Apollo Makes A Bad Call

I have never used this space to write about the protracted battle between Huntsman Corp. and Hexion Specialty Chemicals. And it would seem that the opportunity has passed me by, given that both sides recently agreed to a termination of their $6.5 billion merger agreement, and to a $1 billion settlement of Huntsman’s litigation against Hexion owner Apollo Management.

But I beg of your indulgence, because I’ve been left with a nagging question since the settlement was announced on Sunday night: Namely, who exactly is paying the various pieces of that $1 billion? To be sure, it isn’t all coming out of Leon Black’s pocket. Perhaps more importantly, some of the pockets involved seem to be getting picked.

What follows is based on interviews with limited partners in some, or all, of Apollo’s past four funds. In addition, peHUB has obtained confidential correspondence that Apollo sent its investors on December 15. Apollo itself declined to comment.

To begin, it’s important to understand the origins of Hexion and it was planning to pay for its acquisition of Huntsman.

Hexion was officially formed in 2005 as a roll-up of three different chemical companies: Borden Chemical, Resolution Performance Products and Resolution Specialty Materials. Apollo held Hexion as a portfolio company of both its fourth and fifth funds, because the Resolution investments were originally made out of Fund IV, while Borden was made out of Fund V. Apollo had also ensured that the investments were profitable for limited partners of both funds, via dividends.

By the time Hexion agreed to acquire Huntsman, however, Apollo was in the midst of investing its sixth fund and was talking about raising a seventh. Its solution was to fund the equity portion with the newer money. Funds IV would get cashed out (I’m not certain about Fund V), which was welcome news given that the vehicle was raised back in 1998.

Fast forward to last Sunday, when the deal officially died. In its official statement, Huntsman said that the agreement included an aggregate of $1 billion in considerations. This included:

  • Huntsman would receive a $325 million breakup fee, to be paid by banks Credit Suisse and Deutche Bank.
  • Huntsman would receive $425 million in cash payments from “certain Apollo affiliates.”
  • Apollo affiliates would buy $250 million for 10-year convertible notes, which could be converted into Huntsman common stock or repaid in cash at maturity.

My assumption was that Apollo would pay most of the settlement out of its newer funds (and perhaps via its publicly-traded AAA affiliate), since they were the ones that stood to profit had the merger gone through and proven financially successful. Moreover, they were the ones financing it in the first place. At worst, it would share the pain pro rata with Funds IV and V.

What Apollo actually did, however, is troubling. Here is what it told LPs, as part of its Dec. 15 letter:

“Under the settlement, Apollo Funds IV and V will pay Huntsman $225 million. An affiliate of the General Partner will pay $200 million to settle all claims, and we are hopeful that a portion of these payments will be covered by existing insurance policies. Apollo entities will also be sharing certain proceeds when and if received by Huntsman as a result of the Texas litigation against the banks were it to settle. This is a potential offset to the settlement payments.

In addition, Apollo Fund VI and its co-investment affiliate AAA have agreed to purchase $250 million of senior convertible notes of Huntsman, with a 7% interest rate and a conversion price of $7.86. Based on updated macro-economic assumptions, this investment is underwritten to a mid 20’s internal rate of return.”

To be specific, Fund IV is being asked to pay $70 million, while Fund V is being asked to pay $155 million. In other words, the only Apollo funds paying actual penalties – monies that cannot be recovered by future performance of Huntsman common stock – are the only two funds that could never have profited from the Huntsman-Hexion merger, had it gone through. Fund VI and AAA, on the other hand, don’t pay a dime in unrecoverable monies.

But wait, it gets worse. Not yet reported is that Apollo also decided that Funds V, VI and AAA would invest an additional $200 million into Hexion “for general business purposes… This investment will be senior to the common equity.” In other words, not only does Fund IV pay out instead of cashing out, but now it’s getting crammed down on its remaining Hexion stake. 

Imagine being an LP in Fund IV but not in Fund VI (and there are some). If it were me, I’d be on the phone with my lawyer before sending out a check by next Tuesday’s due date.

Apollo obviously won’t explain itself to me, but one theory is that Fund IV is no longer allowed to make new investments, due to its advanced age. In fact, the Fund IV capital call letter refers to the payment as an “operating expense.” Again: If you’re an LP in all three funds, this doesn’t matter a bit. But if you’re only in Fund IV, only in Fund V or only in both of them, you’re getting taken advantage of.

