What Price Reputation?

Steven Davidoff is a Professor of Law at the University of Connecticut. This post is based on a paper by Professor Davidoff, Matthew D. Cain of the University of Notre Dame, and Antonio J. Macias of Texas Christian University.

In Broken Promises: Private Equity Bidding Behavior and the Value of Reputation, a paper recently made public on the SSRN, we examine the relation between reputation and financial contracting.

Beginning in August 2007, a number of private equity (PE) firms attempted to strategically default on pending acquisitions of publicly-traded targets. These attempts succeeded in a number of notable instances. We document that bidder-initiated terminations accounted for over $168 billion of transaction values announced in 2007 alone, representing an economically sizeable 39% of total announced private equity bids in 2007.

The large number of defaults represented a collapse of the prior relationship between the PE industry and targets. Prior to this wave of contract terminations, a promise between a private equity partner and target management set in motion a tacit relationship based primarily on trust and reputation but not contract. An unwritten rule held that private equity firms do not back out of their arrangements to acquire takeover targets despite the ability to do so under their formal contractual agreements. In other words, the private equity relationship with a target was one in which reputation played an important role. The trade-off between reputation and buyout losses reached a tipping point in 2007-2008 as many financial sponsors faced potential losses in the $billions on their bids for target firms of declining value. The extreme circumstances faced in the recent financial crisis thus provide a natural experiment to examine PE bidding behavior in relation to the value of reputation and contract design.

Our paper does so by examining the contracting structure in a novel dataset of 227 private equity buyouts of U.S. targets from 2004-2010. We show how contract structure is related to private equity strategic defaults during the financial crisis and ex post litigation settlements. Consistent with economic theory, private equity firms were more likely to engage in contract nonperformance when default penalties were lower. Contract structure is economically significant: a one standard deviation decrease in the reverse termination fee increases the predicted probability of contractual nonperformance by 8.7%, and predicted nonperformance increases by 6.0% when third party enforcement (i.e., specific performance) is unavailable.

Using details of target valuation changes and contract default penalties, we estimate the gains from backing out of these contracts. These gains approximate the values that bidders place on their reputations, which range from 5% to 9% of the sponsors’ fund sizes, or $180 million to $2.5 billion in nominal dollars. We find that sponsors are willing to bear losses of up to 5% of their fund sizes despite the implied reduction in current and future general partner income resulting from lower portfolio returns.

We also assess the reputational damage resulting from the wave of terminations during the financial crisis and find evidence consistent with models of collective reputation. Specifically, the private equity industry as a whole appears to have suffered a general decline in the credibility of its reputation among targets and transaction lawyers, the effects of which are evident in the explicit contracting process. We find only minor individualized penalties against specific sponsors for their own behavior. Instead, the costs of default are largely borne by the entire industry, suggesting that sponsors face a moral hazard problem when it comes to contractual performance decisions. Expected default penalties for both defaulting and non-defaulting PE firms have more than doubled following the wave of terminations, with median reverse termination fees rising from 2.2% pre-crisis to 4.7% post-crisis, a 115% increase. However, the higher default penalties appear primarily among transactions in which the target hires a legal team that has prior experience representing PE bidders.

Ultimately, the results demonstrate that in even the most complex transactions subject to financial contracting, reputation and collective group behavior play an essential role in the negotiating process.

The full paper is available for download here.

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