Clayton, Dubilier & Rice did many of the right things, even in hindsight, when it acquired gun manufacturer Sporting Goods Properties (formerly known as Remington Arms Co.) in 1993 in a $300 million buyout.
However, the buyout firm did not anticipate that its portfolio company would be swept up in a cause against gun manufacturers, which recently has seen three pending high-profile lawsuits that could impact the investment.
The situation highlights an issue facing many buyout firms today. G.P.s are having a more difficult time managing companies that have unforeseen product liability risks in a litigation-happy environment. Meanwhile, with more buyout firms investing capital today than ever before, there now are more groups willing to invest in companies with potential product liability issues.
“If you look at the newspapers, the companies that have product liability are often subject to buyouts,” says Andrew Peskoe, an attorney at Golenbock, Eisman, Assor & Bell.
In the case of Clayton Dubilier-which committed $75 million in equity for the Sporting Goods Properties buy-the firm protected itself prior to the buyout by transferring indemnification from product liability lawsuits stemming from before it owned the business to the seller. It also has been a hands-on manager and has helped improve earnings in the company after sales slumped in the first three years of its investment. Sporting Goods Properties generated EBITDA for the year ending Dec. 31, 1998 of $64.2 million, an increase from $52.2 million a year earlier and $29.4 million in 1996. The company’s debt also has decreased to $146.9 million from $195 million in 1997 and $253 million in 1996.
However, that may not be enough to guarantee a decent return from the investment. A Federal court in New York ruled this winter that several gun manufacturers were liable for improperly distributing firearms that were used in crimes, marking the first case in which a jury has ruled against gun makers in a criminal negligence suit.
Although the suit was filed against handgun companies and not rifle manufacturers like Sporting Goods Properties or Savage Arms, which is partly owned by Fleet Equity Partners, it put everyone in the gun industry on notice. As a result, Clayton Dubilier as well as Fleet may now be wishing they had exited their investments earlier, sources say, even though neither company was named in the suit.
A buyer can protect itself when acquiring a mid-size private company by determining what it believes potential future liability costs could be and asking the seller to place that amount in escrow.
“There’s no doubt that people will use the lawsuit as leverage in bringing the price down in Remington,” says Lloyd Grief, chief executive of investment bank Greif & Co. “Someone could buy the company and segregate future lawsuits, and the quid pro quo might be a lower price.”
Clayton Dubilier hired Goldman, Sachs & Co. last year to consider strategic alternatives for Sporting Goods Properties, and the firm decided to grow the company by making add-on investments, rather than exit, said Michael Babiarz, a principal. Clayton Dubilier is comfortable with that decision, Mr. Barbiarz said, and will not look to exit its investment in the gun maker for at least another year.
Partners at Fleet Equity Partners did not return calls.
While buyout firms often invest in insurance packages or set up legal structures that can help eliminate costs from suits and future indemnification, it may prove impossible for firms, as in the Sporting Goods Properties case, to quantify the risks of falling value when buying these kinds of companies.
Analyzing liability risk tends to be subjective, and buyout firms often can look at the same situation differently.
For example, Charlesbank Capital Partners and Brentwood Associates last fall closed a $200 million buyout of Bell Sports Groups, a Los Angeles manufacturer of bicycle helmets (and formerly motorcycle helmets), each committing approximately $25 million in equity (BUYOUTS July 20, 1998, p. 10). The company, before the buyout, had three judgments that had been levied against it. These were cases where the plaintiffs were individuals and claimed the product did not protect them, and Bell is now appealing those decisions.
Charlesbank, however, feels comfortable with the investment partly because Bell has a history of aggressively defending itself and winning product liability suits, says Michael Choe, a Charlesbank associate who helped lead the investment.
To cover itself, the firm took out an insurance policy that protects it from lawsuits stemming from past incidents and accidents that might occur during its time of ownership, Mr. Choe says, adding the insurance does not cover the three suits the business is now appealing.
Many financial buyers looked at the company, and several could not become comfortable with the potential litigation issues.
“We are not in the business of buying companies that have that kind of risk. We factor potential liability in our investment decisions,” says Charles Ayres, a managing director at McCown De Leeuw & Co. who looked at the deal.
The Risk with Health Clubs
Meanwhile, McCown De Leeuw did take a risk in March when it bought Ray Wilson’s California Fitness Centers (now renamed Fitness Holdings Asia), an operator of health clubs in Asia, for about $40 million (BUYOUTS March 8, p. 12). The issue in that investment is that health clubs tend to be prone to sexual harassment suits, Mr. Ayres said.
McCown De Leeuw looked at the case history of the Fitness Centers and the political environment and made an assessment that it could quantify those risks, Mr. Ayres says. The firm has owned 24 Hour Fitness in the U.S. since 1994 and Fitness Holdings Europe since 1996.
“People perceive risk differently,” says Franci Blassberg, a partner at Debevoise & Plimpton. “It doesn’t mean one group is right and another is wrong. That is what makes this business most interesting.”
Sellers Make It Difficult for Buyers
G.P.s, because of their aversion to certain types of risk, always have been cautious about investing in companies that sell consumer brand products that could be subject to lawsuits. However, firms have targeted companies in the past that sell “dangerous” products and have sometimes paid the price-such as Zimmerman Holdings, which owned football-helmet manufacturer Ridell Inc.. Los Angeles-based Zimmerman lost most of its equity in the investment when a player wearing a Ridell helmet became paralyzed after he made a tackle and the helmet cracked, industry sources say.
