The private equity firm that trusted too much

Posted by Dan Primack

May 2, 2011 9:36 am

Even the best investment firms can make inexplicable mistakes in judgment.

General Atlantic is one of those private equity firms you don't hear too much dirt about. Maybe because it's based in Greenwich, where it can get lost amidst the hedge fund rabble. Or maybe because it doesn't raise traditional funds, instead relying on an "evergreen" structure that limits the flow of information to a small number of investors. Or maybe because it's generally considered one of the smartest shops around, having invested in such companies as Archipelago Exchange, Dice Holdings and Gilte Group.

Whatever the reason, one thing is clear: Even the best of us can have an off day.

For General Atlantic, that day was September 11, 2007. Earlier that summer, GA had sold Zantaz, a maker of content arching and electronic discovery solutions, to infrastructure software company Autonomy Corp. (AUTNF). The deal was worth approximately $400 million, of which $20.5 million was kept in escrow to cover any potential indemnification claims. For example, had Zantaz misrepresented its profit margins, Autonomy may have been able to tap that escrow.

[Before continuing, a quick point of minutia: After selling an asset, private equity firms often create a shell company to serve as the shareholder representative (the entity responsible for handling all post-merger details). Sometimes they outsource it. In this particular case, GA set up a limited liability company called GA Escrow LLC. So that is who technically held the $20.5 million in escrow -- not the GA fund which had held Zantaz in its portfolio.]

Okay, back to September 11, 2007: Autonomy sent GA Escrow a letter, requesting $8 million for losses allegedly caused by misstatements in Zantaz's financial statements. Among its complaints was that Zantaz had not disclosed $2 million in "material liabilities for fixed assets."

GA Escrow had 10 business days to object to the request in writing, but it did not do so. Instead, it simply instructed escrow agent U.S. Bank to release the money.

One would assume, of court, that General Atlantic complied with Autonomy's request because it reopened Zantaz's books and found them to be in error. But that's where this smart firm goes inexplicably dumb.

According to court documents, General Atlantic never examined the merits of Autonomy's claim. It simply complied.

In a subsequent lawsuit filed against Autonomy by General Atlantic, GA managing director and general counsel Chris Lanning said:

"Had I known the claims were not in any way based in fact, I would not have relied on the Notice and these representations and would have objected to the claims immediately."

In other words, GA believed Autonomy was telling the truth because Autonomy said it was telling the truth. It wasn't until GA participated in a conference call with former Zantaz CFO  Steve Klei that it felt something might be rotten in Greenwich. Klei told GA that the indemnification claims did not appear correct, at which point GA requested additional information from Autonomy (after the objection period had expired). After that, GA filed suit.

From a judge on the case:

"[GA] has persuasively argued, both in its papers and at oral argument, that its knowledge and experience have led it to believe that representations made by a large, publicly-traded company working with a reputable and prominent law firm will generally be truthful and have an adequate factual basis."

Does that mean GA would have investigated the indemnity claims had the buyer been a smaller, privately-held company? Or one using a regional law firm? Is this laziness? Gullibility? It's one thing to get swindled in an elaborate fraud like the Canopy Financial situation (in which a company raised PE funding based on forged financial audits), but quite another to get conned by something barely more sophisticated than a drunk panhandling for "food money."

Autonomy lost a motion to have the lawsuit thrown out, and ultimately reached an out-of-court settlement with GA. Terms of the agreement were not disclosed, except that they preclude GA from commenting on the situation (according to a firm spokeswoman).

I don't bring this all up today to embarrass General Atlantic, and the firm probably is wondering why I'm dredging up a case that officially closed last October (although I never saw it reported elsewhere). Two reasons:

(1) It's a reminder that Reagan's famous "trust, but verify" line applies to mergers and acquisitions. The idea that any PE fund would pay an $8 million claim -- or even an $8,000 claim -- without any investigation is astounding.

(2) GA's reason for not investigating seems reflective of a deeply-ingrained belief that the bigger the company, but smarter -- and more compliant -- the company. Never mind the countless times that such a belief has been proven false. It's like the capital markets' version of the Birthers. Just because the your professional friends and colleagues are trustworthy, it doesn't mean that everyone is. I'm not saying to be obsessively skeptical. I'm just saying to take a step back, and be smart.

Tags: General Atlantic, Private Equity