Whole thing reminds me of a political campaign I was once a part of. Everyone worked the field on election day, and we were told during orientation to knock on our voters’ doors at least five times throughout the day. Someone pointed out that such persistence might actually annoy our voters, particularly if they’d already gone to the polls. Our field director replied: “If they’ve already voted for us, then we can’t lose their vote. It no longer matters if we annoy them.”

Apollo apparently believes that its Fund IV and Fund V LPs have already voted. It no longer matters if they get annoyed.

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7 Comments

  • You said that Fund IV stood to cash out if the acquisition went through as it would’ve been funded by Fund VI. Since Fund IV had a benefit of being cashed out, doesn’t that mean that they were also on the line should it not go through?

    I’m not for/against Apollo, but just wanted to understand the logic of whether Fund IV was actually penalized if they stood to benefit initially.

  • Richard,

    I’ve also wrestled with that a bit over the past few days. Seems to me, though, that the fund(s) that agree to do the deal should be the ones penalized for not doing the deal.

    Imagine a different deal whereby Fund IV and V opted to simply sell most of Hexion to Huntsman. Under this deal, the unsold part of Hexion would be transfered to Fund VI (so that IV and V can wind down faster). Then Apollo balks and agrees to pay a settlement. Should Fund VI be penalized? I don’t think so. Not exactly apples to apples, but close. To me it’s a question of active vs. passive.

  • I think you’re being a little harsh on Apollo. Cross-over investing is tricky business, but I’d be shocked if the limited partnership agreements didn’t explicitly authorize Apollo to engage in it. If the LPs in Apollo IV & V are unhappy with this state of affairs, they should negotiate a more restrictive cross-over investing covenant in future funds. Moreover, don’t forget that even on basic fiduciary duty principles, Apollo would have distinct duties to protect the interests of its LPs in IV vs. V vs. VI. In other words, any deal that protected the old money might pose a dilemma with Apollo’s Fund VI investors—further underscoring why cross-over investing is tricky business.

  • Understand – my sense is that if one stands to benefit, one becomes a party to the transaction in some form and as such shares in the gain as well as the pain. Not sure how this unfolded in any docs/agreements in this case. The 2nd example isn’t exactly apples to apples, but as a party to a transaction, Fund VI may be a party to…

    I recognize your point and you’re right that there’s two sides to this. Fact of the matter is, we see who experiences the pain in this case.

  • Richard,

    understood… BUT: isn’t what apollo’s doing benefitting fund vi investors
    over funds iv/v investors? iv/v have to pay unrecoverable penalty, while vi
    gets to make investments in common stock.

  • I think it’s too early to tell. Hexion faced a real risk of being hit with
    a much larger judgment in Texas, so the settlement may very well have
    preserved a lot of the equity value of Hexion (which directly benefits Fund
    IV and V investors). As for the new money coming in at a senior position, I
    think this just reflects the nature of today’s financing market. That is,
    if it were KKR instead of Apollo who was providing the new funding, KKR
    would certainly demand a senior position (and may in fact demand much more
    dilutive terms given the fact that they don’t know Hexion nearly as well as
    Apollo).

    Ideally, Fund IV would participate in the new financing on a pro rata basis,
    but I think you’re correct in assuming that Fund IV is probably tapped out
    except for reserves for management fees (which is why they are probably
    calling the settlement payment an “operating expense”). For what it’s
    worth, the exact same thing happened during the dot-com blowout when VC
    funds ran out of money to fund existing portfolio companies, thereby
    requiring future funds to provide the cram-down financing. This poses some
    difficult fiduciary duty questions for the GPs, but if the fund is
    structured as a Delaware limited partnership, the LPA can permit cross-over
    investing which is what I assumed happened in Apollo IV. If true, this is
    why I don’t have a lot of sympathy for the LPs, who should have learned
    about this risk during the dot-com meltdown.

    By the way, if Fund IV’s settlement money is really coming out of management
    fees, then the LPs shouldn’t be upset at all since this just comes out of
    the pocket of Leon Black.

  • Great reporting. Not much “open” talk about this yet in LP circles. It will be interesting to see how LPs are going to react to the spahgetti mess created by this. The work involved for an LP to have a lawyer look over this, as you rightfully suggested, is expensive, time consuming and as we know tough to go to court for a resolution. Further, I bet many LPs will find themselves conflicted depending on how many and which Apollo funds they have stakes. Overall this is not good for the industry at a time when investor confidence is shaken.

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