Sponsor-Controller Cleared of Conflicts in Sale Near Fund’s Term End

In Manti v. Authentix, minority stockholders of Authentix Acquisition Corp. (the “Company”) challenged the $87.5 million sale of the Company by private equity firm The Carlyle Group to private equity firm Blue Water Energy, LLC (the “Merger”). In an earlier decision in the case—issued seven years ago at the pleading stage of litigation—the court had found that the Merger potentially was a conflicted-controller transaction in which Carlyle had received a non-ratable benefit based on the liquidity needs of its soon-to-expire fund (the “Fund”) that had invested in the Company. The court had, therefore, at the pleading stage, declined to dismiss the Plaintiffs’ claims; and held that the entire fairness standard of review presumptively applied and Carlyle and its representatives on the Company’s board may have breached their fiduciary duties by causing a quick sale to coincide with expiration of the Fund’s term. Now, seven years later, the court, in a post-trial decision issued January 7, 2025, concluded instead that the Merger was not a conflicted-controller transaction. Therefore, business judgment review applied and the case was dismissed.

Key Points

• Generally, a private equity sponsor and its affiliated directors will not have liability for timing a portfolio company’s exit in alignment with expiration of the term of the fund invested in it—at least where the sponsor received pro rata consideration in the sale and the record does not establish that the sponsor and the board failed to seek to maximize value in the sale. The court emphasized that Carlyle, as would usually be the case for a sponsor-controller selling its portfolio company to a third party, had the same interest as the other stockholders in maximizing stockholder value on the sale.
• It is only in narrow circumstances that, on the sale of a portfolio company, a sponsor may be deemed to have had a liquidity need that invokes entire fairness review of the sale. Manti reaffirms the line of cases (including Synthes (2012) and Larkin (2016)) holding that although the private equity investment model contemplates liquidity for the sponsor after a certain investment period, the model in and of itself does not create a conflict for the sponsor such that entire fairness review applies. Rather, a liquidity-based conflict arises only where the particular sponsor at issue has a particular exigent need for immediate liquidity (not just a desire to sell the portfolio company to be able to close out a fund or to start a new fund), and, generally, in addition, the sale process indicates that the sale was in the nature of a fire sale.
• Manti highlights the benefits of an appropriate sale process. After trial, the court concluded that the sponsor did not have a disabling conflict and did not receive a non-ratable benefit that disadvantaged the minority stockholders. The court stressed that the sponsor engaged in a board, arm’s-length sale process that included vigorous negotiations with competing bidders. Accordingly, the court applied business judgment review—even though the sponsor was a controller; the court found that a majority of the Company’s board was not independent of the sponsor; the sponsor did not dispute that it wanted to sell the Company because the Fund’s term was expiring; the sponsor’s interests arguably diverged to some extent from the other stockholders’ interests due to the sponsor’s ownership of Company preferred stock (which received almost all of the consideration in the Merger); and the sale process included neither an independent special committee nor approval by the unaffiliated stockholders.
• Manti also highlights, however, the risk to a sponsor, in some cases, of not being able to achieve at the pleading stage of litigation dismissal of fiduciary claims based on alleged liquidity needs. As noted, the recent decision dismissing the case came seven years after the court declined to dismiss the case at the pleading stage. We note, however, that the factual context in which the court reached its pleading-stage decision included that: the board process did not exclude the sponsor-affiliated directors; the board process excluded a director who objected to the timing of the sale; the sponsor allegedly exerted pressure on the directors for a quick sale; and arguably the sponsor received a non-ratable benefit from the Merger as it obtained a profit on its preferred stock investment in the Company while the holders of the common stock received almost nothing.

Background. The Company sold “tracers” that it applied to products (such as barrels of oil) so that the products could be readily authenticated, in order to prevent fraud and counterfeiting. The Company’s prospects were volatile, as demand for the tracers was subject to a high level of uncertainty given that the client base was small and mostly comprised of foreign governments.

