Private Equity’s Competitive Landscape

I spend an unhealthy amount of time with venture capitalists, which means that I’m regularly badgered about creating or joining a startup. During last week’s TechStars event in Boston, for example, it came up in three separate conversations.

I’ve got a variety of explanations (excuses?), but none of them involve a lack of consideration. In fact, peHUB was originally conceived as an independent venture. Even had a prominent journalistic partner, and productive conversations with investors.

What killed that effort, however, was a noncompete agreement that I (unwittingly) signed when Old Daddy Thomson listed in New York. Its enforceability was questionable, but it wasn’t a battle that I could afford to win, let alone lose.

All of this is preamble to establish my bias against noncompete agreements. They often do little more than cause massive headaches while delaying the inevitable (no boss, that’s not preamble). And, regrettably, they are playing a larger and larger role in private equity.

Last week I shared the story of Omega Funds, which has sued one of its former employees for breach of a noncompete agreement. Omega believes that the defendant – who claims to have left, in part, due to the embarrassment of Omega failing to fund its winning bid for a Boston Scientific portfolio — is using proprietary techniques and relationships to launch his own firm. A short trial is expected to begin late next month, with the defendant arguing that Omega’s special sauce is really just store-bought mayonnaise.

That case is quite specific, but the noncompete agreement is not. Attorneys tell me that most private equity firms require employees to sign some sort of noncompete agreement, with the severity and applicability varying based on firm preference and geography. In states where noncompetes are difficult to enforce legally (such as California), a common backdoor is to tie the agreements to ongoing economics (vested carry, for example). If you’re still effectively drawing compensation, it’s tougher to argue that you’ve made a clean break.

In almost all of these cases, however, the noncompete is designed to defend against people who leave voluntarily. This is typically spelled out in corporate America, where layoffs are common. Had I been fired, for example, I would have been free to join Thomson Clone Corp.

Private equity, though, isn’t quite so forward-thinking. Layoffs had long been the exclusive province of portfolio companies, so few investor noncompetes made the distinction between voluntary and involuntary departures. Then came the financial crisis, and headcount shedding at firms like Blackstone, Carlyle, TPG, etc.

Luckily, it does not appear that any of the above firms are enforcing noncompetes against laid-off employees. But at least one PE shop is being far less gracious: Sun Capital Partners, which has laid off more than 15% of its 200-person staff so far this year.

When employees joined Sun Capital, they agreed to a pair of provisions (I’m paraphrasing, as this comes from human sources rather than source documents):

1. Departed employees may not form a new (read: competitive) firm with other ex-Sun Capital employees, for two years following end of employment.
2. Departed employees may not join any other firm that has hired an ex-Sun employee within the past two years.

Sun’s separation agreements refer back to these provisions (note: one source said it’s a one-year period, but consensus is two years), and the firm has been very active in enforcing them. I’ve heard multiple stories about how Sun execs have called former employees who were interviewing for jobs at firms that already had a recent ex-Sunnie, and warned them about continuing. Same thing for folks who wanted to form a new firm.

I know of just one situation in which two recent ex-Sunnies are working at the firm, albeit in different groups. Unclear if Sun made an exception in this case, or simply doesn’t know about it.

Sun’s position is much like Omega’s: We have a proprietary way of doing business, and need to protect our interests – and those of our investors – by guarding against the creation of mini-Suns. And, unlike the Omega defendant, some laid-off Sun employees do believe that their former home has a unique way of doing business. They also acknowledge the validity of Sun’s legal position, while strongly disagreeing with it on moral grounds.

Let me concur with that dichotomy, but emphasize the second part. Sun is simply wrong to enforce noncompetes against employees it fired without cause (unless you consider drought-stricken fee-streams to be cause).

These people didn’t quit on Sun – Sun quit on them. If they were so important from a competitive perspective, why lay them off? This is an incredibly difficult environment in which to find work, and Sun has made it much harder for those it kicked to the curb. Every time an ex-Sunnie finds a job, that firm is suddenly off limits to others. And considering how few firms are hiring anyone at all…

The right to do something doesn’t make it right to do.