The fact that private equity contracts are costly to negotiate yet very much skewed toward the fund managers, aka general partners, is hardly news to those who have been paying attention. Yet it serves as the centerpiece of an important article, High-End Bargaining Problems, by William Clayton, which we have embedded at the end of this post. And that’s because the law and economics movement has placed contract negotiation between sophisticated players on a pedestal, and has mistakenly fantasized that private equity negotiations are battles of titans and therefore must produce virtuous outcomes.
Clayton’s piece, as written, does a fine job of kneecapping the “law and economics” Panglossian celebration of the negotiation of contracts as ever and always producing the best outcomes. There are more deficiencies with these negotiations which we regard as important and will discuss in this post Clayton may have decided not to include them because they’d be more difficult to substantiate or might (correctly) depict the investors (the “limited partners”) in a negative light. Clayton would have reason to go easy on them to maintain access. Their cooperation was important for this paper; his survey of 70 investors is a key part of his evidence and has details that are likely new to those not actively involved in private equity. The biggest is that the investors spend most of their energies on trying to negotiate a better deal via individual side letters, rather than improving the terms of the limited partnership agreement.
They define it as maximizing the economic surplus that both parties can obtain, and then devising a suitable division of that pie. Clayton is particularly well suited to this task. He worked for Wachtell Lipton and Simpson Thatcher and was a member of the private funds practice.
For the benefit of those of you who’ve had limited contact with law and economics, we’ll give a brief background first and then turn to the paper proper. Note that it cites our “Document Trove” of limited partnership agreements as an illustration of outsider unhappiness with poor disclosure in private equity, given that US public pension funds are its single biggest source of capital.
Background: How the Law and Economics Movement Gave Business the Upper Hand
We’ll hoist from ECONNED:
The third avenue for promoting and institutionalizing the “free market” ideology was inculcating judges. It was one of the most far-reaching actions the radical right wing could take. Precedents are powerful, and the bench turns over slowly. Success here would make the “free markets” revolution difficult to reverse.
While conservative scholars like Richard Posner and Richard Epstein at the University of Chicago trained some of the initial right-leaning jurists, attorney Henry Manne gave the effort far greater reach. Manne established his “law and economics” courses for judges, which grew into the Law and Economics Center, which in 1980 moved from the University of Miami to Emory in Atlanta and eventually to George Mason University….
Manne approached his effort not simply as education, but as a political movement. He would not accept law professors into his courses unless at least two came from a single school, so that they could support each other and push for others from the law and economics school of thought to be hired.
The program expanded to include seminars for judges, training in legal issues for economists, and an economics institute for Congressional aides. A 1979 Fortune article on the program noted that the instructors “almost to a man” were from the “free market” school of economics.60 Through 1980, 137 federal district and circuit court judges had finished the basic program and 56 had taken
additional “advanced” one-week courses.
It is hard to overstate the change this campaign produced, namely, a major shift in jurisprudence. As Steven Teles of the University of Maryland noted:
In the beginning, the law and economics (with the partial exception of its application to antitrust) was so far out of the legal academic mainstream as to be reasonably characterized as “off the wall.” . . . Moving law and economics’ status from “off the wall” to “controversial but respectable” required a combination of celebrity and organizational entrepreneurship. . . . Mannes’ programs for federal judges helped erase law and economics’ stigma, since if judges—the symbol of legal professional respectability—took the ideas seriously, they
could not be crazy and irresponsible.
Now why was law and economics vantage seen as “off the wall?” Previously, as noted above, economic thinking had been limited to antitrust, which inherently involves economic concepts (various ways to measure the power of large companies in a market). So extending economic concepts further was at least novel, and novel could be tantamount to “off the wall” in some circles. But with hindsight, equally strong words like “radical,” “activist,” and “revolutionary” would apply.
Why? The law and economics promoters sought to colonize legal minds. And, to a large extent they succeeded. For centuries (literally), jurisprudence had been a multifaceted subject aimed at ordering human affairs. The law and economics advocates wanted none of that. They wanted their narrow construct to play as prominent a role as possible.
For instance, a notion that predates the legal practice is equity, that is, fairness. The law in its various forms including legislative, constitutional, private (i.e., contract), judicial, and administrative, is supposed to operate within broad, inherited concepts of equity. Another fundamental premise is the importance of “due process,” meaning adherence to procedures set by the state. By contrast, the “free markets” ideology focuses on efficiency and seeks aggressively to minimize the role of government. The two sets of assumptions are diametrically opposed.
The Misguided Idealization of Contract Negotiation and Private Equity Negotiations in Particular
Clayton throws down the gauntlet in his overview:
Traditional law and economics theory places great confidence in the ability of contracting parties to bargain for optimal contracts, and the law reflects this confidence in many important ways. In this Article, I question the wisdom of a formalistic faith in bargaining by uncovering significant flaws in the bargaining process at the high end of the market, where parties are sophisticated and have substantial resources to aid them in bargaining.