“Clayton Dubilier is in a business that clearly has turned on them, and the clock is ticking, and they may have waited too long to sell.”
In spite of these war stories, competition is forcing more firms to consider riskier investments, including those with product liabilities. Even worse for G.P.s, buyout firms must walk through more minefields when making these investments today.
For one thing, because of the frantic auction process G.P.s are having a difficult time getting information from sellers about liability issues, sources say.
“There is an increased amount of reluctance for sellers to share information because they do not need to,” says Richard Colton, a managing executive vice president at AON Risk Services. He adds that many sellers know they will find buyers for their companies so they believe they can gloss over product liability issues.
Easton Sports, a manufacturer of baseball bats and hockey sticks, is a case in point.
The company held a limited auction last year that included financial buyers, says a G.P. who looked at Easton but declined to speak on the record. The company makes aluminum bats with a graphite composite that allows players to hit balls with greater force, sending them into the playing field at a greater speed than a wooden bat would allow. Major League Baseball, mainly for this reason, does not allow players to use aluminum bats.
“There is an increased amount of reluctance for sellers to share information because they do not need to.”
Several firms were interested in buying the business when a surprise hit them three days before the company was going to accept bids. The NCAA announced it too would be limiting the number of aluminum bats it would allow its players to use because it ruled that aluminum bats should be thinner and lighter to make them less dangerous. Easton sued the NCAA in August to try to stop the changes. The lawsuit also seeks $267 million in damages and is still pending. “We had no sense this was about to come down,” the G.P. says. Executives at Easton did not return calls.
Industries in which product liability problems arise go beyond sporting goods. G.P.s and intermediaries say pharmaceutical packagers and operators of health-care service companies, among others, also face similar issues.
G.P.s Can Suffer For Seller’s Mistakes
Buyout firms today also are buying more stakes in public companies and investing in more recapitalizations. In these transactions, the seller may not be able to pay a customer liability suit that stems from when it owned a company, so a plaintiff suing the company for accidents that occurred under prior ownership now may go after the current owner.
Charlesbank handled this potential problem when acquiring Bell, a former public company, by investing in an insurance policy that covered Bell’s past and current indemnification. This increased the company’s expenses but gave the owners a greater level of security.
Attorneys who structure agreements for buyouts of companies that have liability issues can protect groups legally in some circumstances.
Protection Possible with Private Cos.
A buyer can protect itself when acquiring a mid-size private company by determining what it believes potential future liability costs could be and asking the seller to place that amount in escrow, Ms. Blassberg said. The seller can receive the portion of the escrow back that is not used in product liability cases. This might be difficult to execute, though, when buying a highly desirable company, sources say.
However, public companies are a different matter. “There are not a whole lot of options when acquiring public companies,” says Ms. Blassberg, because all liabilities are assumed by the buyer when acquiring a public company.
When buying a corporate orphan, a deal can be structured so the seller can retain certain liabilities, and the buyer, in conjunction with the seller, can overlay a risk management program going forward, she says.
Debevoise & Plimpton, which represented Clayton Dubilier in its buyout of Remington from E.I. du Pont de Nemours & Co., believes the litigation exposure in Remington is well under control, Ms. Blassberg says.
Clayton Dubilier Defends Its Company
One downside is that the firm and company’s legal exposure may be limited, but so are its exit options, sources say. Companies like Sporting Goods Properties can likely be sold only to a strategic buyer because only they can absorb future product liability suits, lawyers and intermediaries say.
Sporting Goods Properties now is facing a suit in Arkansas stemming from the murder of four students and a teacher last year at a Jonesboro school. Relatives of the shooting victims are suing the gun manufacturer for a non-specified amount because it did not include trigger locks on its rifles, easily allowing Andrew Golden, then 11, and Mitchell Johnson, 13, to use the rifles when shooting their classmates. “The gun was inefficiently designed because it does not have a trigger lock,” says Jonesboro attorney Robert McDaniel, who is representing the plaintiffs in the case. “I clearly recognize we are on the cutting edge of litigation in this area.”
He is not alone. The City of Cleveland this month filed a similar suit against gun manufacturers for failing to add trigger locks.
The Jonesboro suit likely will go to trial in the coming year.
“There’s no doubt that people will use the lawsuit as leverage in bringing the price down in Remington. Someone could buy the company and segregate future lawsuits, and the quid pro quo might be a lower price.”
Meanwhile, there is some reaction supporting gun manufacturers in states in which people often hunt for sport. Georgia this year became the first state to prohibit cities and counties from taking gun makers to court.
This may give little comfort to financial and strategic buyers. For example, Jordan Cos. last year looked at buying a business that sold hunting gear and accessories but would likely not invest in a similar business today, says Partner Richard Caputo.
He adds that Sporting Goods Properties, the maker of Remington rifles, is a solid company and might still be attractive to a foreign strategic buyer or a firm already in the hunting industry.
Mr. Greif does not believe gun manufacturers should be liable for criminal acts caused by people who steal guns, but he adds that one has to look at the reality of the situation.
“It may have been an absurd judgment [in New York], but Clayton Dubilier is in a business that clearly has turned on them, and the clock is ticking, and they may have waited too long to sell,” he says.
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