Carlyle and its affiliates controlled the Company through the Fund’s ownership of 70% of the outstanding preferred stock and 52% of the outstanding common stock. The Fund’s partnership agreement had a standard term of ten years, which was to expire on September 30, 2017. The agreement did not impose a contractual obligation to exit any particular investment upon expiration of the Fund’s term.

In 2016, the Company’s board of directors (the “Board”) commenced a process to sell the Company. At the time, the Company faced several business challenges, including the non-renewal of certain major contracts by the counterparties. Following a broad sale process, the Company was sold to BWE in late 2017.

Certain minority stockholders of the Company brought suit, claiming that Carlyle’s private equity business model required that it sell the Company in 2017 (by or close to expiration of the Fund’s term), regardless of price. The Plaintiffs contended that, as a result, Carlyle caused the Board to run a sale process that was unfair to the minority stockholders, with Carlyle obtaining the non-ratable benefit of a timely exit from the Company for the Carlyle investors’ interest in the Fund. The Plaintiffs claimed that the Board knew that waiting a year to sell the Company would have yielded more than twice the consideration paid by BWE, as uncertainties regarding the Company’s key contracts would have been resolved. They argued that, as Carlyle received a non-ratable benefit in the Merger, the Merger was a conflicted-controller transaction to which the entire fairness standard of review applied. They sought damages based on the higher price that they claimed should have been obtained for the Company absent a fire sale.

In a pleading-stage, decision (2022), Vice Chancellor Glasscock had declined to dismiss the claims, and held that entire fairness presumptively applied. (See our Briefing, Sale of Portfolio Company is Subjected to Entire Fairness Review.) A 7-day trial was held in January 2024. In the post-trial decision (Jan. 7, 2025), the Vice Chancellor concluded that Carlyle did not receive a non-ratable benefit from the sale. The court held that therefore the business judgment standard of review applied; and the court dismissed the claims.

Discussion

The court rejected the Plaintiffs’ argument that Carlyle received a non-ratable benefit because the sale resolved the pressure on Carlyle to sell the Company prior to expiration of the Fund’s term. The court found that Carlyle was not “under compelling pressure to sell” the Company prior to expiration of the Fund’s term. Any pressure on Carlyle to sell the Company near the end of the Fund’s term was not “such that [Carlyle’s] self-interest, shared with the minority, to maximize value was overborne,” the court wrote. The court observed that, under the Plaintiffs’ view, “[s]o overweening was Carlyle’s need [to sell the Company], apparently, that it left more than $100,000,000 of value behind, of which more than 50% would have flowed to Carlyle.” The court noted that:

• No contractual deadline to sell. Under the Fund’s Limited Partnership Agreement, there was no deadline imposed for selling the portfolio companies. To the contrary, Carlyle could continue to hold portfolio companies beyond expiration of the Fund’s term; and Carlyle had previously held portfolio companies beyond expiration of its funds’ terms.
• Term could be extended. Under the Fund’s Limited Partnership Agreement, with consent, the Fund’s term could be extended to permit further investment in portfolio companies. Indeed, Carlyle had been considering seeking (and, after the Merger, sought and obtained) an extension of the term so that it could continue to invest in two other (albeit smaller) remaining portfolio companies.
• No pressure from investors. There was no evidence indicating that Carlyle’s investors were pressuring it to sell the Company as soon as possible. Fund investors had sent emails to Carlyle requesting updates on the Fund’s performance and the potential timing of exits—but these were not the equivalent of “pressure for immediate liquidation of the Fund.”
• Extensive sale process. The court viewed “the comprehensive sales process that took a full year” as “indicative that Carlyle was not driven by a liquidity pressure to sell off [the Company] for less than fair value.”

