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Wall Chair in Corporate Law and Governance
University of Missouri Law School

Thomas A. Lambert is the Wall Chair in Corporate Law and Governance and Professor of Law. Professor Lambert’s scholarship focuses on antitrust, corporate and regulatory matters.


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Antitrust Exam Question: Do the Major Institutional Investors Have an Antitrust Problem?

The Wall Street Journal is reporting that major institutional investors — CalPERS, CalSTRS, the Teacher Retirement System of Texas, etc. — have collectively adopted a set of recommended practices that is “rankling” private equity firms. Had I not discussed the article in my Antitrust class, I’d use it as the basis for an exam question. Here are the basics:

Private equity funds are normally organized as limited partnerships, where the investors are the limited partners (i.e., they lack management control, but their liability is limited to the amount of their investment in the firm) and the managers that make investment decisions are affiliated with a general partner, whose liability is unlimited. The rights of limited and general partners are set forth in a limited partnership agreement. The limited partners — largely institutional investors like pensions, endowments, etc. — typically compensate the managers by paying annual management fees and allowing them to collect “carried interest,” which is a share of the profits of the fund’s investment (assuming that the investment reaches a minimum rate of return or “hurdle rate”). Because limited partnerships are creatures of contract, all these arrangements are agreed upon from the outset. So are the rights of the limited partners.

In the last few months, a group of major institutional investors, the Institutional Limited Partners Association (ILPA), promulgated a set of investor principles that call for certain caps on fees, increased disclosure, particular methods for calculating carried interest, and greater investor oversight. The ILPA has 215 members controlling $1 trillion in private equity assets. In addition, the ILPA seems to be soliciting other (non-member) private equity investors to endorse its principles.

On first glance, this resembles a buyers’ side conspiracy: Multiple “buyers” of investment services have agreed not to purchase from “sellers” who do not adhere to preferred terms, including preferred pricing terms. If that’s what’s going on, then the arrangement among the institutional investors violates Section 1 of the Sherman Act, even if the parties to the agreement collectively lack market power. (See Footnote 59 of Socony-Vacuum.)

Not surprisingly, the members of ILPA insist that they haven’t “agreed” to withhold investments from funds that decline to follow the recommended principles. Instead, they say, their principles simply “reflect suggested best practices and are intended to serve as a basis for continued discussion among and between the general partner and limited partner communities with the goal of improving the private equity industry for the long-term benefit of all its participants.” They further maintain that “the authors, sponsors and the groups … that have provided an endorsement of these Principles are not specifically committing to (nor seeking the commitment of) [sic] any private equity investor to each and every outlined term.” Thus, they conclude, their mutual endorsement of a set of best practices does not constitute a contract, combination, or conspiracy to withhold investment funds from fund managers who fail to adhere to the recommended practices.

According to the Journal, though, the most prominent institutional investors are using these widely endorsed principles for more than just “a basis for continued discussion” with fund managers:

The nation’s two largest pension funds — the California State Teachers’ Retirement System and Calpers — have held discussions with each other about whether to insist that private-equity firms agree to the principles, according to people familiar with the talks. Texas Teachers has told at least one firm that the principles were non-negotiable and had to be accepted, according to people familiar with the situation.

Lawyers for private-equity firms also point to a public remark made by Calpers spokesman Clark McKinley in trade publication Pension & Investments. “We are collaborating with other investors in an effort to get better alignment with private-equity partners, including more favorable fees. This requires more than a unilateral action by any one investor,” Mr. McKinley said.

If the point of the principles is merely informational — i.e., to set forth a set of best practices that will minimize agency costs — then why solicit public “endorsements” of the principles? On this question, Mr. McKinley’s remarks are pretty revealing. They suggest that a single investor’s insistence on adherence to the principles wouldn’t work; fund managers would find other, more accommodating investors. But if all the major institutional investors adopted the same stance, the fund managers might have to give in to their demands. Could we infer an Interstate Circuit-like agreement from institutional investors’ parallel action in adhering to the principles?

If there’s no “agreement” to adhere to the principles themselves, could liability arise from the concerted action of signing on to the principles, thereby creating a “facilitating device”? I’m analogizing here to the data exchange cases, where the mere exchange of cost or price information among competitors can create antitrust liability even if there’s no agreement to adhere to specified prices. Data exchanges, unlike horizontal agreements to adhere to price schedules, are not per se illegal; instead, they are evaluated under a rule of reason that looks hard at the nature of the information exchanged (the degree to which it could facilitate price-fixing) and the structure of the market in which the competitors participate (the degree to which it is susceptible to cartelization). If a court were to analyze the principles as a facilitating device, it would likely examine their content — e.g., the degree to which they are specific enough to form the basis for price-fixing — and the “cartelizability” of investors in private equity funds. Under such a rule of reason analysis, liability is unlikely.

Even if a court were to conclude that actual price-fixing had occurred, it’s hard to imagine that it would impose liability on the institutional investors:

Buyout executives acknowledge that even if there are legal problems with ILPA members’ conduct, there is likely to be little sympathy for the plight of private-equity firms.

“Even if there was an antitrust problem from a legal perspective,” said one senior private-equity executive at a large firm, “I don’t see the Justice Department coming to the rescue of Henry Kravis and Stephen Schwarzman.”

Still, I think, this arrangement could form the basis for a pretty good Antitrust exam question.

UPDATE: Danny Sokol pointed me to this release from law firm Bingham McCutchen (or is it just “Bingham” now?). The antitrust lawyers there appear to agree that there are some tricky antitrust issues here.

Filed under: antitrust, markets, private equity