Sunday, October 22, 2006

Private Equity and Venture Capital Firms Acting Anti-Competitively?

An interesting story last week suggested that the Justice Department was investigating private equity firms for possible anti-competitive behavior.

Just this last spring, a student of mine at Tuck did an independent study on the incentives and potential for cooperative behavior in the private equity and venture capital arenas. How's that for prescience?

Justice's focus appears to be on private equity firms and their behavior in auctions for companies (by the way, I have a paper with exactly that title: "Auctions of Companies", Economic Inquiry Vol 39 Issue 1 January 2001). Judging from the news reports, the investigation focuses on behavior by the firms that could reduce competition in the auctions and result in lower prices. This reminds me a bit of claims that the major audit firms were not aggressively competing against one another in bidding for audit jobs, since they realized that they were in a repeated game with the same players. Certainly there are good arguments from game theory to suggest that in a repeated context there are numerous strategies that evoke ongoing cooperative behavior and overcome any tendency to the classic "prisoners' dilemma." One strategy that has gotten a lot of play in theory is "tit for tat." In the private equity world, this would mean that if one firm were to bid aggressively for a company in one auction, then in the next auction a competitive private equity firm would bid aggressively just to punish the first firm. Of course, in the Middle East tit-for-tat seems to cause unrelenting cycles of escalating retaliation...

This is also nothing more than an interesting theoretical possibility without any convincing empirical evidence. And the story can be applied to almost every industrial setting where a relatively small number of firms compete with one another in a repeated context. So at this point it sounds like a Justice Dept. fishing trip.

My student and I were more interested in other areas where cooperation would pay. This story goes back to work by John Lott and myself: "Externalities and Corporate Objectives in a World with Diversified Shareholder/Consumers," Journal of Financial and Quantitative Analysis, March 1996.

Suppose one venture capital firm has investments in two portfolio companies, which we will call A and B. What if A and B have some competitive fronts, or even more interesting, areas where there are complementarities? Then the venture capitalist should internalize those externalities and make sure that the two firms act so as to maximize their JOINT value rather than maximizing values independent of one another. If the two firms are interacting competitively, then joint value maximization could be contrary to consumer welfare, but if the two firms interact with complementarities, then joint value maximization would enhance consumer welfare.

Or to take it another step, suppose there are two venture capital firms, VC1 and VC2. And suppose that, through the syndication process, each venture capital firm has investments in both of the client firms A and B. Typically in these situations, one VC firm takes the lead investment role in each syndication. So VC1 might be the lead in Firm A and VC2 would be the lead in Firm B. On the surface, since the two VCs would have unequal stakes in the two clients, they would not each have incentives to maximize joint value of A and B. However, if VC1 runs Firm A as to maximize value of A at the loss of value to Firm B, VC2 will suffer. Similarly if VC2 runs B so as to destroy value at client Firm A, then VC1 will suffer. The two VCs might see that they would both be better off if they managed their clients with an eye to joint maximization. As with the private equity firms, any such coordination like this is much more likely to arise if VC1 and VC2 are in repeated syndications.

In 1953, the US government brought suit against 17 investment banking firms (US v. Morgan et al), alleging that they had used the syndication system as a means to perpetuate their coordination in investment banking. The case was lost, with the judge concluding that the defendants had acted independently and that the syndication system had an efficiency role to play.

My prediction is that history will repeat itself. Maybe this time we will be spared the cost of an extensive fishing trip. On the other hand, maybe the guys in Justice agree with me on something: A bad day fishing is better than a good day at work.

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