Private Equity Firms as Gatekeepers

The following post comes to us from Elisabeth de Fontenay, a Climenko Fellow at Harvard Law School.

My article, Private Equity Firms as Gatekeepers, identifies an important and overlooked way in which private equity creates value: private equity firms act as gatekeepers in the debt markets. As repeat players, private equity firms establish reputations with lenders that are tied to the credit performance of the companies that they acquire and manage. In turn, private equity firms use their reputations both to certify the creditworthiness of their companies ex ante and to bond against misconduct or poor performance by their companies ex post. Private equity firms thereby mitigate the problems of borrower adverse selection and moral hazard that plague the debt markets. These certification and bonding functions of private equity are best understood as gatekeeping: by causing companies to behave better toward creditors than they otherwise would, private equity firms afford companies access to more capital, and on better terms, than they could otherwise get. The article provides both conceptual and formal proofs of this gatekeeping hypothesis.

The most obvious benefit from private equity’s gatekeeping role is that, all else being equal, it should allow private equity-owned companies to borrow money on better terms than other companies. And crucially, this role will become increasingly valuable in light of sweeping changes in the corporate loan markets. Lenders’ traditional methods of controlling borrower adverse selection and moral hazard – screening, monitoring, and covenants – are in sharp decline. This decline is due to the major shift from relationship banking, in which a company borrows from a single bank that holds the loan until maturity, to syndicated lending. Syndicated loans are funded by large numbers of unrelated creditors and may be traded or securitized to reach still more creditors. As the chain from the borrowing companies to their ultimate creditors lengthens, the information gap between them increases significantly, while creditors’ incentives to monitor their borrowers decline. If private equity firms can credibly fill the void in monitoring left by lenders, their companies will get significantly better financing than other companies.

The article advances the literature on private equity by revealing that private equity firms’ value lies at least as much in their ability to broker cheap debt as in their routinely-touted expertise with “turnarounds” and corporate governance. Private equity firms lend companies not only their operational expertise, but also (and perhaps more importantly) their financial reputations. The article also advances the literature on gatekeeping, by demonstrating that there is a broader array of gatekeepers in the debt markets than the credit rating agencies that are the focus of current gatekeeping scholarship, including “insider” gatekeepers such as private equity firms.

Of course, private equity firms cannot eliminate borrower adverse selection and moral hazard; they can only mitigate them. The article therefore identifies potential limitations on the gatekeeping role of private equity firms and compares their performance to that of credit rating agencies.

Finally, the article argues that the recent Dodd-Frank Act is likely to impede private equity’s gatekeeping function. Under this legislation, most private equity firms are now required to register as investment advisers under the ’40 Act. Like mutual fund managers, private equity firms will now be subject to additional disclosure obligations, compliance requirements, anti-fraud liability, and non-waivable fiduciary duties, above and beyond what investors in their funds may have contracted for. ’40 Act registration will make private equity firms more accountable to their investors. Though this might seem uncontroversial, the end result is likely to be lower returns for these investors. To successfully perform their gatekeeping function, private equity firms must have the leeway to forego short-term opportunities to profit at creditors’ expense in order to maintain their long-term reputations with creditors. This privileging of long-term reputation maximizes returns for investors in private equity funds as a whole and over time.

The problem is that investors in private equity funds do not have the same incentive as the private equity firm to preserve the latter’s reputation indefinitely. Unlike the private equity firm, the funds have finite lifecycles. Particularly at the end of a fund’s investment period, investors will want the private equity firm to maximize short-term profits at the expense of its long-term reputation, because they have already benefitted to the maximum extent from the firm’s reputation and will bear none of the future harm from sacrificing it. The fiduciary duties imposed by the ’40 Act may well require private equity firms to accede to such demands from investors in each fund. Thus, making private equity firms more accountable to their investors will impede private equity firms’ gatekeeping function, ultimately harming private equity investors as a whole, and forfeiting the efficiencies that private equity firms introduce to debt markets. In the absence of obvious benefits from ’40 Act registration of private equity firms, this is an unfortunate policy choice and, notably, one that investors did not ask for.

The full article is available for download here.

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