The court rejected the Plaintiffs’ argument that “fund investors’ well-understood expectations” put pressure on Carlyle to sell quickly. The court acknowledged that fund investors have a “general interest” in the fund’s adhering to a timeline under which portfolio companies are sold within the fund’s term. If fund managers do not adhere to that timeline, the court acknowledged, it is a “black mark” against them when they seek commitments for new funds; while, conversely, “returning capital on a timely basis [gets them] a five-star rating.” However, the court stressed, “[t]o prove a liquidity-driven conflict of a controller, it is not enough to show a general interest in investors that a fund adhere to a timeline; a plaintiff must show sufficient evidence of a cash need that explains why rational economic actors have chosen to short-change themselves.” The court wrote: “Sweeping characterizations of the industry writ large are insufficient. And the private equity lifecycle is not so formulaic and structured that the cycle itself can support an inference of a liquidity-based conflict.” Rather, such a conflict would exist only where the particular PE firm at issue has a particular, compelling need to sell the portfolio company in a quick timeframe. We note that such a need might arise, for example, due to a severe cash shortage or a provision in the fund agreement requiring the sale of portfolio companies before expiration of the fund’s term.

The court rejected the Plaintiffs’ argument that Carlyle’s desire to move quickly in the sale process evidenced that it was subject to liquidity pressure. The court found that, to the extent Carlyle was interested in “moving quickly” with the sale, it was not due to liquidity pressure but due to the volatility of Authentix’s business. A Company director who represented Manti Holdings (an investor in the Company) testified that he had advised the Board before the sale that the Company’s prospects would improve over the following year; and he had advocated that the sale process should be suspended so that a higher price could be obtained. The court noted, however, that the other directors had testified that they had focused on the volatility of Manti’s prospects and had feared that “the momentum of the Company’s growth over the past four years would be lost, decreasing value.” There were risks associated with either course of action, the court stated—and “the case for delay [was] not of sufficient weight to cause [the court] to conclude that a ‘fire sale’ must have occurred, in light of the other evidence.”

The court rejected the Plaintiffs’ argument that Carlyle received a non-ratable benefit in the sale based on its having received most of the merger consideration through its preferred stock stake. Pursuant to the terms of the preferred stock, the first $70 million in merger consideration was payable to the preferred shares. That left $17.5 million of merger consideration for the common shares. Carlyle owned 70% of the preferred shares and 52% of the common shares. The court stressed that, absent Carlyle’s having had a unique liquidity need, Carlyle’s interests were aligned with those of the common stockholders— “Carlyle had the most to gain from a higher sale value…, as…for every dollar over $70 million, approximately $0.50 went to Carlyle.” Here, the court concluded there was not a non-ratable benefit for Carlyle—in a context where there was no evidence that Carlyle was making decisions based on its preferred stock ownership; Carlyle had conducted the sale process to maximize price; and Carlyle had made what appeared to be a reasonable decision not to wait to sell the Company. We would note that the court conceivably might reach a different result where less or no proceeds were received by the common stock; the controller owned less of a stake in the common stock; and/or there was more uncertainty as to the potential for other deals to accomplish a full take-out of the preferred stock.

The court rejected the Plaintiffs’ argument that Carlyle obtained a non-ratable benefit based on the sale eliminating potential applicability of the Fund’s clawback mechanism. The Fund’s partnership agreement included a usual clawback provision under which certain Carlyle affiliates faced potential disgorgement of funds that had been distributed to them for their carried interest if Company proceeds ultimately did not exceed the 7% preferred return (compounded annually) to investors. The Plaintiffs pointed to certain communications from Carlyle deal team members that discussed the clawback provision. The court viewed the emails, however, as “simply Carlyle deal team members discussing the possibility of [the Fund] entering clawback and the effects of such on personal distributions.” The emails did not, in the court’s view, indicate “any personal pressure,” nor a “specific intention” to avoid a clawback, nor that the clawback “was a potent motivator that colored their judgment.” In addition, the court did not view the clawback provision as “plac[ing] pressure on Carlyle’s deal team members to sell portfolio companies…in a fire sale.” Rather, the court concluded that the clawback was structured to incentivize Carlyle to: “(1) hold onto portfolio companies that are growing in proceeds, which generally protects against a clawback and increases overall proceeds for the fund…and (2) sell portfolio companies that are more likely to decline than grow in proceeds, which returns the capital to the limited partners and benefits all shareholders of the company through a sale prior to further decline.”