My analysis focuses on the private equity fund industry, which is widely regarded as one of the most elite and sophisticated contracting spaces in the market. There are few industries where parties are better-positioned to bargain for optimal outcomes, but a careful review reveals many problems. Drawing on proprietary survey data and dozens of conversations with industry participants, this Article offers an in-depth analysis of problematic bargaining practices in private equity funds.
These bargaining problems raise a difficult question for scholars and policymakers: If theory does not reflect reality in the high end of the market, what can be expected in other areas where parties are less sophisticated and have fewer resources? These findings call for greater skepticism of formalist assumptions about bargaining across the market more broadly, with important implications for contract law, the law of business organizations, and securities law.
Clayton explains why private equity has been assumed to represent the apotheosis of good negotiating outcomes:
The private equity fund industry has many characteristics that theoretically should make it an ideal contracting space. First, the investors in the industry generally must satisfy investor qualification standards that are higher than the baseline standard typically required for investing in private markets. As a result, this industry is dominated by institutional investors that should have sufficient resources to hire capable in-house lawyers and/or external lawyers. Second, because private equity funds are typically dissolved after about ten years and institutional investors tend to diversify their investments across managers, the in-house lawyers at many of these institutions participate in a high volume of fund investments each year, making them particularly experienced in these types of transactions. Third, the limited life of private equity funds also means that there are fewer potential contingencies for the contracting parties to account for than in most operating businesses, which typically have an indefinite life when they are formed. Finally, the limited life of private equity funds means that this is an industry built on repeat transactions, a factor that should give managers and investors strong reputational incentives and facilitate greater trust and reliance on the contracts entered into by the parties. For all of these reasons, the parties in this industry are unusually well-positioned to bargain for optimal outcomes.
Clayton then goes on to recount some of the issues we’ve covered long-form here over the years, starting with the results of the initial Dodd-Frank-mandated SEC examinations of private equity firms. SEC chair Mary Jo White and exam chief Andrew Bowden described how they’d found serious violations, including what amounted to embezzlement (the SEC was too cowed to say so in simple English) and that unlike other areas it oversaw, many of the abuses were perpetrated by the most prominent players in the industry. Recall that the SEC decided rather than take the industry on and keep riding herd on misconduct, it instead went after various marquees for one deal and nearly always one type of misconduct per firm, irrespective of the actual amount and value of underlying abuses. They generally consisted of violations of their own limited partnership agreements via charging fees not agreed to (as in the aforementioned embezzlement) like “termination of monitoring fees” and self-serving allocation of broken deal expenses.
The SEC tried to act as if all this cheating was the result of misunderstandings or sloppiness, and of course these big prestigious firms would now keep their hands out of the cookie jar, particularly since the SEC also presumed that the limited partners, now wiser, would ride herd on them. That didn’t happen, as confirmed by our 2020 post: SEC Issues Devastating Risk Alert on Private Equity Abuses; Effectively Admits Failure of Last 5+ Years of Enforcement.
Clayton also mentioned another proof of the inability of limited partners to get satisfaction from general partners, which led 13 prominent public pension trustees to write the SEC asking for help (see our critique: Our Bloomberg OpEd on Public Pensions’ Failure to Stand Up to Private Equity Stealing and Other Abuses).
Clayton does dryly note, “Formalist law and economics models would never anticipate that such a thing [an SEC examination unit] would be necessary in this high-end contracting space.” But instead of relying over-much on the sorry history of this effort, Clayton describes how the results of private equity bargaining diverge from law and economics fantasy, with considerable backup:
Private equity fund contracting flies in the face of formalist expectations about bargaining in other ways as well. For example, law and economics scholars theorize that sophisticated parties will bargain for optimal non-price contract terms regardless of how the balance of bargaining power is distributed between them. The basic logic—which is elegant in theory—is that sophisticated parties to any voluntary arrangement will agree to final terms that maximize the collective surplus generated by the transaction they are entering into, after which they will split that surplus through the price term.
Yves here. I need to interject. I’ve repeatedly pointed out that in finance, every problem can be solved by price. But that does not mean it will be solved by price, as strong-form law and economics touts assert.
Back to Clayton:
However, in practice this is not how the private equity industry works at all. Across the industry, non-price terms relating to the governance of the fund vary greatly depending on the balance of bargaining power between managers and investors.14 More generally, many scholars over the years have criticized the substance of common private equity fund terms, arguing that they are one-sided and unlikely to maximize the joint welfare of all parties involved.
Yves again. “One-sided” while accurate, manages through its bloodlessmess to understate how unfavorable these agreements are. One of the world’s richest men, not all that long ago, hired a top M&A lawyer who’d gone into solo practice to review a private equity limited partnership agreement. The lawyer was excited, since he’d never read an LPA before and from his prior life, was sensitive to how transaction/investment contracts were tightly drafted, with literally every word mattering.
He emerged after a two day review and told a colleague “People really sign these documents?”
