Does consortium bidding by private equity firms undermine competition?

Paralleling the boom in private equity deals in recent years has been a growing sense of alarm about these multibillion dollar transactions. One aspect that has elicited special concern is the growing trend of "club bidding" — the formation of consortia of two or more private equity firms to acquire companies at public auction. But determining whether consortium bidding undermines competition is not a simple matter, according to Elizabeth Bailey, clinical assistant professor of economics at the W. P. Carey School of Business.

Paralleling the boom in private equity deals in recent years has been a growing sense of alarm about these multibillion dollar transactions. The practice of buying large, public firms, then selling them for huge profits can invite suspicion, which is intensified by the enormous paydays, low tax rates, and extravagant lifestyles of the individuals who run these vast and largely unregulated pools of capital.

One aspect of the private equity boom that has elicited special concern is "club bidding," or the formation of consortia of two or more private equity firms to acquire companies at public auction. These alliances raise the specter of "monopsony" — the opposite of monopoly, or one big buyer dominating the marketplace and artificially lowering the price of the company being sold.

In October 2006, the New York office of the U.S. Department of Justice reportedly sent letters to several private equity firms requesting voluntary disclosures of information about consortium bidding. Shareholders of one target firm have filed a lawsuit against 13 private equity firms involved in club bidding. But determining whether consortium bidding undermines competition is not a simple matter, according to Elizabeth Bailey, a clinical assistant professor of economics at the W. P. Carey School of Business.

While it may seem logical to conclude that that when private equity firms collaborate there will be fewer bidders in the market, the opposite actually can be the case, according to Bailey. "You have to look at other theories, and one of these finds that having consortia can increase competition," Bailey says. "There are a lot of reasons why consortium bidding can be a good thing."

Clubs yeild big deals, joint bids

In an article in the April 2007 edition of the journal The Antitrust Source, Bailey outlines the complex factors at work in club bidding. She describes the reasons private equity firms might choose to collaborate and how to evaluate whether these arrangements promote or hamper competition.

There is no question that club bidding is a growing trend involving some of the biggest names in the field, according to Bailey. In August 2005, a consortium of seven private equity firms — including Bain Capital, the Blackstone Group, Goldman Sachs Capital Partners, and Kohlberg Kravis Roberts — acquired SunGard for $11.4 billion. A few months later, a consortium that included the Carlyle Group and Merrill Lynch Global Private Equity purchased the Hertz Corp. for $15 billion.

A year later, an $18 billion buyout of Freescale Semiconductor was executed by an alliance that included the Blackstone Group, the Carlyle Group, and Texas Pacific Group. When private equity firms submit joint bids, the reason could be that none of them have the resources to do so individually, Bailey points out.

This is not a far-fetched notion, she asserts, given the sky-high prices firms have sold for and the limited funds available to non-marquee private equity firms. There are about 2,700 private equity firms in existence and only about ten have funds of more than $8 billion. Club bidding thus can increase the number of bids submitted for a company, according to Bailey.

"Most private equity firms do not have funds large enough to permit them to submit a bid individually for very large target companies," she writes. Also, private equity players often are not the only bidders at auctions. Firms that have been competitors with the target company sometimes are in the mix, as are companies that have been suppliers to the target firm or buyers of its products or services.

A private equity firm also might have the resources to bid for a company but not want to take the risk of a high stakes deal. A consortium spreads the exposure among several companies and allows a private equity firm to be involved in a bid that it otherwise would shun, according to Bailey.

Avoiding the winner's curse

Bailey identifies one other reason consortium bidding can produce higher prices: It allows potential buyers to pool information and avoid a phenomenon known in economics as "the winner's curse." In a typical auction, bidders do not know what each other's assessment of an object's value is. Winners tend to be the bidders who have overestimated the object's value. At the auction's conclusion, the winner realizes this, and suffers winner's regret.

Thus, participants in an auction tend to reduce their bid prices to avoid the winner's curse. However, when bidders share information — which is what happens in club bidding — they may find others who agree with a high valuation, and the outcome tends to be higher bids. Bailey does not overlook the potential for consortia to soften competition and drive down prices paid for companies.

In repeated auctions, bidders can observe the actions of rivals and learn to signal intentions to each other. This occurred when the Federal Communications Commission auctioned wireless spectrums in the mid-1990s, she notes. "By embedding three digits at the end of their bid amount, bidders were able to signal to rival bidders which licenses they wanted to purchase and signal which of their bids were submitted in retaliation for continued aggressive bidding by rival bidders," she writes.

The potential for this sort of behavior exists in auctions of companies because so many of the auctions involve the same private equity firms, according to Bailey. And the existence of consortia creates even greater risk of intentions being telegraphed, she says.

In joint bids, firms discuss explicitly such matters as bid price, governance of the firm being acquired, and exit strategy. She writes, "In communicating this type of information to one another, private equity firms may reveal intentionally or unintentionally, their strategy with respect to other companies that are expected to come on the block in the future."

Sorting out the evidence

So how is one to know whether consortium bidding is stifling competition or promoting it? The question obviously is important to regulators, lawmakers, investors, and interested observers. Bailey suggests several strategies for making a determination. The first step is to do a thorough assessment of all of the other possible determinants of bid prices, she says.

Cost and demand factors related to the target company could have a strong influence. "You have to think of all of the factors that matter," she says. Comparative analysis also is essential, according to Bailey. She suggests establishing a benchmark — either the behavior of the same set of firms in a different time period or the behavior of a different set of firms in the same time span.

The questionable behavior then can be analyzed in relation to this benchmark. "Sometimes people just look at the time period or the people they think are engaging in anti-competitive behavior in isolation. You always need to compare it to something," Bailey says. If one suspects collusion is driving down prices, the precise method of the scheme needs to be hypothesized, according to Bailey.

One possibility is an agreement by consortium members not to bid against one another in other auctions. Another Bailey cites is false bidding, which simulates the appearance of competition while providing a clear path for another bidder. "You have to have a theory of how it works," she says. Finally, alternate hypotheses need to be ruled out before a charge of anti-competitive behavior can be credibly made, according to Bailey.

She suggests analyzing economic data to see if the valuations of target companies match with bid prices. Bailey stresses that although club bidding may appear questionable on its surface, a thorough and reasoned analysis is required before any conclusions are drawn. "There are numerous reasons why bidding consortia may have no effect on competition and may in fact lead to more aggressive bidding for companies on the auction block."

Bottom Line:

• Club bidding by consortia of private equity firms has sparked concern that competition could be stifled by a small number of buyers. Some of the biggest players in private equity have formed consortia to buy target firms in multi-billion dollar deals.
• Consortium bidding actually can increase competition by bringing in bidders who would not have the resources on their own to compete in auctions for large firms.
• When firms in a consortium share information, they actually can push sale prices upward by reducing the effect of the phenomenon identified by economists as the "winner's curse." In certain auctions in which the principals do not communicate, prices can be depressed because bidders do not want to get stuck overpaying for something.
• Club bidding does create a risk that private equity firms will learn enough about each other when collaborating that they will signal their intentions to each other when they bidding in a public auction at another time.
• Determining whether an instance of club bidding is anticompetitive requires a thorough analysis, using comparative data and ruling out alternative hypotheses.

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