement between the two businesses, for instance), it planned to piece together this argument from phone calls, emails, patterns of behaviour, chronology and so on. Then it would be up to the sitting judge to decide whether it could be inferred, on the balance of probability, that an agreement existed.

Pala had a couple of key points in its favour. First, the sheer impracticality of any buyer – strategic or financial – doing the proper due diligence, establishing a price and signing a deal for a new acquisition within seven hours. And second, the clear and long-standing links between Bradken and Castle Harlan, via CHAMP Private Equity, the latter's Australian affiliate. The two have done deals together in the past, and Bradken chairman Nick Greiner – an influential former politician who resigned as Premier of New South Wales in 1992 after a corruption row – is also deputy chairman of CHAMP.

However, the goalposts moved when Greiner – who's been named personally as a co-defendant, along with CEO Hodges – took the stand this week. Under cross-examination, Greiner reportedly admitted that there had indeed been an implicit agreement between Castle Harlan and Bradken before the original deal was signed – but this was only necessary because Bradken had previously been specifically excluded from the process by Pala. The latter hotly disputes this: it insists it had no reason to exclude any potential bidder, let alone one with as many potential synergies as Bradken. A banker from Goldman Sachs is expected to take the stand next week to confirm that he specifically approached Bradken on behalf of Pala about the Norcast deal.

So why does any of this matter? Two reasons. One, establishing collusion in this kind of situation is no easy task; just ask the US Department of Justice, which has supposedly spent the last six years trying to prove that some of the world’s biggest buyout firms colluded unfairly on various boom-era deals. So a successful prosecution here may provide a template for future cases (albeit the precise rules will obviously differ between jurisdictions).

And two, in a world where private equity continues to face a serious image problem (even post-Romney), the industry needs to be focusing people's attention on deals where it adds clear value to a business over a period of time. That's not to say quick flips are always a bad thing; if a private equity owner gets an approach for a business early on in its investment period, and the deal makes financial sense for the firm's LPs, it would be remiss to ignore it. However, since quick flips are more likely to attract negative attention, it's important that the industry is vigilant in making sure that any sharp practices do not go unpunished. It may be that in this instance, Castle Harlan is 'guilty' of nothing other than buying low and selling high. But the fact that it's having to justify its actions is no bad thing.

The trial is due to conclude next week, with a verdict expected sometime in the next two months. Watch this space.

PS: If by chance your appetite for US election coverage hasn't been sated yet, here's our take on the likely consequences for private equity – and for Bain Capital specifically (clue: the election may not be its biggest issue).