Back to Clayton:
In addition to these problems with substantive contract terms, there are also many problems with the process by which private equity fund agreements are bargained. The process is unusually time-consuming and costly, with most of the time being spent on the negotiation of individual side letters outside the primary fund documents. Moreover, bargaining incentives are distorted in private equity funds because fund investors typically pay nearly all of the manager’s legal fees for negotiation of the fund documents (in addition to their own legal fees). This makes investors particularly sensitive to legal costs associated with bargaining, and makes managers far more insensitive by comparison. Finally, information flows in the market are extremely restricted due to confidentiality provisions, which makes it difficult for investors to benchmark and compare contract terms across the market.
Moreover, in addition to problems with the substance of private equity fund terms and the process by which contracts are formed, scholars have identified various ways in which private equity investors face perverse incentives. These include agency problems that arise when the interests of staff members within institutional investors deviate from the interests of the institution’s beneficiaries, coordination problems that cause investors to bargain in sub-optimal ways, and perverse incentives to avoid liability under the federal securities laws.
Finally, this Article also presents new survey data that reveals new problems with bargaining in private equity and also reinforces the relevance of many of the problems identified above…. Drawing on a private dataset of survey responses from 70 institutional investors, this data shows that information flows are even more restricted in private equity funds than previously known, that the private equity fund bargaining environment is even more fractured than has been documented in the literature, and that the private equity industry deviates even more from the bargaining power irrelevance proposition than previously understood.
Needless to say, this evidence, particularly the detail from the investors themselves, is more than sufficient to prove Clayton’s thesis. But we’ll provide some additional shortcomings with private equity bargaining below.
Why the General Partners Have the Upper Hand in Private Equity Negotiations
To keep this post to a manageable length, we’ll limit ourselves to a few additional issues:
One-to-many negotiation. The law and economics “battle of titans” myth assumes one to one contract negotiation. Here you have one to many. No institutional investor wants to represent more than 10% of a private equity fund (unless it is a “fund of one” or a dedicated fund, but those are typically side vehicles that parallel a flagship fund).
Clayton acknowledges but does not stress this issue (he does point out that investors face a free rider problem: why should they do the heavy lifting to improve terms for everyone?) Limited partners do not band together to demand better terms. They often hide behind the excuse that doing so would constitute an anti-trust violation. Experts beg to differ. The bigger impediment is that even if investors were willing to sit down to try to hammer out a joint negotiating position, they aren’t likely to agree on much. Even supposedly similarly positioned public pension funds often have very different ideas as to which issues matter to them most.
Perception that private equity is a “must have” investment. Institutional investors follow the dictates of modern portfolio theory, if nothing else, to escape liability. Among other things, that requires investing in every available asset class so as to assure that the investor is on the efficient investment horizon. Private equity have been deemed to be an asset class even though it isn’t. As CEM Benchmarking pointed out in a recent major paper, private equity returns are lagged, typically reported a quarter late. So “year end” public pension fund returns are usually as of June 30 for public market and hedge fund investments, but with private equity results as of March 31.
But as CEM showed, confirming the work of some academics, when the timing of returns is put on an apples to apples basis, private equity very closely correlates with public equity returns. That means it’s really simply levered equity and not a bona fide asset class.
But investment consultants like Wilshire still accept the inaccurate private equity timing as well as other distortions, such as “smoothing” or understating how low valuations are in bear markets. Those factors make private equity looks far more attractive than it is, and again makes it look like a “must have”. As we’ve explained, in reality, private equity has failed to deliver high enough returns to justify investing it for over a decade; Oxford professor Ludovic Phalippou found that private equity hasn’t outdone public stocks since 2006.
So investors, particularly return-starved long term investors like pension funds and life insurers can’t “just say no” to private equity. That greatly reduces their bargaining power.
General partner law firms “cartelizing” contract terms. Even though there differences in many terms across firms (for instance, few are as cheeky as Apollo in providing for indemnification of some types of criminal acts) the difference between the most general partner favorable and the least isn’t all that great (the Japanese call this phenomenon “a height competition among peanuts”).
The law firms that represent general partners play a role in preventing one general partner’s terms from departing too much from industry norms. For instance, one established medium-large general partner wanted an additional disclosure requirement. Simpson Thatcher, arguably the top law firm in private equity, hotly opposed the change and backed down only when the head of the firm insisted on it.
In another case, a newbie general partner planned to engage an expert to advise him on how to structure the most limited partner-friendly contract. He had to abandon his idea when his law firm, a top international firm but not one of the leaders in private equity, flat out refused to draft such an agreement.
Anchoring. Many of the key provisions in limited partnership agreements were set in the 1980s, when public pension funds started investing in leveraged buyout funds. Typical returns were 30% to 40%. Investors weren’t about to quibble about contract terms to get such juicy returns. Even though Clayton points out that the stringency of various provisions ebbs and flows with the ease of fundraising, in reality these changes are around an unfavorable baseline and don’t do much to change the basic nature of the deal, that the general partners call the shot and the limited partners have effectively no veto rights and poor disclosure.
While it is gratifying to see a promising academic join the ranks of private equity skeptics, the industry so far has proven to be immune to the considerable evidence that it is both on balance destructive to the real economy and not so hot for investors either. But there are far too many people feeding from the trough for this to change any time soon.00 SSRN-id3900197