Singed by Refco's Scandal


By Aaron Pressman Legendary buy-out investor Thomas H. Lee won't manage the next private equity fund at the firm he founded in 1974, instead using his own money to invest in smaller, fast-growing companies, Businessweek Online has learned. It marks the first time Lee's firm will be in the market without him, even as he helps the firm try to rescue its multimillion dollar investment in bankrupt Refco (RFX).

Lee, 61, has been scaling back his involvement in Boston-based Thomas H. Lee Partners for some time, but the latest move to invest separately and with his own money signifies a further break. The firm has been telling potential investors in its upcoming fund -- its sixth, aimed at raising $7.5 billion -- that Lee wouldn't be managing investments, people familiar with the pitch said.

LOTS OF FURY. Lee has been looking for junior associates to help with his personal-investing venture, according to people at competing firms. Lee "has been phasing out over the last couple of years," says a person familiar with the firm. "He may look at doing some smaller deals now." Lee wasn't available for comment.

Lee's decision to strike out on his own comes at a tough time for his namesake firm, which is grappling with the bankruptcy of Refco (see BW Online, 10/17/05, "Refco's Painful Lessons for Investors"). Lee's firm purchased 57% of Refco in 2004 for $507 million and took the derivatives dealer public only two months ago. People at the firm have told recent visitors that they were blindsided by the problems at Refco and are furious that Lee's reputation has been tarnished by the debacle.

The Refco scandal ignited on Oct. 10 when the company said there was evidence its chief executive, Phillip Bennett, had hidden a $430 million debt for years, and that its financial statements going back to 2002 were unreliable (see BW Online, 10/17/05, "The Family Man Behind Refco's Woes"). The resulting crisis of confidence saw Refco shares plunge from more than $28 two weeks ago to under $1 following its Oct. 17 bankruptcy filing. Bennett has declined comment to the media, and his attorney has asserted his client is innocent of wrongdoing.

DELICATE SITUATION. The hidden debt wasn't uncovered when Lee's firm bought a large chunk of Refco, or when a group of underwriters led by Credit Suisse Group's (CSGN.VX) Credit Suisse First Boston took the company public. "If a CEO wants to commit fraud, he can probably do it successfully," says Kevin Landry, who heads Lee competitor TA Associates in Boston but defends Lee's involvement. "It's rare to be totally fooled but it's not an endangered species."

The fallout from Refco means Lee's firm may have to delay plans or lower its sights in regard to the new fund. "This is going to be painful for them for a while beyond just the lost money on the [Refco] investment," says Steven Kaplan, a professor at the University of Chicago Graduate School of Business who specializes in the private-equity market. Some investors in prior Lee funds say Thomas H. Lee Partners should wait until the Refco situation clears up and regulators complete their probes.

That's not because they think anyone at Lee's firm will be implicated. Rather, investors such as public pension funds are loath to be associated with negative publicity surrounding a scandal. More importantly, many funds have bylaws requiring them to have firms sign a "no-bad-actors" letter, promising that no one it employs has been convicted of violating securities laws.

It's a formality, but one nonetheless that becomes trickier to fulfill when there are active regulatory and potential criminal investigations underway. "If [Lee's firm] went ahead now, you have to believe that they'd lose some of the limited partner [investors] they had in the past," says an investor in the current Lee fund.

TRACK RECORD. Thomas H. Lee Partners asserts it has no plans to delay the upcoming fund, a person familiar with the firm said. The firm is still looking for formal commitments from investors early next year, the person said. People at the firm are confident they'll be able to raise at least $7.5 billion and won't be charged with any wrongdoing because of Refco, the person said.

The firm has told investors that even if Refco's stock is worthless, the current $6.1 billion fund started in 2000 will sport a return better than 90% of funds started at the same time, thanks to winners like Warner Music Group (WMG) and Transwestern Publishing. The fund put up $450 million of the Refco purchase price and has previously gotten back about $210 million, a person familiar with the firm said.

Even if the Lee firm delays its upcoming fund or seeks less money than planned, its long track record of success ensures that it's still a desirable destination for big institutions such as pensions and endowments, investors said. "We are trying to get as much money as we can into private equity, and they won't have a problem as long as nothing worse comes out," says one current Lee investor.

METEORIC RISE. Even before Refco, Lee's firm knew that Lee wanted to move onto other activities. Last September, Thomas H. Lee Partners quietly named three younger men as co-presidents: Anthony DiNovi, Scott Schoen, and Scott Sperling. Sperling is credited with leading the firm's $2.6 billion takeover of Warner Music in 2003. Schoen, who served on Refco's board, heads a committee digging into its problems. Lee was on Refco's board and is involved in the salvage effort as well.

Thomas H. "Tommy" Lee, a Harvard graduate who grew up in the Boston suburbs, started his career as an analyst at L. F. Rothschild in New York. He joined the Bank of Boston in 1968 and rose to head the unit that was lending to high-technology firms.

He then started his own buyout firm in 1974, initially concentrating on companies like those he was lending to previously. As the firm grew, so did the size of Lee's deals. Lee was often seen chomping on a cigar around the office, and some compare him to the fictional private-equity banker Thomas Crown played by Pierce Brosnan in the 1999 movie, The Thomas Crown Affair.

"CAPITAL SLOSHING AROUND." By looking for smaller companies to purchase, Lee is moving in the opposite direction to the private-equity industry, where huge, record-breaking funds are the order of the day. Just this year, Lee competitors at Goldman Sachs (GS) have raised $8.5 billion in funding; Warburg Pincus LLC, $8 billion; and the Carlyle Group garnered $10 billion in the U.S. and abroad. The Blackstone Group has more than $10 billion for its next fund and is still raising money.

The University of Chicago's Kaplan is worried that it's too much money, and that future investment returns may suffer -- as happened in the late 1980s. "The last time you had so much capital sloshing around and easy [lending] markets, a lot of deals were done with marginal companies that probably shouldn't have been," he warns.

Of course, as the big buyout funds look for larger target, that may leave abundant choices of smaller prey in the thicket for investors such as Tommy Lee.

Pressman is a correspondent in BusinessWeek's Boston bureau


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