The court viewed the “comprehensive” sale process as supporting a finding that the sponsor’s potential conflicts did not disadvantage the minority stockholders. In the year-long process, the banker contacted 127 potential buyers (including 27 financial buyers); there were “fireside chat meetings” with 18 parties; four parties conducted full due diligence; and ultimately there were three competing bidders. There was no evidence that the sponsor caused the Company or the banker “to fail to contact logical buyers, contact too few buyers, or refuse[] to work with any particular buyer.” Also, the court stressed, the Company engaged in “vigorous,” “extensive back-and-forth” negotiations with the three bidders, including by using price increases by any of them as leverage to seek increases from the other two, and, after a decrease in price by the bidder to which exclusivity had been granted, again soliciting bids from the other two bidders.

We would observe that other cases potentially could be distinguishable, with a different judicial result, where: the sponsor had an exigent need for immediate cash; the fund’s partnership agreement required that portfolio companies be sold before expiration of the fund’s term and did not permit extension of the term; the fund’s investors exerted significant pressure for a sale of the company; the sale process or negotiation of terms was seriously deficient; and/or emails or other communications indicated that the sponsor’s need for liquidity strongly motivated the sale and the sale price indicated a fire sale.

Practice Points

• A strong record of a good sale process should be maintained contemporaneously. By focusing on maintaining such a record, a company may be able to avoid the court’s sustaining complaints at the pleading stage of litigation and then having to endure litigation to achieve dismissal of the complaints. As highlighted in Manti, a “good sale process” does not necessarily have to include an independent special committee, minority stockholder approval, or other special protections. Most critical is establishing what the business reasons were for the company’s decisions—with respect to the timing of the process and the sale, the potential bidders contacted and considered, the negotiating strategy, and so forth.
• A sponsor’s focus when selling a portfolio company should be to seek to maximize value in the sale. Where the sponsor has a desire for liquidity, its representatives and the other directors on the portfolio company board should understand the other business reasons motivating the sale and those reasons should be reflected in the record. Emails, issues lists, presentations, and other communications should be drafted with care to avoid any possible inference that the sale will provide a non-ratable benefit to the sponsor or that decisions were made based on the sponsor’s interests alone.
• When crafting a sale process, potential litigation risk should be taken into account. Generally, a sponsor-controller’s desire to achieve liquidity through sale of a portfolio company should not present a level of litigation risk that compels submission of the sale to approval by a special committee of independent directors and the other investors (i.e., MFW compliance). However, where there may be special concerns, a sponsor-controller should consider the benefits and disadvantages of MFW compliance (which leads to business judgment review), or of obtaining approval of an independent special committee (which shifts the burden of proof to the plaintiffs under entire fairness review). Accordingly, it is generally helpful to have at least some number of directors on the board who are clearly independent of the sponsor. Certainly, when there is little or no cost to taking an action that would improve the sale process, a board generally should take such action. For example, as highlighted by the pleading-stage decision in Manti, if a director opposes a proposed sale, absent a specific corporate reason to exclude the dissenting director, the other directors should listen to and consider the dissenting director’s views even though they may disagree with and ultimately reject them.
• A sponsor should be aware of its potential conflicts and proactively consider whether and how to address them. (i) The terms of preferred stock and the impact on distribution of merger proceeds, as well as the terms of any clawback mechanism relating to previous distributions to the sponsor and the incentives it creates, should be reviewed and considered. (ii) A sponsor should seek to have its fund’s organizational documents, if possible: not require that portfolio companies be sold before or close to expiration of the fund’s term; and permit extension of the fund’s term so that investment can continue to be made in portfolio companies. (iii) A sponsor defending against an alleged conflict based on liquidity needs should focus on its own particular circumstances supporting the absence of an urgent, crisis-level need for immediate cash. A conflict suggested by the imperatives or expectations inherent in the private equity (or venture capital) business model, or prevalent in the industry generally, should not be relevant.